IRS Limits Tax Exclusion of Qualified Small Business Stocks

After issuing a series of taxpayer-friendly rulings, the IRS recently issued guidance limiting the scope of item 1202. Section 1202 is the tax provision that allows taxpayers to exclude the capital gain on the sale of qualified small business corporation (QSBS) stock if certain conditions are met. As summarized in a previous item, Section 1202 allows individuals to exclude from gross income the greater of $10 million or 10 times their initial investment in their business, with the ability to exclude up to $500 million of gain. This is one of the most powerful earnings exclusion provisions in the Internal Revenue Code.

The most recent advice took the form of a memorandum of advice from the Chief Counsel, ACC 202204007 (4 November 2021)which was published on January 28, 2022. This type of notice is from the IRS National Office of Chief Counsel, headquartered in Washington, D.C. This is a written notice that is issued to employees from the IRS, and while it technically does not have the force and effect of law, that is to say., it is not “precedent” in tax jargon, it reflects the legal interpretation of the Office of the Chief Counsel.

Most important for our purposes is that this type of advice constitutes “authority” for the purposes of determining whether there is substantial authority for the tax treatment of an item. This is important because taxpayers must have at least “substantial authority” over the tax treatment of an item to avoid penalties. Substantial authority usually equates to a 40% chance of success. In the absence of substantial authority, taxpayers must have a reasonable basis (approximately 25% chance of success) for the position and affirmatively disclose it to the IRS on Form 8275 in order to avoid penalties. Filling out this form with a tax return is like running into the lobby of the IRS while raising a red flag and asking to be audited.


The taxpayer in the CCA sold appreciated shares in a corporation and sought to exclude the capital gain under section 1202. The issue addressed in the CCA is whether the corporation is engaged in a trade or business qualified (QTB). Remember that any business is a QTB except those specifically listed in section 1202(e)(3). The relevant exclusion here is the “brokerage services” exclusion.

The IRS addressed the “brokerage services” exclusion in January 2021 when it issued a favorable opinion private decision for an insurance broker who provided administrative services to his clients. The IRS ruled that the taxpayer was not engaged in brokerage services because he was doing more than a traditional broker, which he defined as a mere middleman. The ruling had the effect of reducing the brokerage services exclusion, which expanded the number of taxpayers eligible for a QSBS exclusion. This decision was summarized in a previous item.

The CCA Company operates a website that facilitates the rental of real estate between lessors (those who have property to rent) and tenants (those who want to rent property). Prospective tenants use the site to make non-binding reservations for the use of certain facilities which are in the site’s database. Once a lessor and lessee come to an agreement, they sign a rental agreement through the website and all rental payments are also made through the website. Although the company operating the website does not have the authority to enter into rental agreements, it does collect from the lessor a fixed fee to maintain its listing on the website and a percentage of the rental payments to facilitate the rental transaction. . The Website also provides other fixed price services to Lessors, such as website hosting to be used in conjunction with the rental of Lessor’s facility. In its terms of service (you know, the fine print that no one reads), the company stated that it is not engaged as a broker, and it asserted to the IRS that it was not a broker even though she “may hold a real estate broker’s license in one or more states.

Based on these facts, it should come as no surprise (except to the taxpayer, perhaps) to learn that the IRS has deemed the company’s activity of operating the website to constitute “services of brokerage”. The company acts, after all, as an intermediary between landlords and tenants, and this activity fits perfectly with the definition of a broker according to any reasonable interpretation of the word.

In reaching its conclusion, the IRS observed that neither Section 1202 nor any case law defines the term “brokerage services”. He therefore proceeded to analyze the dictionary meaning of the word “broker” as well as the authority under other provisions of the Internal Revenue Code that provide similar exclusions for brokerage services.

Dictionaries consulted by the IRS generally designate a broker as (i) one who acts as an intermediary and (ii) one who is engaged for another, usually on commission, to negotiate contracts or act as intermediary, in particular between prospective buyers and sellers. The IRS has recognized that there can be many types of brokers and has stated that the mere fact that a party is not commonly referred to as a broker does not in itself exclude the possibility that it is a broker.

The IRS has also consulted analogous tax provisions. Under a section dealing with the communication of information, the term broker has been broadly defined to include “any person who (for remuneration) regularly acts as an intermediary in respect of goods or services”. Although regulations under this section limit the disclosure of information to brokers who only deal in certain types of financial assets, the IRS noted that nothing limits the types “brokers” subject to the reporting obligation; in other words, the definition of a broker remained broad enough to apply to company website operations. Additionally, when Congress added real estate transactions to the types of transactions subject to reporting, it included a broker ordering rule that applies to various types of brokers. The definition of a real estate broker for the purposes of this rule includes (i) the person responsible for entering into the transaction, (ii) the seller’s broker and (iii) the buyer’s broker. The IRS viewed this as evidence of Congress’s intent to apply a broad meaning to the definition of a broker, and certainly a meaning that includes the firm’s rental facilitation operations.

Under another tax arrangement dealing with tax accounting methods, the regulations provide that the question of whether a person’s services constitute brokerage services is based on all the facts and circumstances, including the manner in which the person is remunerated (for example., if compensation is conditional on completion of the transaction that the services were intended to perform). In one example, the settlement finds that a taxpayer provides a brokerage service when it executes transactions for clients and its compensation is based on the actual transactions made by the clients.

The last tax arrangement reviewed by the IRS has regulations which define brokerage services as including “services in which a person arranges transactions between a buyer and a seller in securities. . . for a commission or fee, including stockbrokers and other similar professionals, but does not include the services of real estate agents and brokers, or insurance agents and brokers. The IRS has disregarded this definition of brokerage services because the regulation only applies for the purposes of that specific section and because the tax policy objective of that section is not similar to the tax policy objective of section 1202.

After reviewing the above authorities, the IRS has ruled that the operations of the company’s website are “brokerage services” in the ordinary sense of that term, even though the company claims that it provides advertising services. rather than brokerage services. The company acts as a middleman, matching buyers and sellers, which is the classic definition of a broker, and it does more than passively post ads on its website. Moreover, it is different from a search engine that delivers targeted content and advertisements to users based on their search history. The company’s website is devoted solely to the execution of agreements between potential lessors and tenants of real estate, and it charges a commission contingent on the execution of a rental transaction. Finally, the IRS was not moved by the fact that the services are provided by software rather than people because the functional nature of the services remains the same.

The CCA is the sixth IRS statement addressing the QTB issue, and it is the first to conclude that the company under review is not a QTB. It would be hard to argue, however, that these guidelines represent some sort of paradigm shift on the part of the IRS, as the CCA facts are not particularly favorable to the taxpayer. The takeaway here seems to be that the IRS reviews statements asserting a QSBS exclusion and will not hesitate to challenge taxpayers’ positions. Taxpayers requesting a QSBS exclusion should document their entitlement to the exclusion and work with their advisors to ensure their positions will stand up to IRS scrutiny.

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