Capital gain treatment may depend on 'active business'

Owners of qualified small business stock, other than shareholders who are corporations, may elect to roll over capital gain from the sale of the stock.

To qualify for rollover treatment, replacement small business stock must be purchased within 60 days of the date of sale, and both corporations must be engaged in active businesses.

A recent Tax Court case (John P. Owen, et ux., et al. v. Commissioner, TC Memo 2012-21, Jan. 19, 2012) involved a transaction in which John Owen sold his stock in FFAEP, a corporation actively engaged in the business of selling prepaid legal service policies and estate planning services. Owen received about $2 million for his shares, resulting in a gain of almost $1.9 million.

Within 60 days of the sale, Owen formed J&L Gems, Inc., as a retail jewelry business and deposited the proceeds from the FFAEP sale in J&L's account. During its first six months of operation, J&L purchased 16 pieces of jewelry at a total cost of less than $150,000. For its first year of operation, the company reported six sales grossing about $12,000, and three of those sales were to friends or parties related to Owen.

Based on the facts presented, the Tax Court determined that J&L did not meet the active business requirement set forth in the tax law. The law requires at least 80 percent of the corporation's assets to be invested in the active conduct of one or more qualified trades or businesses. Only 8 percent of the amount invested was in inventory with the balance in cash. As a result, Owen was taxable on his capital gain from the sale of the FFAEP stock.

It was not enough for Owen to form and capitalize a new corporation during the 60-day rollover period. He also had to demonstrate that the new corporation was engaged in an active business. According to the court, having 92 percent of the corporation's assets in cash did not meet the active business requirement.

Owen was also assessed the substantial understatement of tax penalty of 20 percent. The Tax Court concluded that Owen failed to follow his tax adviser's advice.

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