People are stupid. No, no…not you. You’re sharp as a tack. I was referring to everyone else. Those other people, well, they’re the reason we have to put the protective language on the side of this website that reads:
The items in this blog are informational only and are not meant as tax advice. Consult with your tax advisor to determine how any item applies to your situation.
If we didn’t, readers would base their critical tax decisions on a blog post rife with toilet humor and Simpsons references, and we can’t have that.
Consider the case of Ralph Holmes. Holmes, by all indications, was one of the “smart” ones; he was a surgeon after all. But even the brightest among us occasionally put the batteries in the remote backwards, and it appears Holmes chose to let his intellectual guard down when preparing his tax return.
In 1997, Holmes founded a C corporation, receiving 1,000,000 shares of stock in MacroPore Corporation for 1 cents per share. In 2000, Holmes cofounded another C corporation, LeonardoMD, Inc.
During 2000, Holmes decided to start selling his shares of MacroPore so he could acquire more shares of LeonardoMD. Between 2000 and 2004, Holmes sold 972,500 of his 1,000,000 MacroPore shares, generating nearly $3,000,000 in capital gains. The gains, however, were never reported on Holmes tax returns. And why not?
Because one of Holmes’ coworkers told him he had “read an article” concerning a tax provision that permits taxpayer to roll over gain from a startup company into another startup company and defer the tax.
The provision in reference, of course, is Section 1045, which does permit a taxpayer (other than a corporation) to defer recognizing gain from the sale of qualified small business stock that is reinvested within 60 days into additional qualified small business stock. The problem is, Holmes never bothered to read Section 1045. In fact, there’s no evidence that Holmes even bothered to read the article his coworker referenced. Instead, he just heard “your gain can be deferred,” and ran with it, neglecting to report the gains on his 2000-2004 returns.
Had he actually read Section 1045, Holmes would have realized that there are a number of statutory hurdles that must be met before a taxpayer can defer gain on the sale of stock under this provision, including:
- The sold stock must be held more than six months;
- Both the stock sold and the stock purchased within 60 days must be a “qualified small business stock.” This is further defined as a C corporation that has aggregate gross assets of less than $50 million before and after the issuance;
- The stock must be acquired at its “original issuance;” in other words, the individual must put the cash into the corporation in exchange for stock. The stock cannot be purchased from an existing shareholder.
- Lastly, and most importantly, Section 1045 deferral must be elected. It must be elected by the due date (including extensions) for filing the income tax return for the year in which the stock is sold. Generally, it’s elected by reporting the gain in full on Schedule D, and then removing the gain on Schedule D by showing the amount deferred as a capital loss.
Because Holmes failed to timely elect to defer the gain — and in fact, never reported the gain at all – the Tax Court refused to allow any deferral. Furthermore, the court noted that Holmes could not prove that the two corporations qualified as “qualified small businesses,” as he failed to provide evidence that both corporations had assets less than $50,000,000, and it appeared that some of the stock in LeonardoMD was purchased from an existing shareholder rather than acquired at original issuance.
The lesson? Read the statute. Better yet, hire a tax professional to read the statute for you.