On 27 May 2022, the IRS published its sixth statement on the types of enterprises that can qualify for the qualifying share of small business (QSBS) off. The decision is the fourth time the IRS has dealt with the health exclusion in section 1202 (e) (3), the third time it has dealt with the exclusion for businesses where the main asset is the reputation or skills of one or more employees, and the first the time the IRS opened the door for the pharmaceutical business to qualify for QSBS exclusion.
QSBS in general
Section 1202 provides for the total or partial exclusion of capital gains realized on the sale of QSBS. If the requirements are met, then taxpayers can exclude from gross income capital gains of more than (i) $ 10 million, or (ii) an annual 10-fold exclusion of their base in inventories sold (for an exclusion amount up to $ 500 million). Both restrictions apply to every issuer and every taxpayer, and while the exclusion is limited to the larger of the two rules, in practice the $ 10 million rule is most often the limiting factor for start-ups.
An important question in determining the eligibility of QSBS is whether the business is a qualified trade or a business (QTB). The Articles of Association define QTB as any trade or business other than the following excluded enterprises:
A. Any trade or business involving the provision of services in the fields of healthcare, law, engineering, architecture, accounting, actuarial science, performing arts, consultancy, athletics, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skills of one or more of its employees;
B. Any banking, insurance, financial, leasing, investing or similar business;
C. Any agricultural business (including the activity of growing or collecting trees);
D. Any business involving the production or extraction of products of a nature in respect of which a deduction is permitted under Section 613 or 613A; and
E. Any business for the management of a hotel, motel, restaurant or similar business.
For a more detailed summary of the QSBS eligibility rules, read here.
The decision concerns the scope of two excluded businesses: (i) the healthcare sector and (ii) any business whose main asset is the reputation or skills of one or more of its employees. It does not apply to any of the other QSBS exclusion requirements, such as the gross assets test, the asset utilization test or the holding period policy.
The taxpayer in PLR 202221006 (3 March 2022) is a pharmaceutical distributor that retails a limited number of medicines. It enters into exclusive distribution agreements with drug manufacturers, but does not manufacture any drugs. Its staff includes licensed pharmacists who dispense medicines by mail and unlicensed staff who coordinate insurance coverage for prescriptions. Unlicensed staff will contact patients from time to time to inquire about side effects of prescriptions and to plan recharging.
Pharmacists and other employees do not interact with doctors except to receive prescriptions from them. Pharmacists will interact with patients only to answer questions, but they are not involved in the diagnosis, treatment or management of medical care, and interactions with patients are limited to completing and maintaining prescriptions as prescribed by a physician.
The IRS ruled that the taxpayer was not involved in healthcare because it did not provide medical services to patients and its employees were not certified healthcare providers. He just fills out prescriptions and interacts with patients randomly to secure prescriptions and answer prescription questions. The IRS noted that all taxpayer income is generated from drug sales.
The IRS also ruled in favor and without explanation that the taxpayer’s main asset was not the reputation or skills of one or more of its employees.
The IRS concludes that the taxpayer is not involved in trade or business (i) involving the provision of health services or (ii) when the principal asset of the trade or business is the reputation or skills of one or more of its employees.
Significance of the decision
The decision is useful for two reasons: (i) it is based on previous guidelines that narrow the scope of the health exclusion and (ii) it confirms that the IRS will issue decisions in private lettersPLR) for taxpayers who are in the process of negotiating the sale of their business, and not just for taxpayers with already signed agreements.
This second point is especially useful for selling shareholders who want clarity on whether their business is QTB so that they can calculate how much tax will be due on the sale of shares. For example, if a zero-shareholder sells such shares for $ 10 million, then it will not pay federal income tax if the business is QTB and otherwise it qualifies for QSBS exclusion. Conversely, if the business is not a QTB, then the shareholder will owe federal income tax of approximately $ 2,380,000 ($ 10 million at 23.8%).
Sellers can obtain advice on the eligibility for QSBS exclusion from either a qualified tax advisor or the IRS in the form of a PLR. PLR provides more security, but can be more expensive to obtain, as the taxpayer will have to pay an IRS user fee of $ 38,000 along with a tax advisor’s fee for preparing and filing a request for a ruling and attending a conference. with the IRS if necessary.
The IRS has the right to issue PLRs and will not normally issue them for alternative proposed transaction plans or hypothetical situations. This is where it can become difficult for taxpayers who want to get a PLR. Taxpayers want tax security in the form of a PLR before agreeing to a sale price in a signed agreement, but without an agreement, the IRS may not issue a decision if it deems the request hypothetical or seeks advice on alternative plans for a proposed deal.
This is a classic situation with chicken and egg. The IRS will not rule on hypothetical transactions and taxpayers want tax security before finalizing the terms of the deal. In the present decision, the IRS gave a look at its thinking on the matter, as it issued the decision, although it acknowledged that the taxpayer and its shareholders “are in the process of negotiating the sale of their shares. . . This makes it convenient for the IRS to issue a decision, even though no final sale agreement has been reached. This is welcome news for taxpayers who are considering seeking a solution from the IRS but have not yet finalized the deal. .
Summary chart of current QTB guidelines
The chart below summarizes the QTB guidelines issued by the IRS at the date of this article. It includes the types of business discussed in the authorities and whether the IRS has established that the taxpayer’s business is within the relevant exceptions. Recall that if a trade or business is not within exclusion, then it is QTB and therefore qualifies for exclusion if the other QSBS requirements are met.