IRS Issues Rare Insight into IRC Section 1202 Definition of “Qualified Trade or Business”

In early April of 2021, the IRS released Private Letter Ruling (PLR) 202114002 in response to a request by a business seeking to determine if it is considered a qualified trade or business under IRC Sec. 1202 (“Sec. 1202”).  PLRs typically do not make headlines; however, very little guidance has been issued by the IRS on this crucial tax provision since the enactment of Sec. 1202 in 1993. Due to this lack of guidance, taxpayers should take notice any time the IRS releases guidance on this topic. 

The Importance of IRC Sec. 1202 

Sec. 1202 was enacted with the intent of encouraging long-term investment in startup companies and other small businesses by exempting capital gains taxes upon the sale of stock in these entities.  Sec. 1202 allows holders of qualified small business stock (“QSBS”) to exclude 50% to 100% of capital gains upon the sale of QSBS, provided the stock and taxpayer meet all of the criteria. The provision allows eligible taxpayers to exclude the greater of $10 million or up to ten times the taxpayer’s basis in the QSBS sold. 

Background of PLR 202114002 

A PLR is a written statement issued to a taxpayer upon their request that interprets and applies tax laws to the taxpayer’s represented set of facts. In the PLR at hand, a taxpayer that operated as an insurance agent/broker requested a PLR to determine whether their business was engaged in “brokerage services,” which would not be a qualified trade or business for purposes of Sec. 1202. 

The business worked with its customers to obtain insurance, including property, casualty, surety, worker’s compensation, employee benefits, personal and medical, and professional practice insurance. The business acted as either a representative or appointed agent of insurance companies or as an agent appointed with a general wholesale agent. 

Two Models of Business 

The taxpayer operated under two general business models. 

First, the business had contracts with insurance companies (referred to as "direct appointments") to sell a product. Insurance companies use this model to select and control who can sell the company's products. For example, an insurance company may only want to work with certain agents capable of a certain sales volume; thus, excluding smaller agencies. The business generates revenue directly from the insurance company, often in the form of commissions and other similar compensation arrangements paid either directly from the insurance company or through withholding on a portion of a customer's premium payments. 

Contracts with insurance companies require the business to perform a number of administrative services. For example, the business must report all known incidents, claims, suits, and notices of loss to the insurance company or its designated claims adjuster. It must also cooperate fully to facilitate any investigation, adjustment, settlement, and payment of any claim. 

Second, the business also contracted with insurance wholesalers. Under this model, the business has a contract with a wholesaler and not an insurance company, and these wholesalers contract with multiple insurance companies. In this case, the business would select an appropriate policy for a customer provided by a wholesaler. If the customer accepts the policy, the wholesaler procures the policy from the insurance company. 

Definition of “Brokerage Services” 

The Internal Revenue Code does not define the term “brokerage services” in the context of Sec. 1202. Therefore, the IRS turned to the dictionary definition of the word. The dictionary defines a broker as a “mere intermediary” to a transaction, such as a stockbroker or real estate agent. Given that the business provided many administrative services well beyond what a mere intermediary would typically provide, the IRS concluded that the taxpayer was an eligible trade or business under Sec. 1202 and, thus, not an excluded brokerage business. 

This PLR is a welcome development for businesses seeking clarity on the rules of QSBS; however, it is important to note that a PLR can only be cited as precedent for the requesting taxpayer. A tax professional should be consulted to determine potential Sec. 1202 eligibility. Contact us today to find out how we can support you.