In a recent Chief Counsel Advice (“CCA”) issued by the IRS, the IRS concluded that the taxpayer’s sale of stock did not qualify for the gain exclusion as Qualified Small Business Stock (“QSBS”) under Section 1202 since the business of the corporation was akin to brokerage services. The IRS concluded that the corporation’s business, one in which the corporation essentially connected lessors and lessees, did not meet the active trade or business requirement discussed below.
Section 1202 and the Gain Exclusion for the Sale of Qualified Small Business Stock
We have previously written about the gain exclusion available for the sale of QSBS. As noted in our prior article, the gain exclusion under Section 1202 only applies to C corporations, an entity structure that has somewhat lost favor in terms of popularity but one that has seen a slight resurgence due to changes in the corporate tax rate from 35% to 21% enacted as part of the Tax Cut and Jobs Act taking effect on January 1, 2018. Please review our prior article for a great discussion of some considerations as to when it might make sense in today’s tax environment to elect C corporation tax treatment.
While our prior article provides a great primer on Section 1202 and the definition of QSBS found in Section 1202, a quick discussion will still prove helpful. QSBS is generally defined as stock issued by a Qualified Small Business (“QSB”) in exchange for money, services, or other property (except for stock). A QSB is a business that meets the following requirements:
- The issuing corporation must have been a domestic C corporation with no more than $50 million in gross assets on the date of issuance;and
- The issuing corporation must use at least 80% of its assets (by value) in the active conduct of a qualified trade or business (“QTOB”).
Generally, for stock to qualify as QSBS several requirements must be met:
- The issuing corporation must be a QSB as of the date of issuance of the stock;
- The stock must be issued after August 10, 1993;
- The stock must be held by a noncorporate taxpayer;
- The taxpayer must be the one to whom the stock was originally issued unless an exception applies;
- The stock must have been issued to the taxpayer in exchange for money, other property not including stock, or services, unless an exception applies; and
- The taxpayer must hold the stock for more than five years.
A QTOB is defined as any trade or business other than:
- 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;
- any banking, insurance, financing, leasing, investing, or similar business;
- any farming business (including the business of raising or harvesting trees);
- any business involving the production or extraction of products of a character with respect to which a deduction is allowable under Section 613 or 613A (depletion deduction for mining, wells, and other natural deposits); and
- any business of operating a hotel, motel, restaurant, or similar business.
Under Section 1202, up to 100% of the gain on the sale of QSBS can be excluded based upon acquisition date. QSBS acquired after September 27, 2010, is generally 100% excluded from tax and is no longer included as an alternative minimum tax preference item. Stock acquired after August 10, 1993, but on or before September 27, 2010, is eligible for a 50% exclusion rate.
Facts of CCA 202204007
The corporation at issue operated a website that connected potential lessees of certain properties with the owners/lessors of the properties. The website was clear that the corporation had no control over the listed properties and did not guarantee that any of the properties were available and that a lease would be consummated once the lessee moved forward. The legally binding agreement to rent a property did not arise until the two parties entered into a lease agreement. In essence, the corporation simply provided the connection.
The corporation was paid by the lessor, with all responsibility for such payments being that of the lessor. The corporation charged a periodic fee for a lessor to list property on the corporation’s database. The corporation also charged the lessor a percentage of the rent paid by a lessee where the lessee and lessor entered into an actual lease as result of the corporation’s connecting the two parties through its database of listed properties. The lessee paid all rent through corporation’s website.
The corporation represented to potential lessees that it is not responsible for, and does not engage in, brokering, selling, purchasing, exchanging, or leasing posted properties. While the corporation did hold a broker’s license in certain states, it asserted that it was not a broker. The corporation’s website made clear to potential lessees that it had pre-negotiated rental rates with the lessors/owners of listed properties included on its website and that part of that rate was paid to the corporation as compensation for services.
Analysis of CCA 202204007
The IRS began its analysis with a brief overview of Section 1202 and then dove into the question at hand, whether the corporation was engaged in brokerage services such that it was not a QTOB. The term “brokerage services” is not defined in Section 1202 nor is it discussed in the related Treasury Regulations. Thus, the IRS first looked to other code sections that might provide some guidance, and in doing so the IRS examined Sections 6045, 448, and 199A.
Section 6045(a) requires every person doing business as a broker to file information returns regarding the person’s customers, and Section 6045(c)(1) provides that the term broker includes—(A) a dealer, (B) a barter exchange, and (C) any other person who (for a consideration) regularly acts as a middleman with respect to property or services. In 1986, Congress added real estate transactions to the types of transactions for which broker reporting is required under section 6045. As there are often many parties to a real estate transaction, the IRS provided some specific ordering rules to ensure there was only one “broker” with a reporting obligation under Section 6045. The “real estate reporting person” to be treated as a broker includes the following persons (in order): the person responsible for closing the transaction, the mortgage lender, the seller’s broker, the buyer’s broker, or such other person designated in the regulations. Based on Section 6045 and its related Treasury Regulations, the IRS concluded that “this regime for real estate brokers shows that Congress understood that the term broker had an expansive meaning, certainly broad enough in this context to apply to corporation’s lease facilitation operations.”
Next the IRS examined Section 448 which deals with C corporation accounting methods, and provides a specific exception to the accrual method for a qualified personal service corporation (“QPSC”) which is treated as an individual, thereby creating an exception to the accrual method requirement for such C corporations and partnerships whose only C corporation partners are QPSCs. Section 448(d)(2) requires that substantially all of the activities of the corporation involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. As the IRS highlights, the list in Section 448(d)(2) notably fails to list brokerage services but rather discusses consulting services. An examination of the Treasury Regulations and examples therein led the IRS to conclude, as to Section 448, that, “as brokerage services are not consulting services under the regulation, the examples do not provide enough facts or criteria to allow a reader to distinguish between sales services, brokerage services, and services economically similar to brokerage services.” Accordingly, Section 448 did not provide an answer to the question at hand.
Last, the IRS examined Section 199A, specifically Section 199A(d)(2)(A) which references Section 1202(e)(3)(A) in determining what businesses are specified service trades or businesses for purposes of Section 199A. Treas. Reg. Sec. 1.199A-5(b)(2)(x) provides that for purposes of Sec. 199A(d)(2) and Treas. Reg. Sec. 1.199A-5(b)(1)(ix) only, the performance of services in the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities (as defined in Section 475(c)(2)) for a commission or fee, including stock brokers and other similar professionals but does not include services by real estate agents and brokers, or insurance agents and brokers. While the Treasury Regulation discussed only applies to Section 199A and is not determinative as to the question at hand, it nevertheless provides guidance since Section 1202 fails to define “brokerage services”.
After discussing the relevant Sections of tax law, the IRS looked into the definition of a broker in the dictionary, with Black’s Law Dictionary defining a broker as “One who is engaged for another, usually on a commission, to negotiate contracts to property in which he or she has no custodial or proprietary interest, or an agent who acts as an intermediary or negotiator, especially between prospective buyers and sellers.”
After walking through the relevant Internal Revenue Code sections and the common meaning of the term “brokerage services”, including the definition of a broker in Black’s Law Dictionary, the IRS concluded that the common meaning and that of Section 6045 was determinative. As noted earlier, Section 6045 has a broad meaning when it comes to the term broker, and may encompass a variety of particular roles played in a real estate transaction. Ultimately, a broker is an intermediary between a buyer and a seller. This is exactly what the corporation did. The corporation was an intermediary connecting the buyer/lessee and the seller/lessor.
While the corporation maintained it did not provide brokerage services but rather provided advertising services by listing and advertising the available properties on its website, the facts did not support this position. The corporation did not provide target ad services such as might be provided by a search engine, and the corporation charged fees to lessors to list property on its website. Further, the corporation charged an additional commission when property was leased through its website.
Ultimately, the IRS determined that the corporation failed to meet the QTOB definition since it was essentially providing brokerage services and was thus excluded. While the definition of “brokerage services” is not specifically defined for purposes of Section 1202, the IRS was able to look to other statutes as well as the common meaning of the word “broker” for guidance. In simple terms, brokers connect buyers and sellers, whether it be a real estate broker, stock broker, gun broker, or any other intermediary. That is what the corporation did here, and it appears the IRS reached the correct conclusion. Since the corporation provided “brokerage services” and “brokerage services” are specifically excluded from a QTOB, the corporation was not a QSB and thus the stock was not QSBS. Unfortunately for the taxpayer, this means no gain exclusion under Section 1202.
 CCA 202204007
 Sec. 1202(c)
 Sec. 1202(d)(B)
 Sec. 1202(e)(A)
 Sec. 1202(c)(1)(A)
 Sec. 1202(a)(2)(A)
 Sec. 1202(a)(1)
 Sec. 1202(c)(1)(B)
 Sec. 1202(c)(1)(B)
 Sec. 1202(a)(1)
 Sec. 1202(e)(3)(A)
 Sec. 1202(e)(3)(B)
 Sec. 1202(e)(3)(C)
 Sec. 1202(e)(3)(D)
 Sec. 1202(e)(3)(E)
 Sec. 1202(a)(1)
 Sec. 1202(a)(4)
 Sec. 1202(a)(1)
 Sec. 448(b)