IRS Ruling Provides Insight into Section 1202 Qualified Small Business Stock

BY BENJAMIN ASPIR, CPA, MST, EISNER ADVISORY GROUP LLC

In late January 2022, the IRS released Private Letter Ruling (PLR) 202204007 in response to a request by a business seeking to determine if it is considered a qualified trade or business under IRC Sec. 1202. The PLR provided IRS insight into IRC Sec. 1202, a crucial tax provision.

IRC SEC. 1202 Section 1202 of the Internal Revenue Code 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. Section 1202 allows holders of qualified small business stock (QSBS) to exclude 50 percent to 100 percent of capital gains on the sale of QSBS, 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 percent of its assets (by value) in an active trade or business, other than in certain personal services and types of businesses

> Issued after Aug. 10, 1993

> Held by a non-corporate taxpayer

> Acquired by the taxpayer on original issuance

> Held for more than five years

The percentage of gain on the sale of QSBS excluded from federal income tax is determined as follows:

> QSBS issued from Aug. 11, 1993, to Feb. 17, 2009 = 50-percent gain exclusion

> QSBS issued from Feb. 18, 2009, to Sept. 27, 2010 = 75-percent gain exclusion

> QSBS issued from Sept. 28, 2010, to present = 100-percent 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.

PLR 202204007

A taxpayer that operates a business that facilitates the leasing of property between lessors and lessees requested a PLR to determine whether their business is engaged in the field of “brokerage services,” which would not be a qualified trade or business for purposes of IRC Sec. 1202.

The taxpayer’s website allows potential lessees to make non-binding reservations for the use of certain facilities at specified rental rates from lessors in the website database. The taxpayer has no authority to enter into or sign leases on behalf of the potential lessors or lessees. Potential lessees do not pay any fee to the business for the use of its website.

The taxpayer charges lessors a recurring fee for being listed in the database and a contingent fee based on a percentage of rent paid by a lessee leasing a facility from a lessor through the database. The taxpayer asserted to the IRS that it is not a broker with respect to the leasing of the facilities. The taxpayer also provided other services to lessors such as website building and hosting to be used in conjunction with the leasing of the lessor’s facility.

The Internal Revenue Code does not define the term brokerage services in the context of IRC Sec. 1202. Therefore, the IRS turned to several other Code sections and tax regulations that discuss the definition of “brokerage services” (IRC Secs. 199A, 448 and 6045). Additionally, the PLR discussed the dictionary definition of the word “broker.”

The IRS concluded in its PLR that the taxpayer should be classified as a broker under the common meaning of the term and as it is defined under IRC Sec. 6045, rather than the narrower definition that applies to IRC Sec. 199A. The IRS disagreed with the taxpayer’s assertion that its website merely provided an advertising service and was not a broker.

The IRS stated the following reasons for its position:

> The taxpayer did not merely passively publish advertisements on its website.

> The taxpayer’s website was solely devoted to effectuating agreements between potential lessors and potential lessees of certain property.

> The taxpayer was compensated on a commission basis based on leasing transactions that were entered into as the result of the use of its website.

> The taxpayer did not have the authority to enter into leasing agreements on behalf of lessors that use its services.

> The website was merely a vehicle for potential lessees to transmit non-binding reservation requests to potential lessors.

While the ruling is not favorable for the taxpayer, it provides much-needed clarity on the rules of QSBS. It is important to note that a PLR can only be cited as precedent for the requesting taxpayer.

Benjamin Aspir, CPA, MST, is a senior manager at Eisner Advisory Group LLC. He is the leader of the Federal Taxation Interest Group and can be reached at benjamin.aspir@eisneramper.com.