Editor: Greg A. Fairbanks, J.D., LL.M.
Sec. 1202 allows shareholders to exclude gain from the sale of qualified small business stock (QSBS) from income. Many requirements at both the shareholder and corporate level must be satisfied for stock to qualify as QSBS. Of these requirements, perhaps the most difficult to apply is the active business requirement, which mandates that at least 80% (by value) of the assets of the corporation must be used in the active conduct of one or more qualified trades or businesses. A qualified trade or business is defined through exclusion, with a laundry list of categories of businesses that may not be treated as qualified trades or businesses. Among these excluded businesses is any trade or business involving the performance of services in the field of brokerage services (Sec. 1202(e)(3)(A)). There is no definition of "brokerage services" in Sec. 1202 or its regulations.
Letter Ruling 202114002 involves a corporation that assists clients in obtaining various types of insurance policies. In the business line that is the subject of the ruling, the corporation enters into contracts with insurance companies to sell policies to customers in exchange for commissions from the insurance companies. These contracts require the corporation to perform certain administrative services, including reporting incidents, claims, suits, and notices of loss to the insurance company and cooperating to facilitate any investigation, adjustment, settlement, and payment of any claim. The corporation is also required to keep records of all transactions and correspondence with the insureds and to make those records available to the insurance companies for examination, inspection, verification, and audit.
In the ruling, the IRS noted that there is no definition of "brokerage services" in Sec. 1202 and no explanation in the legislative history. Citing case law holding that "[w]ords in a statute generally are presumed to bear their ordinary, contemporary, common meaning," the IRS turned to dictionary definitions of the term "broker": "one who acts as an intermediary: such as ... an agent who negotiates contracts of purchase and sale (as of real estate, commodities, or securities)." In applying this definition, the IRS concluded that the corporation was not a mere intermediary because the corporation performed administrative services under its contracts with the insurance companies (reporting claims/incidents and keeping records of transactions and correspondence). Accordingly, the corporation was granted a ruling that it was engaged in a qualified trade or business.
Although letter rulings may not be used or cited as precedent by other taxpayers, the conclusion in this ruling does provide some insight into the IRS's approach to the definition of "brokerage services." Corporations that primarily arrange transactions between other parties may still be engaged in a qualified trade or business, depending on the specific facts of the situation. It appears to be a helpful fact if the intermediary remains involved after arranging the transaction, to provide services to one or both of the parties to the transaction it arranged. On the other hand, an intermediary that concludes its service once the transaction is consummated will have a harder time arguing that it is not engaged in brokerage services.
Letter Ruling 202114002 may also provide some insight into the IRS's approach to interpreting the other categories of businesses that are excluded from the definition of a qualified trade or business. In determining whether the corporation was engaged in brokerage services, the IRS ignored definitions of the term in other areas of the tax law and instead resorted solely to the plain meaning of the term as found in a dictionary.
Most obviously, the IRS disregarded the definition of the term in the regulations under Sec. 199A. Sec. 199A(d)(2) references the Sec. 1202 list of excluded trades or businesses in enumerating its own list of "specified service" trades or businesses. Accordingly, many of the Sec. 1202 excluded businesses, including brokerage services, have fleshed-out definitions within the Sec. 199A regulations (for "brokerage services" under Sec. 199A, see Regs. Sec. 1.199A-5(b)(2)(x)). Although these definitions explicitly apply only to Sec. 199A, the lack of definitions for excluded qualified trades or businesses within Sec. 1202 may drive some taxpayers to refer to the specified service trade or business definitions by analogy. The approach the IRS took in Letter Ruling 202114002 should give taxpayers some pause in relying on the Sec. 199A regulations or other definitions in the tax law for Sec. 1202 purposes, especially where those analogous definitions conflict with or narrow the plain dictionary definitions of a term.
Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.
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