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:
On the shareholder side, the requirements are as follows:
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 –
It issued 7 private letter rulings discussing the effect of certain reorganization transactions on 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.