The IRS Limits the Tax Exclusion of Qualified Small Business Stocks

After issuing a series of taxpayer-friendly rulings, the IRS recently issued guidance limiting the scope of section 1202. Section 1202 is the tax provision that allows taxpayers to exclude capital gain on the sale of qualified small business stock (QSBS) if certain conditions are met. As summarized in a previous article, section 1202 allows individuals to exclude from gross income the greater of $10 million or 10 times their initial investment in their business, with the potential to exclude up to $500 million of profit. This is one of the most powerful earnings exclusion provisions in the Internal Revenue Code.

The most recent guidance came in the form of a General Counsel Advisory Memorandum, CCA 202204007 (November 4, 2021), which was published on January 28, 2022. This type of advice comes from the National Office of the Office of the General Counsel of the IRS, which is based in Washington, DC It is a written notice that is issued to employees of the IRS, and although it does not technically have the force and effect of law, that is, it is not "precedent" in tax jargon, it conveys the legal interpretation of the Office of the Chief Counsel.

Most importantly for our purposes, this type of advice constitutes “authority” for purposes of determining whether there is substantial authority for the tax treatment of an item. This is important because taxpayers must have at least "substantial authority" for the tax treatment of an item in order to avoid penalties. Substantial authority generally equates to a 40% chance of success. In the absence of substantial authority, taxpayers must have a reasonable basis (about a 25% chance of success) for the position and affirmatively disclose it to the IRS on Form 8275 to avoid penalties. Filing that form with a tax return is like running down the IRS lobby while a red flag is waved and an audit is requested.

THE CCA

The taxpayer in the CCA sold appreciated stock in a company and sought to exclude the capital gain under section 1202. The issue addressed in the CCA is whether the company is engaged in a qualified trade or business (QTB). Remember that any business is a QTB, except those specifically listed in section 1202(e)(3). The relevant exclusion here is the "brokerage services" exclusion.

The IRS addressed the "brokerage services" exclusion in January 2021 when it issued a favorable private letter ruling for an insurance broker providing administrative services to its clients. The IRS ruled that the taxpayer was not engaged in brokerage services because he was doing more than a traditional broker, which he defined as a mere intermediary. The ruling had the effect of narrowing the brokerage services exclusion, which broadened the number of taxpayers eligible for a QSBS exclusion. That ruling was summarized in a previous article.

The company in the CCA operates a website that facilitates the leasing of real estate between landlords (those who have properties to rent) and tenants (those who want to rent properties). Prospective renters use the site to make non-binding reservations for the use of certain facilities found in the website's database. Once the landlord and tenant reach an agreement, they execute a lease through the website and all lease payments are also made through the website.

Although the company that operates the website does not have authority to enter into lease agreements, it charges the landlord a flat fee to maintain its listing on the website and a percentage of the lease payments for facilitating the lease transaction. The website also provides other fixed fee services to lessors, such as website hosting to be used in conjunction with the lease of the lessor's premises. In its terms of service (you know, the fine print no one reads), the company stated that it is not engaged as a broker and claimed to the IRS that it was not a broker even though it "may have a real stake." real estate broker license in one or more states.”

Although the company that operates the website does not have authority to enter into lease agreements, it charges the landlord a flat fee to maintain its listing on the website and a percentage of the lease payments for facilitating the lease transaction. The website also provides other fixed fee services to lessors, such as website hosting to be used in conjunction with the lease of the lessor's premises. In its terms of service (you know, the fine print no one reads), the company stated that it is not engaged as a broker and claimed to the IRS that it was not a broker even though it "may have a real stake." real estate broker license in one or more states.”

In reaching its conclusion, the IRS noted that neither section 1202 nor any case law defines the phrase "brokerage services." Therefore, he proceeded to discuss the dictionary meaning of the word "broker," as well as the authority under other provisions of the Internal Revenue Code that have similar exclusions for brokerage services.

The dictionaries consulted by the IRS generally refer to a broker as (i) one who acts as an intermediary and (ii) one who is hired by another, usually on commission, to negotiate contracts or act as an intermediary, especially between prospective buyers and sellers. . The IRS recognized that there may be many types of brokers, and stated that the fact that a party is not commonly known as a broker does not, in itself, exclude the possibility that it is a broker.

The IRS also consulted analogous tax provisions.

In a section dealing with information reporting, the term broker was broadly defined to include "any person who (for consideration) regularly acts as an intermediary with respect to goods or services." Although the regulations under that section limit the reporting of information to brokers who deal in only certain types of financial assets, the IRS noted that nothing limits the types of “brokers” subject to the reporting requirement; In other words, the definition of a broker remained broad enough to apply to the company's website operations.

Additionally, when Congress added real estate transactions to the types of transactions subject to information reporting, it included a broker ordering rule that applies to multiple types of brokers. The definition of a real estate broker for purposes of this rule includes (i) the person responsible for closing the transaction, (ii) the seller's broker, and (iii) the buyer's broker. The IRS viewed this as evidence of Congress' intent to apply a broad meaning to the definition of broker, and certainly one that includes the business's lease facilitation operations.

Under another tax provision dealing with tax accounting methods, the regulations state that whether a person's services constitute brokerage services is based on all the facts and circumstances, including how the person is compensated (p. (eg, if compensation is dependent on completion of the transaction that the services were intended to effect). In one example, the regulation concludes that a taxpayer is providing a brokerage service when it executes transactions for clients and its compensation is based on actual transactions made by clients.

The latest tax provision examined by the IRS has regulations that define brokerage services to include “services in which a person arranges transactions between a buyer and a seller with respect to securities. . . in exchange for a commission or fee, including stockbrokers and other similar professionals, but does not include the services of real estate agents and brokers, nor those of insurance agents and brokers”. The IRS dropped this definition of brokerage services because the regulation applies only for the purposes of that specific section and because the tax policy objective of that section is not similar to the tax policy objective of section 1202.

After considering the above authorities, the IRS ruled that the company's website operations are "brokerage services" under the common meaning of that term, even though the company claims that it provides advertising services rather than brokerage services. The company acts as an intermediary, bringing buyers and sellers together, which fits within the classic definition of a broker, and does more than just passively advertise on its website.

Also, it is different from a search engine that provides targeted content and advertising to users based on their search history. The company's website is dedicated solely to making deals between potential landlords and tenants of real estate, and charges a fee contingent upon the execution of a leasing transaction.

El CCA es el sexto pronunciamiento del IRS que aborda el problema de QTB, y este es el primero que concluye que el negocio en consideración no es un QTB. Sin embargo, sería difícil argumentar que esta guía representa algún tipo de cambio de paradigma en el IRS, porque los hechos de la CCA no son particularmente favorables para el contribuyente. La moraleja aquí parece ser que el IRS está examinando las declaraciones que afirman una exclusión de QSBS y no evitará desafiar las posiciones de los contribuyentes. Los contribuyentes que reclaman una exclusión de QSBS deben documentar su derecho a la exclusión y trabajar con sus asesores para garantizar que sus posiciones resistan el escrutinio del IRS.

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