On May 12, 2023, the Internal Revenue Service (IRS) published private letter ruling 202319013 (the PLR),1 which concluded that an enterprise cloud application software company is engaged in a qualified trade or business for purposes of the “qualified small business stock” (QSBS) provisions of Section 1202.2 The company’s business was to provide software solutions tailored to the needs of its clients, and the company’s employees possessed special technical skills and knowledge used to develop and implement these solutions. The IRS concluded, however, that the company’s principal asset was its intellectual property, i.e., the processes and packages it utilized to train its employees to deliver services, and not the reputation and skills of its employees. This PLR demonstrates that a company that utilizes a skilled workforce to provide tailored services to customers may still be engaged in a qualified trade or business for QSBS purposes to the extent such skills are unique to the company and nontransferable.
Stock in a corporation is not QSBS unless at least 80 percent of the assets of the corporation are used in the active conduct of one or more qualified trades or businesses.3 Qualified trade or business is defined by excluding any trade or business involving the performance of services in certain fields enumerated by the statute (e.g., health, law, or engineering) or any trade or business for which the principal asset of such trade or business is the reputation or skill of one or more of its employees. While the nature and scope of these exclusions are not clearly established by the statute and no regulations have been issued thereunder, the IRS has previously issued several private letter rulings providing helpful guidance.4
The PLR
The PLR addresses an enterprise cloud application services software company that provides solutions to the operating functions and industry-specific challenges of its clients. While the company’s employees possess technical skills and knowledge that allow for effective implementation and the quality of the company’s services, these skills are derived from training on the company’s proprietary service delivery processes and methodology packages that are unique to the company. In addition, the skills are not transferable and cannot be utilized by the employees at other employers that provide similar services. Furthermore, the company can train new employees to perform substantially identical services using its proprietary methodology packages.
The issuance of the PLR demonstrates that a company that utilizes skilled employees to provide tailored services to customers can still be engaged in a qualified trade or business for QSBS purposes if the employees acquired their skills during unique and proprietary training provided by the company. In the PLR, the IRS focused on the fact that the skills were not transferable to the company’s competitors and could easily be acquired by new hires, indicating that the company’s primary asset was its own intellectual property and not the skills of the employees themselves.
[1] While private letter rulings generally apply only to the taxpayer to whom they are written, they often are viewed as an indication of the IRS's current position on issues.
[2] All section references herein are to the Internal Revenue Code of 1986, as amended.
[3] For prior coverage of the QSBS provisions of Section 1202, see https://www.wsgr.com/en/insights/understanding-section-1202-the-qualified-small-business-stock-exemption.html.
[4] See, e.g., PLR 201436001; PLR 201717010; PLR 202221006.
