IRS Issues Rare Insight into IRC Section 1202 – Qualified Small Business Stock

In early April, the IRS released Private Letter Ruling (PLR) 202114002 in response to a request by a business seeking to determine if it is considered a qualified trade or business under IRC Sec. 1202. A PLR is a written statement issued to a taxpayer (upon request) that interprets and applies tax laws to the taxpayer’s represented set of facts.  Generally PLRs do not make headlines; however, since the enactment of IRC Sec. 1202 in 1993, very little guidance has been issued by the IRS on this crucial tax provision.

The Importance of IRC Sec. 1202

IRC Sec. 1202 was enacted with the goal of encouraging long-term investment in startup companies and other small businesses by exempting capital gains taxes upon the sale of stock in these entities. Accordingly, IRC Sec. 1202 allows holders of qualified small business stock (“QSBS”) to exclude 50% to 100% of capital gains upon the sale of QSBS provided the stock meets all of the criteria of IRC Sec. 1202.  IRC Sec. 1202 allows eligible taxpayers to exclude the greater of $10 million or 10 times the taxpayer’s basis in the QSBS sold.

PLR 202114002

In the recently issued PLR, a taxpayer that operates as an insurance agent/broker requested a PLR to determine whether their business is engaged in “brokerage services,” which would not be a qualified trade or business for purposes of IRC Sec. 1202.

The business works with its customers to obtain insurance, including property, casualty, surety, worker’s compensation, employee benefits, personal and medical, and professional practice insurance. The business acts as either a representative or appointed agent of insurance companies or as an agent appointed with a general wholesale agent. The taxpayer operates under two general business models.

First, it has contracts with insurance companies (referred to as "direct appointments") to sell a product. Insurance companies use this model to select and control who can sell the company's products. For example, an insurance company may only want to work with certain agents capable of a certain sales volume, thus excluding smaller agencies. The business generates revenue directly from the insurance company, often in the form of commissions and other similar compensation arrangements paid either directly from the insurance company or through withholding on a portion of a customer's premium payments. Contracts with insurance companies require the business to perform a number of administrative services. For example, the business must report all known incidents, claims, suits and notices of loss to the insurance company or its designated claims adjuster and cooperate fully to facilitate any investigation, adjustment, settlement and payment of any claim.

Second, the business also contracts with insurance wholesalers. Under this model, the business has a contract with a wholesaler and not an insurance company, and these wholesalers contract with multiple insurance companies. The business selects an appropriate policy for a customer provided by a wholesaler. If the customer accepts the policy, the wholesaler procures the policy from the insurance company.

The Internal Revenue Code does not define the term brokerage services in the context of IRC Sec. 1202.  Therefore, the IRS turned to the dictionary definition of the word. The dictionary defines a broker as a mere intermediary to a transaction, such as a stock broker or real estate agent. Given that the business provides many administrative services well beyond what a mere intermediary would typically provide, the IRS concluded that the taxpayer is an eligible trade or business under IRC Sec. 1202 and thus not an excluded brokerage business. The recently issued PLR is a welcome development for businesses seeking clarity on the rules of QSBS. However, it is important to note that a PLR can only be cited as precedent for the requesting taxpayer. A tax professional should be consulted in order to determine potential IRC Sec. 1202 eligibility.