The Qualified Small Business Stock (QSBS) exclusion is a coveted tax benefit that offers up to 100% tax exemption upon sale. However, entrepreneurs and investors must navigate a critical question: Is their business a “qualified trade or business” under Section 1202 of the Internal Revenue Code?
Given the intricacies and statutory nuances, claiming this tax advantage can be a daunting task. One of the critical questions companies struggle with is whether or not their company is operating in a “Qualified Trade or Business” for QSBS. IRC Section 1202(e)(3) defines qualified trades in the negative, listing trades that do not qualify, such as “insurance”, “health” services, or “legal” services; but does that exclude companies operating in InsurTech, Bioscience or LegalTech?
Shareholders in certain companies have requested clarification, for which the IRS issued Private Letter Rulings (PLRs) to clarify if their companies are indeed operating in Qualified Trades for QSBS purposes.
To help decipher what the PLRs indicate about how the IRS considers a particular company, Christopher A. Karachale, and his team at Hanson Bridgett LLP created an Interactive Guide to the rulings.
Empowering More Informed Decisions with the Interactive Tool
The Interactive Guide to Qualified Trades or Businesses for QSBS Qualification is an online resource curated by Hanson Bridgett LLP. The guide offers a comprehensive summary of the key elements of each PLR issued by the IRS on qualified trade or business status under IRC Section 1202(e)(3).
The Interactive Guide to Qualified Trades or Businesses for QSBS Qualification provides a clear and concise overview of the IRS guidance on qualified trades or businesses. The guide demonstrates how the test for qualified trades or businesses is qualitative, not purely based on the facial language of the statute or how those fields may be viewed in other parts of the tax code. Five of the rulings describe companies operating in the health field, and in each case, the IRS concludes that the company conducts a qualified trade or business.
Key Themes to Illuminate The Path Towards Qualified Trades
Both PLRs and the Interactive Guide highlight central themes that illuminate the path towards assessing whether businesses are operating in Qualified trades.
Value Creation: One of these themes is that a qualified trade or business generally manufactures or creates an asset or intellectual property (IP) that adds value for their customers. For example, the guide cites a pharmaceutical company that engaged in R&D for experimental drugs and deployed specific manufacturing assets and intellectual property assets to create value for customers. Similarly, a med-tech company that developed and commercialized software was found not to be in the business of providing health services but rather creating an asset to be utilized by their customers in the healthcare industry.
Qualitative Assessment: The test for qualified trades or businesses is qualitative, not a mere checklist. Even if a business operates in a field listed in IRC Section 1202(e)(3) (like healthcare), it doesn’t automatically disqualify them. The IRS recognizes diverse business models within these fields as qualified, demonstrating the importance of substance over form.
Not just Services: The guide notes that the IRS is focused on businesses that deliver tangible or intangible products, rather than simply evaluating services business. For example, an online marketplace that acted as an intermediary with a website solely devoted to effectuating agreements between landlords and potential tenants was determined to be engaged in “brokerage services”, but the creation of a more robust online application that for example provides content to users and also sends targeted advertisements to those users based on their search history might have avoided the brokerage service ruling.
The Takeaway: A Confident Step Towards Success
By combining the insights of PLRs with the user-friendly guidance of the Interactive Tool, entrepreneurs and investors can gain insights in navigating the QSBS eligibility maze.
With expert guidance, entrepreneurs and investors can unlock the golden doors of the QSBS tax exclusion and propel their businesses toward greater success.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.