Section 1202 of the Internal Revenue Code provides savvy business founders and investors an opportunity for large tax savings. In fact, if the entity and the business exit are structured correctly, upon an exit, the founders and investors holding Qualified Small Business Stock are eligible for a gain exclusion equal to the greater of $10,000,000 or 10 times the investor’s initial investment in the stock.[1] However, the devil of the section 1202 exclusion hides in its convoluted requirements, many of which do not have any published guidance from the IRS and leave taxpayers guessing at their meanings.

One of section 1202’s requirements that practitioners have struggled with is what constitutes a qualified trade or business for purposes of section 1202. This is because section 1202(e) defines a qualified trade or business by listing a plethora of activities that do not constitute a qualifying trade or business.

Whether a business qualifies under section 1202(e) is vital because failing to qualify means the business does not satisfy section 1202’s “active business” requirement which demands at least 80 percent of the C corporation’s[2] assets be used in one or more qualified trades or businesses. As a result, the taxpayer would lose the gain exclusion.

Section 1202(e)(3) lists activities that are excluded qualified trades or businesses, including, among other things, “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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[.]”[3]

Included in the Tax Cuts and Jobs Act, enacted in December 2017, section 199A[4] was added to provide a deduction for income derived from qualified trades and businesses. Section 199A references section 1202(e)(3) to exclude those same activities from qualified trades and businesses (except for a modification to permit “engineering” and “architecture”) for purposes of section 199A. Although section 199A is separate and distinct from section 1202 and the section 199A regulations specify that the rules thereunder only apply for purposes of determining a qualified trade or business for section 199A purposes, practitioners speculated that the section 199A regulations shed light on what constitutes a qualified trade or business for purposes of section 1202(e)(3)(A) because of the nearly identical excluded trades and businesses.

To the dismay of many practitioners, 2021 saw the issuance of Private Letter Rulings 202114002 and 202125004 which both showed that the IRS has a different route in mind. In both of those Private Letter Rulings, the taxpayers sought rulings from the IRS that the activities in which they were engaged were a qualifying trade or business under section 1202. While the facts of each Private Letter Ruling differ, the IRS’ analysis in both rulings relied exclusively on the plain definition of the words listed as non-qualifying trades and businesses in section 1202(e)(3) and did not reference section 199A and the regulations thereunder.

The take away from these two Private Letter Rulings is clear: consistent with the specific provisions in the section 199A regulations, the IRS does not plan to apply those regulations to clarify section 1202(e)(3)(A)’s definition of a qualifying trade or business for purposes of section 1202. Given this message, taxpayers should be cautious when repurposing other regulations to inform their interpretations of section 1202’s requirements as well.

When evaluating eligibility for the section 1202 exclusion, taxpayers should be vigilant in ensuring that each of section 1202’s requirements is satisfied. Unfortunately, the IRS did not make that easier with its issuance of Private Letter Rulings 202114002 and 202125004. Therefore, taxpayers are strongly advised to contact their tax representatives to strategically analyze section 1202’s requirements and the latest guidance.

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[1] IRC § 1202(b)(1).

[2] Or an LLC taxed as a C Corporation for federal income tax purposes.

[3] IRC § 1202(e)(3)(A).

[4] IRC § 199A targets pass-through entities and allows qualifying taxpayers to deduct up to 20% of their Qualified Business Income (which is a defined term in the section).