Favorable IRS Ruling Issued on Qualified Small Business Stock
- Dec 13, 2023
On October 20 , 2023 the IRS released Private Letter Ruling (PLR) - 202342013. This is noteworthy because IRS rulings or guidance related to IRC Sec. 1202 are a rare occurrence. In the PLR the taxpayer was seeking to determine if their business is considered a qualified trade or business for purposes of IRC Sec. 1202.
The Benefits of IRC Sec. 1202
IRC Sec. 1202 was enacted in 1993 with the goal of encouraging long-term investment in startups and other small businesses by exempting capital gains from taxation on the sale of stock in these entities. Sec. 1202 allows holders of QSBS to exclude 50% to 100% of capital gains on the sale of QSBS (depending on date of purchase), provided the stock meets all of the following criteria:
- Issued by a domestic C corporation with no more than $50 million of gross assets at the time of and immediately after issuance;
- Issued by a corporation that uses at least 80% of its assets (by value) in an active trade or business, other than certain types of personal service businesses;
- Issued after August 10, 1993;
- Held by a non-corporate taxpayer;
- Acquired by the taxpayer on original issuance; and
- Held for more than five years.
For purposes of #2 above, under IRC Sec. 1202(e)(3), the following business do not qualify:
- Any trade or business 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 one or more of its employees.
- A banking, insurance, financing, leasing, investing, or similar business,
- A farming business,
- A business involving the production or extraction of products of a character with respect to which a deduction is allowable under IRC Secs. 613 or 613A, or
- A business operating a hotel, motel, restaurant, or similar business.
The percentage of gain on the sale of QSBS excluded from federal income tax is determined as follows:
- QSBS issued from August 11, 1993 - February 17, 2009 = 50% gain exclusion;
- QSBS issued from February 18, 2009 - September 27, 2010 = 75% gain exclusion;
- QSBS issued from September 28, 2010 - present = 100% gain exclusion.
The amount of gain eligible for exclusion is limited to the greater of $10 million or 10 times the taxpayer’s basis in the QSBS.
In the PLR, the taxpayer‘s business consists of data migration and management services. It does not sell software or technical equipment as part of the services it provides. The business will implement and troubleshoot the customer’s data migration. The taxpayer also provides post-migration managed technical services, which include monitoring and resolving incidents. The taxpayer does not separately bill for advice and counsel. The PLR was requested by the taxpayer in effort to determine whether their business is engaged in a qualified trade or business and is not specifically engaged in a disqualified trade or business involving the performance of services in the field of consulting.
The IRS concluded in its PLR that for purposes of IRC Sec. 1202, the business was a qualified trade or business. It concluded that the taxpayer is not engaged in a trade or business involving the performance of services in the field of consulting.
The key reasons stated by the IRS for its conclusions focused on why the taxpayer was not engaged in the field of consulting:
- The employees provide advice and counsel as part of the process of determining a client’s data management, but the advice and counsel is ancillary and supports the sale of the implementation work performed.
- The business does not separately bill for advice and counsel, but only for its final product of implementing data management solutions.
The PLR provides new insight into the definition of consulting services under IRC Sec. 1202. This is an important tax determination with the potential of millions of dollars in federal income tax savings for eligible stockholders. It should be noted that a PLR can only be cited as precedent for the requesting taxpayer.
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Benjamin Aspir is a Partner and a member of the firm’s National Tax Group, with more than 10 years of public accounting experience. He has extensive experience with IRC Section 1202 - Qualified Small Business Stock and advising cannabis clients on IRC Section 280E, within the Manufacturing and Distribution practice.
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