Section 1202 is one of the most powerful gain exclusion provisions in the Internal Revenue Code. It provides for the full or partial exclusion of capital gain realized on the sale of qualified small business stock (QSBS).
If the requirements are met, then taxpayers can exclude from gross income capital gain in an amount equal to the greater of (i) $10 million, or (ii) an annual exclusion of 10 times their basis in the stock sold (for an exclusion amount up to $500 million). Both of these limitations apply on a per-issuer and per-taxpayer basis, and while the rules limit the exclusion to the greater of the two rules, in practice, the $10 million rule is most often the limiting factor in start-up ventures.
There are a lot of tax planning ideas around maximizing and multiplying the exclusion amount, including stacking, packing, and gifting. These and other ideas are beyond the scope of this article but should be considered in advance of any sale transaction.
In general, section 1202 has requirements that apply to the company issuing the stock, and requirements that apply to the shareholder selling the stock and hoping to qualify for an exclusion under section 1202.
On the issuer side, the requirements are as follows:
- The company must be a domestic C corporation at issuance of the relevant stock, and upon the shareholder’s sale of the stock. The company cannot be a mutual fund, real estate investment trust, or certain other listed entities.
- The company must be engaged in a qualified trade or business (QTB) during “substantially all” of the taxpayer’s holding period. A QTB is any trade or business other than certain excluded businesses.
- Excluded businesses include (i) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees, (ii) any banking, insurance, financing, leasing, investing, or similar business, (iii) any farming business (including the business of raising or harvesting trees), (iv) any business involving the production or extraction of products of a character with respect to which a deduction is allowable undersection 613 or 613A, and (v) any business of operating a hotel, motel, restaurant, or similar business.
- The company must use at least 80% of the value of its assets in the active conduct of the QTB.
- The company’s gross assets at all time before issuance of the relevant stock, and “immediately after,” must not exceed $50 million.
- The company must not have engaged in certain redemption transactions from its shareholders.
On the shareholder side, the requirements are as follows:
- The shareholder must be an individual, trust, estate, partnership, S corporation, mutual fund, or common trust fund.
- The shareholder must have acquired the stock from the company after August 10, 1993 in an “original issuance,” meaning from the company itself in exchange for money, property, or services, but not from another shareholder (referred to as a cross purchase).
- Exceptions from the original issuance requirement include the receipt of stock (i) as a gift or bequest from a shareholder that acquired QSBS in an original issuance, (ii) as a partner receiving a distribution of QSBS from a partnership, (iii) in certain tax-free reorganizations where QSBS is exchanged for other stock, or (iv) in a qualified rollover transaction under section 1045.
- The shareholder must hold the stock continuously for more than 5 years and the shareholder and certain related parties must not have engaged in certain hedging transactions during the taxpayer’s entire holding period of the stock.
The IRS has issued relatively little guidance under section 1202 since its enactment more than 25 years ago. Since 2014, it has issued only 2 private letter rulings dealing with QTB issues under section 1202 –
- PLR 201436001 (Sept. 5, 2014) (pharma company that commercialized experimental drugs is engaged in a QTB and not in “health” business); and
- PLR 201717010 (April 28, 2017) (developer of tool to provide complete and timely information to healthcare providers is engaged in a QTB and not in “health” business).
It issued 7 private letter rulings discussing the effect of certain reorganization transactions on section 1202 –
- PLR 9810010 (Dec. 3, 1997) (section 1202 applies where qualified small business contributed part of its business to “controlled” corporation that was distributed in a divisive D reorg (i.e., a split-off));
- PLRs 201603010, 201603011, 201603012, 201603013 and 201603014 (Jan. 15, 2016) (F reorg from C corp to LLC taxed as a C corp does not affect qualification under section 1202); and
- PLR 201636003 (Sept. 2, 2016) (F reorg from LLC taxed as a C corp to C corp does not affect qualification under section 1202).
Given the sparse amount of guidance to date, it is noteworthy when the IRS issues something. On April 9, 2021, the IRS released a favorable private letter ruling (PLR 202114002) discussing what it means to be engaged in the brokerage business, an excluded business. It ruled that an insurance agent or broker is not engaged in the business of “brokerage services.”
In the ruling, the taxpayer’s business works with its customers to obtain insurance, including property, casualty, surety, worker’s compensation, employee benefits, personal and medical, and professional practice insurance. It conducts business either as a representative or appointed agent of insurance companies or as an agent appointed with a general wholesale agent.
In the “direct appointments” model, it acts as an independent agent and generates revenue directly from insurance companies, usually in the form of commission income paid directly or through withholding on a portion of a customer’s premium payments. Its contracts with insurance companies require it to perform a number of administrative services, such as reporting incidents, claims, suits, and notices of loss to the insurance company. It also must maintain records of all transactions and correspondence with the insureds, which records are open to examination, inspection, verification, and audit by the insurance companies.
In the wholesale model, the taxpayer’s business contracts with a wholesaler rather than with individual insurance companies, and the wholesaler contracts with multiple insurance companies. The business selects an appropriate policy for a customer provided by the wholesaler, and if the customer accepts the policy, the wholesaler procures the policy from the relevant insurance company.
The IRS ruled that the taxpayer’s business was a qualified trade or business, and not an excluded brokerage business. The IRS’s started by analyzing the meaning of a “broker” according to a popular dictionary. There, a broker was defined as an intermediary such as an agent that arranges marriages or one who negotiates contracts of purchase and sale of real estate, commodities, or securities. The IRS then examined the taxpayer’s business and noted its role was not that of a mere intermediary because its contracts require it to perform many administrative services beyond those that would be performed by a mere intermediary facilitating a transaction between two parties. For example, it must report incidents, claims, suits, and notices of loss to the insurance companies, and maintain true and complete records and accounts of all transactions and correspondence with the insureds so that the insurance companies can examine and verify them upon reasonable notice. It concluded that the taxpayer’s business “was engaged in a qualified trade or business as defined in §1202(e)(3).”
This ruling is great news for insurance brokers, and other brokers that perform administrative services beyond that of a mere intermediary, such as real estate brokers. This is the third taxpayer-friendly ruling on the meaning of a QTB, and more are likely to come given the strong interest in section 1202 we are seeing in the market.
Although any guidance under section 1202 is welcome guidance, private letter rulings are only binding on the IRS with regard to the specific taxpayer that requested the ruling. They are helpful to other taxpayers only insofar as they provide an indication of the IRS’s position on the legal issues addressed. But they are less authoritative than other forms of published guidance, such as revenue rulings and chief counsel advice memorandums.