By David Bellumori
After a series of taxpayer-friendly private letter rulings (“PLR”) from 2014 to 2021 (including PLR 201436001, PLR 201717010, PLR 202114002, and PLR 202125004) that take a relatively narrow view of the definitionally excluded trades or businesses for qualified small business stock (“QSBS”) purposes, in 2022 the IRS Office of Chief Counsel (“Chief Counsel”) issued additional administrative guidance in the form of Chief Counsel Advice (“CCA”) 202204007, which addresses the “qualified trade or business” issue as it relates to the provision of brokerage services. CCA 202204007 appears to require that taxpayers need to do something more than merely function as an intermediary between buyers and sellers via a web presence if they want to be a “qualified trade or business” for QSBS purposes.
The “qualified trade or business” requirement under Internal Revenue Code (“IRC”) Section 1202(e)(3) is one of the more difficult requirements for taxpayers to evaluate whether they satisfy because while the statutory language is broad, and there is a general lack of regulatory guidance, the IRS has previously interpreted the proscribed trades or businesses narrowly.
Why it Matters
Taxpayers look to obtain QSBS treatment on the sale or exchange of qualifying stock because it allows them to exclude the greater of $10 million of gain, or ten times their basis in their stock in a small business corporation. The benefit of potentially excluding millions of dollars from federal income tax is obvious; however, demonstrating to the satisfaction of the IRS that the taxpayer meets all the requirements for QSBS eligibility is often not so obvious. While several requirements must be satisfied, the “qualified trade or business” requirement is often one of the more difficult requirements to evaluate for many Bay Area high-tech companies operating in the biotech and fintech spaces because a “qualified trade or business” is defined by exclusion. In other words, the statute says that a “qualified trade or business” means any trade or business other than several listed categories of trades or businesses. On first impression, those listed categories seem quite broad, and include:
- 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 one or more of its employees; (emphasis added)
- Any banking, insurance, financing, leasing, investing, or similar business;
- Any farm business;
- Any business involving mining and mineral extraction; and
- Any business of operating a hotel, motel, restaurant, or similar business.
A plain reading of this statutory language suggests that any trade or business that involves the performance of services in the fields of health, financial services, or brokerage services (among the other listed categories) cannot be a “qualified trade or business”, by definition. Fortunately for many biotech and fintech companies, the IRS’s private letter rulings seemed to have adopted a narrow interpretation of this statutory language, at least until the announcement of CCA 202204007.
So, What Changed In CCA 202204007?
The corporation at issue in CCA 202204007 operates a website through which potential renters could view properties available for rent which are listed on the site by property owners. CCA 202204007 does not explicitly state that the corporation’s business is a web platform advertising short-term vacation rentals, but these types of platforms come to mind (e.g., Vrbo, Airbnb). The corporation at issue has no authority to enter into or sign leases on behalf of property owners or renters. The corporation’s website includes a feature that shows a user that is looking to rent in a specific locale other rental property available in the same general area that is also available for booking on the site. The corporation generates its revenue from two separate revenue streams based on the property owners who used the site: (1) a recurring periodic fee for simply being listed on the site (i.e., a subscription fee); and (2) a contingent fee based on a percentage of the rent paid by the renter to the property owner for a rental booked through the site (i.e., a commission).
The Chief Counsel speculates that there are two primary possibilities for characterizing the services provided by the corporation through its website. First, it could be that the corporation is simply providing advertising services. Second, it could be that the corporation’s services go beyond passive advertising services and constitute the provision of brokerage services. If the corporation’s business is advertising, then it could be a “qualified trade or business”, as advertising is not a proscribed category; however, if the corporation is providing brokerage services through its platform, then it could not be a “qualified trade or business” and its shareholders are therefore not eligible for QSBS treatment.
After examining various definitions of the term “broker”, including definitions for different provisions of the IRC, general legal definitions, and common dictionary definitions of general application, the Chief Counsel figuratively throws up its hands and says that the relevant inquiry is one of substance over form. In other words, what the corporation calls itself is not what controls the analysis, and the mere fact that a taxpayer refers to itself as a broker does not, in and of itself, mean the taxpayer is a broker within the scope of IRC Section 1202(e)(3).
Then, based on general income tax principles, the Chief Counsel says that if what is considered to be income is to be construed broadly, then exclusions from income should be construed narrowly. In turn, this means a broad interpretation of the term “brokerage services” is appropriate, so as to narrowly construe the exclusion. Based on this logic, the Chief Counsel decides that the corporation is providing “brokerage services” under the common meaning of the term because the corporation serves as an intermediary between a buyer and a seller.
This leads to what is the most important statement in CCA 202204007 for other taxpayers, as the Chief Counsel states that:
Unlike a search engine that provides content to users and also sends targeted advertisements to those users based on their search history, Corporation’s website is solely devoted to effectuating agreements between potential lessors and lessees of certain property.
The Chief Counsel’s contrast of the corporation’s platform to a search engine, which uses its users’ search history and a proprietary algorithm to target ads to those users, arguably provides some insight into what the Chief Counsel is really thinking about here, beyond merely what is the “right” definition of the term “broker”. It appears that the Chief Counsel is suggesting that if the corporation had done something more than merely provide a platform that functioned as an intermediary between property owners and renters, then the analysis of the “qualified trade or business” issue might have been different.
For example, if the corporation had utilized user data and search history to target ads or suggest other services or activities that could also be booked through the site, then perhaps this would have made the corporation look less like a mere intermediary between a buyer and a seller. What if the corporation had utilized an algorithm aggregating weather and travel data and data from renters’ social media activity to build a predictive model of not only the best time in which to book the rental to achieve the best price and experience at the destination, but also to predict the activities that the renter would also want to book, based on their likes and dislikes? This seems like more than merely acting as an intermediary. Similarly, what if the corporation’s revenue model had been more heavily weighted in favor of subscriptions and ad clicks, rather than commissions paid by property owners? This arguably could also have influenced a different result. For example, what if the corporation had charged all users to use the site and applied a portion of each user’s subscription fee towards “points” redeemable by renters for reduced-cost tickets, tours, and services at the locations in which they would be staying and redeemable by property owners for reduced cost cleaning, repair, accounting and compliance services, or other reduced-cost services which would have been valuable to property owners and renters alike? This also seems like it might not have so squarely fallen into the mold of brokerage services.
The clearest takeaway of CCA 202204007 is that a proscribed trade or business is not magically transformed into a qualified trade or business for QSBS purposes simply because one performs the proscribed trade or business online. For example, a physician’s practice that only sees patients virtually via web conferencing does not become a qualified trade or business simply because it operates online. Similarly, a virtual law firm that lacks a physical location is no different for QSBS purposes than a traditional brick-and-mortar firm.
Taxpayers operating trades or businesses that are related to a proscribed category of trade or business should consider what other services and revenue models they can implement to distinguish themselves from the commonly understood definitions of the proscribed trades or businesses in order to increase the likelihood of satisfying the “qualified trade or business” requirement for QSBS purposes.
Taxpayers with questions about qualified small business stock can contact David Bellumori to discuss their situation.
About the Author: Mr. Bellumori is an associate attorney with Berliner Cohen’s tax and corporate law group. He can be reached by phone at 408.286.5800 and via email at firstname.lastname@example.org.
Categorized in: General
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