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Big Tax Break for Section 1202: Which Businesses Qualify

Big Tax Break for Section 1202 Stock: Which Businesses Qualify?

Big Tax Break for Section 1202: Which Businesses QualifyTax breaks are being pared, but one that remains is the ability of certain corporations to issue stock that owners will eventually be able to sell tax free. Gain on the sale of qualified small business stock, or QSBS (also called Section 1202 stock after the section in the Tax Code governing it) may be excludable up to $10 million from gross income. But there are many conditions for this tax break to apply. For starters, the corporation must be a C corporation; an S corporation cannot qualify. Another important condition is the type of business that the corporation conducts. Which businesses qualify? This can be problematic.

Basic rules

A qualified small business (QSB) cannot be one involving the provision of personal services. Specifically, this means businesses that perform services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services. It also bars corporations in banking, insurance, financing, leasing, or investing, as well as farming, mining, or operating a hotel, motel, or restaurant.

So what’s left? Businesses involved in manufacturing, retailing, technology, and wholesaling may be able to qualify.

Drilling down

The stakes are high… gain up to as much as $10 million won’t be taxed if the business is a QSB. The problem is that many of the prohibited businesses aren’t well defined. Various IRS informal rulings (which cannot be used as precedent but certainly indicate IRS thinking on a particular situation) try to flesh out the label from the underlying services to determine whether the corporation is a QSB. Here are 3 examples:

Website for leasing. A corporation ran a website on which lessees could make nonbinding reservations for the use of facilities at specified rates from lessors in the website’s data base. The corporation couldn’t enter into or sign leases on behalf of either parties; it was compensated by lessors for the listings. The corporation said it was only providing advertising services. The question: Is this brokerage services, which would mean disqualification as a QSB?

The IRS said the website conducted brokerage services. Absent a definition of “brokerage services” for QSB purposes, the IRS turned to other definitions. For example, Merriam-Webster defines “broker” as “one who acts as an intermediary: such as a: an agent who arranges marriages b: an agent who negotiates contracts of purchase and sale (as of real estate, commodities, or securities).” The IRS listed various examples of parties referred to as brokers: aircraft brokers, freight brokers, real estate brokers, business brokers, yacht brokers, ship brokers, stockbrokers, commodities brokers, insurance brokers, broker-dealers, auto transport brokers, mortgage brokers, list brokers (for direct mail), intellectual property brokers, and produce brokers. A broker serves as an intermediary between a buyer and a seller. But title alone is not determinative. The nature of the activity controls. Where the business is a mere intermediary, as with this website, it is providing brokerage services.

Insurance brokers. A corporation was an insurance broker that sold insurance products for various insurance companies. It was required to perform certain services in connection with these sales. For example, it had to promptly 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. It also had to keep complete records and accounts of all transactions and correspondence with the insureds at its principal office, which records and accounts were open to examination, inspection, verification and audit by the insurance company upon reasonable notice.

The IRS said this corporation should not be treated as providing brokerage services; it was not a mere intermediary. It provided important administrative services beyond those that would be performed by a mere intermediary facilitating a transaction between two parties.

Software for medical practices. A corporation developed software to assist medical providers in treating patients. It didn’t treat patients or wasn’t licensed to issue prescriptions.

The IRS said this corporation did not perform services in the field of health, so it could issue Section 1202 stock (assuming the other conditions are met). The software does not diagnose or recommend treatment; it merely assists licensed physicians to do so.

Final thought

Being in the right business is only one of the conditions for Section 1202 stock. The other conditions are explored in a previous blog. And keep an eye on Congress. Part of the Build Back America Act, which failed to pass in 2021, would have capped the exclusion to 50% of gain for taxpayers with income over $400,000 retroactive to sales after September 13, 2021. Will the same or similar proposal be included in a slimmed down version of the Act that’s expected to be revived this year?