Qualified small business stock exclusion: Who's eligible?

• Author: Andersson, Meghan

Sec. 1202 was enacted to incentivize investment in certain small businesses by permitting gain exclusion upon the sale of qualified small business stock (QSBS). This 30-yearold Code section is very popular, especially since 100% of gain is excluded for QSBS issued after 2010. However, due to limited guidance from the IRS and Treasury, taxpayers are often left wondering whether they hold stock in a company that is engaged in a qualified trade or business (QTB), which is one of the sub-requirements to qualify for the exclusion. This discussion explores the question of how to determine whether a company is engaged in a QTB.

For purposes of the QSBS exclusion, a QTB does not include performing services in certain fields: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset is the reputation or skill of one or more of its employees. The definition of a QTB also excludes any business in banking, insurance, financing, leasing, investing, or farming, and any hotel, motel, or restaurant (Sec. 1202(e)(3)). As such, QSBS does not include investments in service-oriented businesses but does include investments in other industries, such as manufacturing, technology, research and development, and software.

Unfortunately, there are only a handful of examples available to assist taxpayers in determining whether they hold stock in a QTB and can therefore avail themselves of the favorable gain exclusion provisions of Sec. 1202. One such example is a Tax Court memorandum decision from 2012 (Owen, T.C. Memo. 2012-21), and the rest are four private letter rulings, three of which involve taxpayers in the health industry. Letter rulings cannot be relied upon by taxpayers; instead, they can only serve as examples of how the IRS might rule in case of an audit. The most recent letter ruling, issued in June, is one that involves a business in the health industry.

In the June 25 ruling, Letter Ruling 202125004, the IRS concluded that a manufacturer of products prescribed by third-party health care providers was engaged in a QTB. The IRS reasoned that although the taxpayer's products were associated with the health care industry, it did not perform health services. Moreover, even though it employed specialists, its principal asset did not involve the reputation or skill of its employees.

There, the taxpayer employed...