Why Don’t Law Firms Qualify for QSBS?

Colorado QSBS

Qualified Small Business Stock is a phrase gaining momentum in the investment community. Although it has been around since 1993, originally signed into law by President Clinton, it has grown over the past decades in both benefits and complexity.

The History Behind the Creation of Section 1202

In its origin, section 1202 of the IRC, which is dedicated to QSBS, outlined the benefit to small business investors with a 50% exclusion of capital gains on qualifying small business stock from their taxable income. 

In 2012, under President Obama and the American Taxpayer Relief Act, this benefit was elevated to a 75% exclusion for stock issued in most of 2010 and a 100% exclusion for stock issued after September 27, 2010.

These elevated exclusion percentages actually expired, but were reenacted and made permanent by the PATH Act of 2015. 

Now, in 2021, with President Biden’s proposal to raise the tax on capital gains for Americans who make over $1 million annually in ordinary income, more people than ever are looking at the associated benefits of investing in small businesses.

Other Factors Necessary to Qualify for QSBS Capital Gains Exclusion

  • The issuing company must be a domestic C corporation with less than $50 million is gross assets at time of issuance.
  • The issuing company must be actively involved in a qualified trade.
  • The taxpayer must have received the shares directly from the company and must hold said shares for a minimum of 5 years.

Why are Law Firms not a Qualified Trade?

Individuals who own or hold shares in a law firm may be surprised and upset if they learn first of the benefits of QSBS and then the restrictions. But section 1202(e)(3) outlines the unqualified trades rather than the qualified as such:

  • Fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services
  • 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
  • Any banking, insurance, financing, leasing, investing, or similar business
  • Any farming business
  • Any business of operating a hotel, motel, restaurant, or similar business 

The simplest way that this section of the code has been summarized is that product based businesses usually qualify, whereas service based businesses usually do not. In actuality, technology businesses who are creating digital platforms and tools for the fields of health and insurance do seem to qualify, as well as biopharmaceutical companies who are conducting research and creating medical treatments. 

The reason why this list of trades has been excluded from the benefits of Qualified Small Business Stock is because the purpose of this favorable tax treatment was and is to promote economic growth, feed industry competition, and ultimately create more jobs. Service based businesses that rely on the skills of individuals are just not as scalable as product based businesses. 

Looking for specific advice on QSBS and Capital Gains? Contact us to learn more.

For more information surrounding why Law Services is not a Qualified Business look here.

https://qsbsexpert.wpengine.com/irs-define-law-services-from-a-qsbs-perspective/

This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

About QSBS Expert

QSBS Expert was founded by a group of entrepreneurs, investors, accountants and lawyers who came together when trying to navigate a QSBS situation of their own. We quickly realized that the regulations left a lot of open questions and the publicly available information was confusing to sift through…so we thought that others may also benefit from having a “go to” resource for all things QSBS.