IRS rules software company’s stock constituted qualified small business stock

ARTICLE | June 06, 2023

Authored by RSM US LLP

Executive summary: IRS ruling on section 1202 qualifying business

Section 1202 provides for an exclusion from capital gain on the sale of qualified small business stock (QSBS). Only the stock of corporations engaged in certain businesses constitutes QSBS—only those engaged in a qualified trade or business (QTOB). One of the nonqualifying business types is a “business where the principal asset of such trade or business is the reputation or skill of one or more of its employees” (the reputation or skill clause). The parameters of this clause are somewhat unclear. In PLR 202319013, the IRS ruled that a software company constituted a QTOB, the principal asset of the company was its intellectual property and not the skill of its employees. The sale of the company stock was therefore eligible for the section 1202 gain exclusion. 

IRS rules software company’s stock constituted qualified small business stock

Introduction

Section 1202 provides for the exclusion of gain on the sale of qualifying stock. For a summary of key provisions and requirements of section 1202, see our article, Understanding the qualified small business stock gain exclusion. One requirement necessary to qualify for the exclusion is the qualified trade or business (QTOB) requirement. The QTOB requirement applies to the issuing corporation and provides that the corporation must conduct a QTOB and must use at least 80% of its assets, measured by value, in the active conduct of the QTOB for substantially all of the shareholder’s holding period.

Section 1202(e)(3) states that a QTOB includes all trades and businesses other than those explicitly listed as not qualifying. One of the excluded business types is a “business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”

This reputation or skill clause is not defined or interpreted in the section 1202 Code or regulations. In PLR 202319013, the IRS provided non-precedential guidance addressing the meaning of this clause.

We have addressed similar QTOB issues elsewhere. See a discussion regarding consulting, What does ‘consulting’ mean for purposes of Sec. 1202?, and regarding brokerage services, Business connecting lease parties not qualified under section 1202.

PLR 202319013

The company addressed in the PLR is a software company that provides solutions tailored to the operating functions and industry-specific challenges of its clients. After being trained on the company’s proprietary services, the company’s employees utilize their technical training and skills to implement the company services. The company’s processes and methodology are unique to the company and may not be utilized by the employees at any other employers that may provide a similar service. The company can recruit and train new employees with the required technical skillset to perform substantially identical services as those performed by its current employees using its methodology packages.

Based on these facts, the IRS ruled that the principal asset of the company is not the reputation or skills of any of its employees but instead the intellectual property held by the company itself in its proprietary service delivery processes and methodology packages.

RSM observations

The PLR contains helpful guidance. However, unanswered questions remain relating to the reputation or skill clause. Here are several examples that illustrate the lack of clarity:

• Suppose a company that manufactures customized widgets employs a technician whose specialized knowledge of the customized widget manufacturing process is crucial to the company’s success. Does this company fall under the reputation or skill clause?
• Suppose a company that manufactures and sells a product utilizes a salesperson well-known in the marketplace to market the product. Due to the salesperson’s reputation and extensive relationships, the salesperson is critical to the company’s success. Does this company fall under the reputation or skill clause?
• Suppose a biopharmaceutical company employs, among its many employees, an accomplished scientist to help it develop pharmaceutical drugs. Does this company fall under the reputation or skill clause? (And does the answer change depending on the degree of the scientist’s expertise?)

As noted above, section 1202 and the related regulations do not interpret or explain the reputation or skill clause. However, authority outside of section 1202 may shed some light on the matter.

Section 199A, enacted as part of the Tax Cuts and Jobs Act, permits in some cases a partial deduction to offset income from a “qualified trade or business” (QTOB). A trade or business is qualified if, among other requirements, it is not a business described in section 1202(e)(3)(A) (with some exceptions). Section 199A(d)(2)(A). Thus, section 199A’s definition of QTOB draws explicitly from section 1202(e)(3)(A) to determine the section 199A excluded services, one of which is the reputation or skill business type.

The section 199A regulations directly address the meaning of the reputation or skill clause. Those regulations interpret the clause to refer to the following narrow range of services:

(A) A trade or business in which a person receives fees, compensation, or other income for endorsing products or services, (B) A trade or business in which a person licenses or receives fees, compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, (C) Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format. Reg. section 1.199A-5(b)(2)(xiv).

The preamble to the final section 199A regulations explains the Treasury Department’s reasoning for limiting the clause so severely:

The Treasury Department and the IRS remain concerned that a broad interpretation of the reputation and skill clause would result in substantial uncertainty for both taxpayers and the IRS. As stated in the preamble to the proposed regulations, it would be inconsistent with the text, structure, and purpose of section 199A to potentially exclude income from all service businesses from qualifying for the section 199A deduction for taxpayers with taxable income above the threshold amount. If Congressional intent was to exclude all service businesses, Congress clearly could have drafted such a rule.

Accordingly, the final regulations retain the proposed rule limiting the meaning of the reputation or skill clause to fact patterns in which an individual or RPE is engaged in the trade or business of receiving income from endorsements, the licensing of an individual’s likeness or features, and appearance fees.” T.D. 9847 (Feb. 4, 2019).

Note, however, that the section 199A regulations and the preamble to the regulations state that those regulations are intended to govern over section 199A only. Reg. section 1.199A-5(a); T.D. 9847 (Feb. 4, 2019).

Although the section 199A regulations control only regarding section 199A, the above reasoning may hold true regarding section 1202 as well. The bulk of service businesses employ one or more employees whose reputation or skill is, to some degree, a valuable asset. If Congress intended to treat all service businesses as not qualifying for QTOB status under section 1202, Congress could have drafted such a rule. (And if they intended to carve out certain service businesses from others under some dividing line, they would have informed us of that precise line.)

Moreover, one can argue, a broad interpretation of the reputation or skill clause would create a substantial redundancy within the terminology of section 1202(e)(3). A broad interpretation would cause the categories of “health, law, engineering, architecture, accounting, actuarial science…” to be superfluous—as those categories would then per se fall within the reputation or skill category. (See also PLR 201436001 (pharmaceutical company was a QTOB); PLR 201717010 (diagnostic testing business was not disqualified under the reputation or skill clause, even though the diagnostic testing services were performed by highly trained employees); Owen v. Comm’r, TC Memo. 2012-21 (principal asset of company that sold prepaid legal service policies was its training and organizational structure and not the skill of the taxpayer).)

Concluding thoughts

IRS officials stated in recent years that the IRS is considering issuing guidance regarding the meaning of the QTOB terms, as well as other section 1202 open questions. PLR 202319013 is one of several items of non-precedential guidance the IRS has recently provided in this regard. We welcome further clarifying guidance on these and other section 1202 issues.

Taxpayers looking to exclude capital gain on the sale of stock under section 1202 should ensure, among other items, that the stock issuer’s business conducts a QTOB. It is important to consider that the line between a qualified business and a nonqualified business is sometimes unclear. Some of the other various requirements for section 1202 eligibility are also complex and nuanced. Accordingly, taxpayers considering claiming the section 1202 capital gain exclusion benefit should consult with a tax advisor.

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This article was written by Nick Gruidl, Joseph Wiener and originally appeared on Jun 06, 2023.
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