Someone at IRS’s Chief Counsel Office realized the Service may have a qualified small business stock (“QSBS”) interpretation problem. After the IRS released multiple private letter rulings (“PLRs”) with favorable guidance on what constitutes a qualified trade or business under IRC section 1202(e)(3), IRS Chief Counsel appears to have had enough. Chief Counsel Memo (“CCA”) 202204007 (Nov. 04, 2021), released on January 28, 2022, concludes that an online marketplace similar to Airbnb or Zillow is engaged in “brokerage services” for purposes of IRC section 1202(e)(3) and, therefore, cannot issue QSBS.
For the fintech community, such a limitation on qualified trade or business status could have major tax ramifications. Nevertheless, Chief Counsel’s expansion of the definition of “brokerage services” may not ultimately impact most startups that have created significant technology or IP advancements for their users.
Background on Qualified Trade or Business Status
In order for shareholders to obtain the $10 million or 10x basis exclusion benefits of QSBS, the company issuing the shares must meet various requirements. Among these requirements, the company must be engaged in a “qualified trade or business,” meaning any trade or business other than the roughly twenty categories listed at IRC section 1202(e)(3). Restricted categories include the performance of services in the fields of health, financial services, brokerage services, and banking. There are no Treasury Regulations or legislative history explaining how to apply the performance of service limitation for qualified trades or businesses in the context of IRC section 1202.
However, since 2014, the IRS has issued five PLRs regarding the meaning and scope of qualified trade of business under IRC section 1202(e)(3). In each of these five letters, the IRS concluded that even though the company was engaged in one of the proscribed fields, the companies were nonetheless engaged in a qualified trade or business.
In PLR 201436001 (May 22, 2014) and 202144026 (Aug. 10, 2021) the IRS arguably provided a coherent framework for determining why companies can be in one of the fields listed at IRC section 1202(e)(3) and still be a qualified trade or business. PLR 201436001 describes a company in the pharmaceutical industry that worked with clients to help commercialize experimental drugs. The IRS concluded that the company was not in the health field because its “activities involve the deployment of specific manufacturing assets and intellectual property assets to create value for customers.”
Similarly, PLR 202144026 describes a company that developed and commercialized software to assist doctors in providing medical treatment to individual patients. The goal of the software was to make treatment more effective by optimizing the patient’s use of medical treatment or medication. As in the 2014 PLR, the IRS reasoned that the nature of the company’s software showed that the company “was not in the business of providing health services but rather creating an asset to be utilized by their customers in the healthcare industry.”
The underlying reasoning of these PLRs appears to be a distinction between companies that create tangible or intangible assets that add value for customers and those that simply deliver services for customers. Provided the company is in the former group, it can still be a qualified trade or business, even if it operates within one of the listed fields under IRC section 1202(e)(3). If the company only delivers value to customers primarily in the form of services, with value attributable to the relative skill or reputation of the individual service provider, then it cannot be a qualified trade or business.
The IRS also issued PLR 202114002 (January 13, 2021) which is particularly important given the recent CCA. In PLR 202114002, the IRS examined an insurance agent or broker that worked with customers to obtain various kinds of insurance by contracting with insurance companies.
The insurance agency not only sold the policies but also performed a number of administrative services, including reporting known incidents to the insurance company and cooperating fully to facilitate any investigation of any claim. The IRS concluded that the company was not engaged in “brokerage services” for purposes of IRC section 1202(e)(3).
In its analysis, the IRS referred to the dictionary definition of “brokerage services” and determined that the term (for purposes of IRC section 1202(e)(3)) would only apply to a company serving as a “mere intermediary facilitating a transaction between two parties.” Since the company’s contracts with insurance companies required it to perform a number of administrative services beyond those that would be performed by a mere intermediary, the IRS ruled it was not engaged in “brokerage services” and, therefore, could issue QSBS.
CCA 202204007 and Potential Limits on Qualified Trade or Business
CCA 202204007 appears to be a direct response to PLR 202114002. In fact, it seems like Chief Counsel may have realized that PLR 202114002 could potentially open a floodgate of arguments that companies which provide something slightly more than merely facilitating transactions between two parties could be qualified trades or businesses.
The new CCA described a company that operates a website for potential renters to make nonbinding reservations with owners to use facilities at specified rental rates. The website operator charged property owners a recurring periodic fee for website listings and a contingent fee based on a percentage of rent transacted through the website.
As in PLR 202114002, Chief Counsel opined on whether the company was engaged in “brokerage services” as described in IRC section 1202(e)(3). However, unlike PLR 202114002, Chief Counsel did not simply refer to the dictionary definition of “brokerage services.” Rather, Chief Counsel reviewed how the term is used in other IRC sections, including IRC section 6045 (imposing information reporting requirements on certain “brokers”), IRC section 448 (distinguishing consulting services from “brokerage services” for qualified personal service corporation status) and IRC section 199A (defining “brokerage services” for the pass-through qualified business income deduction).
After determining that IRC section 448 does not provide a definition of brokerage services and that IRC section 199A, by its own terms does not apply, the CCA states that the online marketplace website should be classified as a “broker” under both the common meaning of the term and the definition under IRC section 6045, which broadly includes “a dealer, a barter exchange, and any other person who (for a consideration) regularly acts as a middleman with respect to property or services.” Furthermore, the company’s actions and services “support the position that it is a broker for purposes of section 1202(e)(3)(A).” As analysis, the CCA states:
A broker serves as an intermediary between a buyer and a seller, and Corporation does this. Corporation does not just passively publish advertisements on its website that are provided to it from potential lessors desiring to lease property. 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 potential lessees of certain property.
The CCA concludes that the company “only provides a vehicle for potential lessees to transmit non-binding reservation requests to potential lessors” and the fact that company’s “services are provided by software created by people rather than directly by people does not change the functional nature of the services.” Thus, the website operator is not a qualified trade or business under IRC section 1202(e)(3) and it cannot issue QSBS.
Preservation of Prior Guidance
Overall, it seems clear the IRS is worried that prior QSBS guidance under PLR 202114002 may be interpreted too liberally. However, CCA 202204007 may not necessarily limit the application of QSBS to fintechs and other online marketplaces, depending on each company’s specific activities.
The key analysis in the CCA shows that the website’s activities, rather than its nominal categorization, drove Chief Counsel’s conclusions. The website operator was “solely devoted to effectuating agreements” landlords and renters. It did not provide additional services such as “a search engine that provides content to users.” Rather, the website simply provided “a vehicle for potential lessees to transmit non-binding reservation requests to potential lessors.” In short, even if the website operator acted as a broker, this determination was not dispositive, depending on the full context.
Rather, its limited function as an intermediary, without more, is what ultimately supported Chief Counsel’s decision that the company was not a qualified trade or business under IRC section 1202(e)(3). Arguably, if the online marketplace featured other administrative services for enhanced customer experiences (like the agent in PLR 202114002) or provided additional content through targeted advertisements based on search history (as described in CCA itself), then the company could have met the requirements to be a qualified trade or business. Perhaps if the company had created some unique algorithm for connecting owners and renters, rather than using “software created by people” to effectuate agreements between potential lessors and lessees, such value would have been enough to meet the qualified trade or business requirement.
In this respect, the CCA can be read as consistent with the five prior PLRs from the IRS, rather than a change in the IRS’s overall position on qualified trade or business status.
The new CCA does expand the definition of “brokerage services” to many more potential businesses.
However, as outlined in PLR 201436001 (the pharmaceutical optimization company), PLR 202144026 (the medical technology company), and PLR 202114002 (the insurance agent), being in one of the listed categories at IRC section 1202(e)(3) is only the first step in the analysis. Even if a company is in the “health” or “brokerage services” field, it remains to be considered whether the company is “creating assets” for their customers or simply delivering services.
If the company is creating assets, then the consistent historical guidance from the IRS (including the new CCA 202204007) holds that the company can be a qualified trade or business, even if that company is operating within one of the proscribed fields. While the new CCA clarifies the definition of “brokerage services,” it does not necessarily create a limitation on what constitutes a qualified trade or business under IRC section 1202(e)(3).
Taxpayers with questions about qualified small business stock can contact Christopher Karachale or the Hanson Bridgett Tax Group.