What does ‘consulting’ mean for purposes of Sec. 1202?

By Joseph Wiener, J.D., LL.M, New York City, and Stefan Gottschalk, CPA, J.D., LL.M., Washington, D.C.

Editor: Lori Anne Johnston, CPA, J.D.

Sec. 1202 generally provides a 100% exclusion from gain on the sale of stock of a qualified small business. Awareness of the Sec. 1202 gain exclusion has been increasing, and the 21% federal corporate tax rate that went into effect for 2018 and following has made organizing a business as a C corporation more beneficial than it has been in decades. As a result of these developments, interest in Sec. 1202 has increased. A number of issues arise in determining whether, and to what extent, corporate stock qualifies for the Sec. 1202 exclusion. This item discusses one such issue: What is a consulting business?

One Sec. 1202 requirement is that the corporation must constitute a "qualified trade or business," which includes all trades or businesses other than the types explicitly excluded in Sec. 1202(e)(3). One of the excluded business types is consulting. The Code does not define consulting for purposes of the rule on qualified trades or businesses, nor do Treasury regulations or the legislative history addressing Sec. 1202 provide guidance. Accordingly, taxpayers must look to other sources to derive its meaning.

Background on Sec. 1202

Sec. 1202(a) excludes capital gain recognized by noncorporate taxpayers on the sale of qualified small business stock (QSBS) of certain corporations. Requirements include that the stock must be held by the taxpayer for more than five years. For gain on the sale of stock acquired after Sept. 27, 2010, 100% of the gain recognized generally is excluded from gross income. For gain on the sale of stock acquired on or before Sept. 27, 2010, and after Aug. 10, 1993, a lower percentage generally is excluded (either 75% or 50%, depending on the date of acquisition).

The amount of gain a taxpayer is eligible to exclude is subject to a limitation, generally, the greater of: (1) $10 million for all of the taxpayer's QSBS issued by the corporation; or (2) 10 times the aggregate adjusted bases of the corporation's QSBS disposed of by the taxpayer in the tax year (Sec. 1202(b)(1)). For stock held by a passthrough entity, the limitation is computed on a partner/shareholder-level basis and not an entity-level basis (Sec. 1202(g)(1)(B)).

The taxpayer must have acquired the stock directly (or through an underwriter) from the issuing corporation (Sec. 1202(c)(1)). The issuing corporation must remain a domestic C corporation during substantially all of the taxpayer's holding period (Sec. 1202(c)(2)(A)).

Additionally, the company must conduct a qualified trade or business, which is defined as any trade or business other than those providing "services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting," and certain other fields specified in the statute (Sec. 1202(e)(3)).

So what exactly is consulting?

What is the meaning of consulting for purposes of this provision? Sec. 1202 does not define the term, and authorities under Sec. 1202 do not address its meaning. However, authorities in other contexts, including regulations and authority under other provisions of the Code, provide some clarification.

Sec. 199A (discussed below in more detail) includes a category called "specified service trades or businesses" (SSTBs). The SSTB category, by a cross-reference to Sec. 1202(e)(3), generally incorporates a modified version of the Sec. 1202 definition of a qualified trade or business (Sec. 199A(d)(2)(A)). This modified version retains the exclusion of consulting businesses from status as a qualified trade or business for purposes of Sec. 199A. The preamble to the final Sec. 199A regulations states that determining whether a particular business is an SSTB and therefore excluded from being a qualified trade or business requires a facts-and-circumstances analysis (T.D. 9847).

Regarding consulting specifically, some guidance or analytical principle is necessary to delineate the parameters of the term prior to applying that delineation to the facts and circumstances of a particular case. This need arises because the colloquial meaning of the word "consulting" is highly vague. To illustrate, consider whether the following activities constitute consulting:

  • Special education advice and advocacy;
  • Due-diligence services on behalf of prospective buyers of target companies;
  • Real property appraisals for property tax purposes;
  • Risk management assessment services;
  • Business expansion advice and proposal writing.

Do these activities constitute consulting? Based merely on a colloquial use of the term, there is no clearly correct answer. Accordingly, prior to engaging in a facts-and-circumstances analysis, practitioners should interpret the word for federal tax law purposes based on the meaning it has been given in contexts outside Sec. 1202.

'Consulting' as used in Secs. 448 and 199A

Sec. 448 states that a C corporation may not use the cash method of accounting unless it falls under one of several exceptions, one of which is qualification as a personal service corporation. A personal service corporation is defined in part as a corporation that performs substantially all its activities as services "in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting" (Sec. 448(d)(2)(A)).

Temporary regulations under Sec. 448 state that "consulting means the provision of advice and counsel." The temporary regulations state further that consulting "does not include the performance of services other than advice and counsel, such as sales or brokerage services, or economically similar services," and "the determination ... shall be based on all the facts and circumstances of that person's business" including "the manner in which the taxpayer is compensated for the services provided (e.g., whether the compensation for the services is contingent upon the consummation of the transaction that the services were intended to effect)" (Temp. Regs. Sec. 1.448-1T(e)(4)(iv)(A)).

The temporary regulations provide 10 examples that illustrate what does and does not constitute "the provision of advice and counsel." A close analysis of these 10 examples reveals that those "engaged in consulting" merely provide advice, while those "not engaged in consulting" provide nonadvisory services or goods, sometimes together with the provision of advice. Those nonadvisory services include transaction execution, personnel and hiring assistance, and advertising. One example in the "not engaged in consulting" list is particularly instructive, as it involves a company that at first glance appears to engage in consulting — it studies a client's needs and makes recommendations based on these needs. However, because the client orders the equipment through the company and pays the company based on the number of orders made, the temporary regulations held that the company is not "engaged in consulting" (Temp. Regs. Sec. 1.448-1T(e)(4)(iv)(B), Example (6)). In that example, it appears the advice provided is treated as ancillary to the product that is delivered. Advice that culminates in the delivery of a product or nonadvisory service is thus merely an initial step in the delivery of the product or performance of the service and is not independently treated as consulting.

Another provision that uses the term "consulting" is Sec. 199A. Sec. 199A, enacted in 2017, permits an individual (or other noncorporate taxpayer) a deduction of up to 20% of income from a qualified trade or business (Sec. 199A(a)). A trade or business is "qualified" for this purpose if it does not consist of "performing services as an employee" and is not a "specified service trade or business" (Sec. 199A(d)). The term "specified service trade or business" draws explicitly from Sec. 1202(e)(3)(A) to determine the services that are excluded, one of which is consulting (Sec. 199A(d)(2)(A)). Although Sec. 199A does not provide further guidance on the meaning of the excluded services, the Sec. 199A regulations provide a detailed explanation of the meaning of consulting.

The Sec. 199A regulations adopt the same terms used in the Sec. 448 proposed regulations — "advice and counsel." The regulations state further that "consulting does not include the performance of consulting services embedded in, or ancillary to, the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB ... if there is no separate payment for the consulting services" (Regs. Sec. 1.199A-5(b)(2)(vii)). The regulations also provide examples that illustrate the scope of "advice and counsel" and indicate that the answer turns on whether the advice and counsel complement other services provided.

Are these regulations appropriate sources of guidance?

It appears appropriate to use the Sec. 448 temporary regulations as a source of guidance. For more than three decades, the only authoritative interpretation given to the term "consulting" as used in the Code was the interpretation that appeared in the Sec. 448 temporary regulations. Moreover, the preamble to the Sec. 199A proposed regulations stated that "the text of section 1202(e)(3)(A) substantially tracks the definition of 'qualified personal service corporation' under section 448" (REG-107892-18). Accordingly, it stands to reason that the interpretation of consulting under Sec. 1202(e)(3)(A) tracks the interpretation provided under Sec. 448.

However, it may not be appropriate to rely on the Sec. 199A regulations as a source of guidance for the meaning of consulting under Sec. 1202, as the preamble to the Sec. 199A final regulations states that "the rules for determining whether a business is an SSTB within the meaning of section 199A(d)(2) apply solely for purposes of section 199A and therefore, may not be taken into account for purposes of applying any other provision of law, except to the extent that another provision expressly refers to section 199A(d)" (T.D. 9847; see also Regs. Sec. 1.199A-5(a)(1)).

Using the temporary Sec. 448 regulations as guidance does, however, appear appropriate. That guidance indicates that the word "consulting," as used in Sec. 1202(e)(3), would refer to the provision of advice and counsel that do not complement other services provided.


Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.

For additional information about these items, contact Joseph Wiener (Joseph.Wiener@rsmus.com) and Stefan Gottschalk (Stefan.Gottschalk@rsmus.com).

Unless otherwise noted, contributors are members of or associated with RSM US LLP.

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