The IRS recently issued Private Letter Ruling (PLR) 202221006 which dealt with whether a company qualified for the QSBS capital gains deduction. Even though IRC 1202, which governs QSBS, has been around since 1993, the regulations are thin and there have been few PLRs, cases or rulings on the matter.
IRC 1202 allows taxpayers who sell QSBS a 100% exclusion with regard to their gain on sale. That is the reason why the taxpayer requesting the ruling wanted to be certain the sale of the company stock qualified under IRC 1202.
The facts of the ruling were that the business sold pharmaceuticals under exclusive agreements with manufacturers. The taxpayer wanted the IRS to rule that it was not involved in the business of providing health care services, which is a disqualifier under IRC 1202. In addition, the taxpayer wanted the IRS to rule that the principal asset of the company wasn’t the reputation of employees, which is also a disqualifier under IRC 1202. The IRS ruled favorably for the taxpayer under both issues. It’s reasoning was as follows:
The pharmacists filled prescriptions provided by third party health care professionals.
All revenues were generated by the sale of pharmaceuticals.
The employees did not provide diagnostic services or health care.
The employees had little or no contact with physicians other than to fill the prescriptions.
The principal asset of the company was its distribution rights, not the reputation of its employees.
The provisions of IRC 1202 are complex and revolve around the business and the stockholder qualifying under IRC 1202. Here are some of the provisions with regard to exclusion of gain, business and stockholder qualifications.
Exclusion of Gain
The amount of gain excludable is limited to the greater of $10m or 10x the taxpayer’s basis in the QSBS. The limitation references the higher amount of two measures, therefore there is the potential of receiving greater than a $10m exclusion.
This is a per-issuer limitation. Therefore, if you invest in more than one company that qualifies under IRC 1202, you are eligible for the above-mentioned limitation for each company.
The exclusion is per individual or married couple. Taxpayers filing separately have a $5m exclusion each.
Trusts, other than Grantor trusts, and family members, each have a $10m exclusion. Therefore, gifting QSBS to trusts and family members multiplies the $10m exclusion.
Partners in a partnership owning QSBS each have a $10m exclusion.
The stock must be held for 5 years prior to sale for the gain to be eligible for the exclusion.
IRC 1045 allows taxpayers to roll over their gain from sale of QSBS to another QSBS within 60 days of sale. This is beneficial if a taxpayer cannot meet the 5 year rule and has to sell the QSBS.
The stock can be acquired either directly from the company or through an underwriter. It cannot be purchased from an individual or any other entity.
The stock can be purchased for money, property or as compensation.
Individuals, estates, trusts and partnerships are eligible stockholders.
Significant redemptions of stock may result in the company not being eligible for QSBS status.
The company must be a C-Corp.
The stock must be issued after August 10, 1993.
The aggregate gross assets when the stock is issued cannot exceed $50m. The book value, not fair market value of the assets is used for the $50m limitation.
The company must be engaged in an active trade or business. An active trade or business, for these purposes, is a company that employs at least 80% of its assets in one or more qualified businesses. - Assets used for R&D or for start-up activities are treated as active trades or businesses. - Assets which are held as part of a reasonably required working capital reserve will not fail the 80% test. - Assets which are held for investment and are expected to be used within 2 years to finance R&D or increase working capital needs will not fail the 80% test. - The IRS is very strict with regard to the 80% test, which we have encountered on tax audits.
Qualified businesses for these purposes means any trade or business except: - Trades or businesses involving the performance of services in the fields of: - Health - Law - Engineering - Architecture - Accounting - Actuarial Service - Performing Arts - Consulting - Athletics - Financial Services - Brokerage Services – Any trade or business where the principal asset is the reputation of one or more of its employees – Banking, Finance, Leasing, Investing or similar businesses – Farming – Any business involved in the extraction of products that is eligible for the depletion deduction – Any business operating a hotel, motel, restaurant or similar business
The businesses cannot have more than 10% of its assets invested in stock of other companies unless they are subsidiaries (more that 50% of voting power or value).
The business cannot have more than 10% of its assets invested in real estate unless the real estate is used in the company’s business.
In many instances, QSBS is purchased by companies for stock in what is known as a tax-free reorganization. The buyer does not qualify under IRC 1202, but the stock that the buyer received in the transaction will be eligible for the exclusion subject to a limitation. The limitation is the gain that would have been realized if the QSBS had been sold on the date of reorganization. For example, QSBS is exchanged for public company stock when it is valued at $70/share, with a tax basis of $10/share. The public company stock is subsequently sold for $150/share. The gain of $60/share is eligible for the exclusion.
IRC 1202 is very beneficial to founders and private equity investors, but it is complicated with very little guidance from the IRS. We at Perlson LLP have a great deal of experience with businesses that are potential candidates for the IRC 1202 exclusion. If you have any questions on these matters, contact your professional at Perlson LLP at (516) 541-0022.
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