New IRS Ruling Sheds Light on Small Business Stock Gain Exemption

New IRS Ruling Sheds Light on Small Business Stock Gain Exemption

Internal Revenue Code (“IRC”) 1202 allows an individual shareholder a reduced or tax-free gain from the sale or exchange of qualified small business stock (“QSBS”) held for more than 5 years. The percentage of the reduction depends upon when the QSBS was acquired, but cannot exceed the greater of $10 million or 10 times the shareholder’s basis in the QSBS.

QSBS Acquired

  • In the case of QSBS acquired before 2009 or after 2013, eligible taxpayers can exclude 50 percent of their gain from tax;
  • In the case of QSBS acquired between February 2009 and September 2010, eligible taxpayers can exclude 75 percent of their gain from tax; and
  • In the case of QSBS acquired between September 2010 and December 2013, eligible taxpayers can exclude 100 percent of their gain from tax.

PLR APPLICATION

In Private Letter Ruling 201436001 (the “PLR”), a taxpayer owned stock in a company within the pharmaceutical industry. Specifically, the company’s business activities included research on: (i) drug formulation effectiveness; (ii) pre-commercial testing procedures such as clinical testing; and (iii) manufacturing of drugs. The company worked with clients to solve problems in the pharmaceutical industry such as developing successful drug manufacturing processes; to do so, it used physical assets such as its manufacturing and clinical facilities and intellectual property such as its patent portfolio.

The taxpayer disposed of his stock in the company. The issue in the PLR was whether the business of the company was a qualified trade or business pursuant to IRC 1202, thus entitling the Taxpayer to a tax saving on the sale of his QSBS.

The sequence of applicable law pursuant to IRC Section 1202 is as follows:

  • gross income does not include 50 percent of any gain from the sale or exchange of QSBS held for more than 5 years;
  • stock in a corporation is not treated as QSBS unless the corporation meets the requisite active business requirements;
  • a corporation meets the active business requirement if at least 80 percent of the assets of the corporation are used by the corporation in the active conduct of one or more qualified trades or businesses;
  • generally, a qualified trade or business means any trade or business other than a trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, athletics, financial services, brokerage services, consulting, or any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

The PLR explained that the thrust of IRC 1202(e)(3) is that business are not qualified trades or businesses if they offer value to customers primarily in the form of services, regardless whether those services are the providing of hotel rooms or in the form of individual expertise (i.e. law firm partners).

Here, the company was not in the business of offering services in the form of individual expertise. Instead, the Company’s activities involved the deployment of specific manufacturing assets and intellectual property assets to create value for customers. Essentially, the company was determined to be a pharmaceutical industry equivalent of a parts manufacturer in the automobile industry. Despite the fact that the company worked primarily in the pharmaceutical industry, which is a component of the health industry, the company did not perform services in the health industry within the meaning of IRC 1202.

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