Today in Tax: Qualified Small Business Stock, Opportunity Zones, Information Reporting for Digital Assets

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A brief commentary on the past week’s cases, rulings, notices, and related federal tax guidance.

Medical Software Deemed a Qualifying Trade for Qualified Small Business Stock Gain Exclusion

When certain criteria are met, stockholders may be able to exclude proceeds from the sale of qualified small business stock from their taxable income. One of those criteria is that the stock being sold must be the stock of a corporation engaged in specified trades. For companies in those trades, or adjacent industries, meeting the requirements of qualified small business stock may be a powerful tool to obtain significant income tax savings—particularly if tax rates increase.

In a recent ruling (PLR 202144026), the Internal Revenue Service determined that a corporation’s development and provision of software is a qualified trade or business for purposes of the qualified small business stock exclusion, despite providing software related to the provision of medical services. The health industry is one of the trades specifically excluded from the qualified small business stock exclusion program. The IRS determined that because the corporation’s software does not diagnose or recommend treatment, and because the corporation created the software to be used by the healthcare industry, rather than directly providing health services, that the Company was in a qualified trade or business. Therefore, the shares of the corporation’s stock sold by a shareholder could be eligible for gain reduction.

This ruling is significant for software companies and others providing ancillary services to disqualified industries, and should prompt companies to consider whether the qualified small business stock exclusion may provide a benefit for shareholders in a potential sale or stock redemption.

Relief for Late Qualified Opportunity Zone Fund Election

Investors into Qualified Opportunity Zone Funds may defer taxation on invested gains, and in some cases avoid taxation on proceeds of their investment altogether. Yet, the entire investment may be disqualified, leading to unpaid tax, penalties, and interest if the Fund entity is not properly qualified at the time of the investment. Defects in timely electing Fund status may be forgiven where the Fund acts reasonably, engages qualified counsel, and relies on the guidance of their tax advisors.

On November 5, 2021, the IRS granted relief (PLR 20214010) to an LLC intending to become a Qualified Opportunity Zone Fund, but which failed to file the required certification on Form 8996 within the prescribed time (i.e. by the deadline for filing its federal income tax return, including filing extensions). The putative Fund in this ruling engaged an accountant to prepare and file its tax returns, including the Form 8996, but for unexplained reasons, the accountant neglected to file a request for an extension to file income tax returns. Upon learning of the failure, the Fund requested a ruling for relief.

In granting the taxpayer’s request for relief, the IRS reiterated the regulatory requirements that taxpayers act reasonably and in good faith and that granting relief will not prejudice the interests of the government. In most instances, reliance on a qualified tax professional satisfies the requirement that taxpayers act reasonably. Above all else, this ruling should be a reminder that taxpayers should seek the best tax advice available to them when attempting to take advantage of tax incentive programs, because even if the attempted transaction fails, the IRS tends to look favorably on those genuinely trying to comply with the requirements of the law.

Infrastructure Bill Would Create New Information Reporting for Digital Assets

The Infrastructure Bill recently passed by Congress requires all cryptocurrency exchanges to report information to the IRS and customers. Currently the exchanges are under no information reporting obligations.

Late Friday night, the Infrastructure Investment and Jobs Act was approved by the House and sent to the desk of President Biden, who has indicated that a signing ceremony will happen soon. The Act will expand current information reporting requirements used for securities transactions to now include transactions with digital assets. As defined by the Act, digital assets are “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the [IRS].” This definition is broad enough to cover the range of digital assets from cryptocurrencies like Bitcoin and Ethereum to tokens like NFTs and utility tokens.

Once in effect, this Act requires cryptocurrency exchanges to report information to both the IRS and to their customers. Currently, there are no information reporting requirement for cryptocurrency exchanges, although some exchanges, as a courtesy, may send tax forms to taxpayers; for example, Coinbase sends 1099-MISC but only to report rewards received from Coinbase, not capital gains.

For most taxpayers invested in cryptocurrencies and other digital assets, this new information reporting will make filing returns and other compliance easier. No longer will the taxpayer have to independently track basis and gains or losses for each digital asset transaction. The taxpayer will receive much of this information form the required reporting by cryptocurrency exchanges.

However, information reporting can be a double edged sword as the IRS now has more access to information. This information allows the IRS a greater ability to identify underpayments in tax and assess additional taxes. While this is a start to gaining greater compliance with cryptocurrencies, the IRS needs to continue to address novel tax issues that arise from transactions in digital assets.

Access last week’s installment here.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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