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The IRS recently released draft 2023 instructions to Schedule K-1 of Forms 1065 and 1120-S reflecting changes to the required disclosures for IRC Sections 1045 and 1202 gain. These gains are generally expected to be reported on Line 11 with new indicator codes as further described below. Partnerships and S Corporations should be mindful of these new reporting requirements assuming these instructions are finalized as is.

Schedule K-1 of Forms 1065 and 1120-S

Gain eligible for IRC Section 1045 rollover

IRC Section 1045 allows a shareholder who has disposed of qualified small-business (QSB) stock held for more than six months to defer gain on the sale when the shareholder purchases replacement QSB stock within 60 days of the date of sale. When the shareholder is a partnership, the partnership may defer the gain at the partnership level by reinvesting the proceeds directly. Alternatively, the partnership may choose not to defer the gain and instead allocate the gain to its partners; in this case, however, each partner may be eligible to defer its share of the gain by purchasing replacement QSB stock within 60 days of the date of sale. 

Replacement stock purchased by the partnership (Code M)

When the partnership purchases replacement stock, the partnership must report the following information to the partner for the gain eligible for an IRC Section 1045 rollover:

• The name of the corporation that issued the QSB stock
• The partner’s share of the partnership’s adjusted basis and the QSB stock’s sales price
• The dates the partnership bought and sold the QSB stock
• The partner’s share of the gain from the QSB stock sale
• The share of the gain the partnership deferred under IRC Section 1045

A partner is eligible to defer its allocable share of the IRC Section 1045 rollover if:

• The partner held an interest in the partnership for the entire period in which the partnership held the QSB stock.
• The partner’s share of gain eligible for the IRC Section 1045 rollover does not exceed the amount that would have been allocated to the partner based on the partner’s partnership interest at the time the partnership acquired the QSB stock.

The instructions clarify that corporate partners do not qualify for the IRC Section 1045 rollover.

Opting out of the IRC Section 1045 election

If the partnership purchases replacement QSB stock, a partner may opt out of the partnership’s IRC Section 1045 election. To opt out, the partner must notify the partnership, in writing, and either recognize the gain or elect to purchase different replacement QSB stock directly or through another partnership that acquired replacement QSB stock. If the partner chooses to recognize the gain, it must notify the partnership of the amount the partner is recognizing.

Replacement stock not purchased by the partnership (Code N)

If the partnership does not purchase replacement stock, it must still report to a partner most of the information required when replacement QSB stock is purchased, except it does not have to report the share of the gain deferred by the partnership. A partner qualifies for the IRC Section 1045 rollover if:

• The partner held an interest in the partnership for the entire period in which the partnership held the QSB stock.
• The partner’s share of gain eligible for the IRC Section 1045 rollover does not exceed the amount that would have been allocated to the partner based on the partner’s partnership interest at the time the partnership acquired the QSB stock.
• The partner purchases other QSB stock during the 60-day period that began on the date the partnership sold the QSB stock.

Sale or exchange of QSB stock with IRC Section 1202 exclusion (Code O)

IRC Section 1202 permits a shareholder to exclude gain attributable to the sale of QSB stock held for more than five years, subject to limitation. For gain that is eligible for an IRC Section 1202 exclusion, the partnership should report the following information to the partner:

• The name of the corporation that issued the QSB stock
• The partner’s share of the partnership’s adjusted basis and sales price of the QSB stock
• The dates the partnership bought and sold the QSB stock

Like the IRC Section 1045 rollover, corporate partners do not qualify for the IRC Section 1202 exclusion.

To qualify for the IRC Section 1202 exclusion, the partner must have held a partnership interest from the time the partnership acquired the QSB stock until it disposed of the QSB stock.  The partner’s share of the eligible IRC Section 1202 gain must not exceed the amount that would have been allocated to the partner based on the partner’s partnership interest when the partnership acquired the QSB stock.

Schedule K-1 of Form 1120-S

Disclosures similar to those required by partnerships are also required for S Corporations on Form K-1. On Schedule K-1 (1120-S), however, the relevant items are reported on Line 10 with the following indicator codes:

• Replacement stock purchased by the corporation (Code M)
• Replacement stock not purchased by the corporation (Code N)
• Sale or exchange of QSB Stock with IRC Section 1202 exclusion (Code O)

Implications

The changes to Schedule K-1 relating to IRC Section 1045 rollovers and QSB stock come on the heels of an uptick of partnership tax audits as part of the centralized audit regime enacted in the Bipartisan Budget Act of 2015. While the disclosures described previously were effectively required on previous versions of Schedule K-1, they were aggregated as part of Line 11 – Code I with a number of other income disclosure items. By separating items related to IRC Section 1045 rollovers and QSB stock, the IRS may better track this information. It is unclear if the separate disclosure is an indication that the IRS intends to scrutinize eligibility for an IRC Section 1045 rollover or QSB stock on a more regular basis, but partnerships and S Corporations should have proper support and documentation backing up the new K-1 disclosures if they are ever called upon to supply that documentation as part of an IRS examination.

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Published by NTD’s Tax Technical Knowledge Services group; Jennifer A Brittenham, legal editor