This goes without saying, but the Internal Revenue Code is needlessly complicated. It reads as cleanly as Chinese arithmetic, rife with exceptions to exceptions, meandering cross-references and nuanced requirement after nuanced requirement. Miss or misinterpret just one, and all of your best laid tax planning efforts could go for naught.
Consider the case of John Owen (Owen), where a failure to meet one of several statutory requirements cost Owen a $2,000,000 tax deferral.
Owen built a corporation up from scratch, eventually selling the stock and realizing a $4,000,000 capital gain. Hoping to defer a portion of the gain, Owen enlisted the help of a CPA, who advised Owen of the potential for deferral provided by I.R.C. § 1045.
Under I.R.C. § 1045, a taxpayer other than a corporation can defer gain on the sale of qualified small business “QSB” stock held for more than six months to the extent the taxpayer reinvests the proceeds from the sale in replacement QSB stock within 60 days from the date of sale.
In general, a QSB is a subchapter C corporation that:
- Has gross assets of less than $50,000,000 up to and immediately after the issuance of the stock to the taxpayer; and
- Meets an “active business requirement:” At least 80 percent (by value) of the assets of a QSB must be used by the corporation in the active conduct of one or more qualified trades or businesses”.[i]
In search of an adequate replacement investment, Owen decided to start a retail jewelry business, which Owen and his CPA determined would qualify as QSB stock and provide the sought-after deferral of the previously realized capital gain. Owen invested $2,000,000 of the proceeds from his stock sale into his new venture, J&L Gems, which in turn purchased sixteen pieces of jewelry for a total cost of $147,000 during its first two years of operation.
Believing that he had appropriately reinvested half of his proceeds from the sale of one QSB into another QSB within the requisite time period of I.R.C. § 1045, Owen excluded half of the $4 million capital gain on his tax return for the year of sale.
The IRS denied the deferral, arguing that J&L Gems failed to qualify as a QSB. The Tax Court agreed, holding that J&L Gems did not meet the active business requirement of I.R.C. § § 1045 and 1202:
…the active business requirement requires that at least 80 percent of the assets of the new corporation be used in an active trade or business. During the first 6 months J&L Gems purchased 16 pieces of jewelry for a total cost of $147,026. This is a mere 8 percent of the $1,916,827 deposited into J&L Gems’ account from the sale of FFAE. [Two]years after the money was injected, J&L Gems was still not using it. We hold that under the surrounding facts here the fact that 92 percent of J&L Gems’ assets were held in cash causes it to fail the active business requirement.
As for Mr. Owen, well, he just wanted to make it clear that he tried to meet the requirements of the Code:
My view of active business is just that. I went out and I purchased. I took the stock of this company and put it into the stock of this other company. I put the money from the sale of the company within the 60-day period he told me to put it in, and I started buying up gems. So in my opinion, I thought I was doing everything correctly.
The lesson? Neither the IRS nor the courts care about your best intentions. We’re stuck with the statute we’ve got, and it’s incumbent upon the taxpayer and his advisors to make sure that any tax planning strategy has the proverbial I’s dotted and T’s crossed.
[i]A “qualified trade or business” is further defined as any trade or business other than any ones involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.[i]
I.R.C. § 1202(c)(2)