In order to qualify as a “Qualified Small Business”, Section 1202 requires that the corporation to be in a “qualified trade or business.” The general intent of the QSBS tax exclusion is to incentivize investment in entrepreneurship of innovative companies to help drive future economic growth.
Example of a qualifying companies could be a corporation designing/developing a frontier tech product, whether it is software or hardware, such as:
- A new SaaS platform that writes legal documents, however if the primary service of the company is writing legal documents for clients the business may not qualify.
- A company creating an AI robot that quickly changes automobile tires quickly, however if the primary service of the business is the service of changing car tires the business may not qualify.
Below are companies that represent qualifying industries, all of which have been venture capital backed. If stock acquired in these companies meets the other criteria for QSBS, the tax savings can be substantial.
Which Types of Companies Qualify as QSBs and Which Don’t?
To qualify as being able to issue QSBS stock, the corporation needs to be developing or producing a product for businesses or consumers. If the principal asset of the corporation is the skill or reputation of one or more employees than the corporation does not qualify for QSBS. According to Section 1202(e)(3) a “qualified trade or business” is any company other than:
- “Any trade or business where the principal asset is the reputation or skill of one or more of its employees”, such as performance of services in the fields of “health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services”.
- “Any banking, insurance, financing, leasing, investing, or similar business”
- “Any farming business”
- “Any business involving the production or extraction of products”, such as mining.
- “Any business of operating a hotel, motel, restaurant, or similar business.”
The vagueness of the phrase “performance of services” or determining whether the “principal asset” of a business comes from the skill or reputation of a particular employee can be subjective, however, some clarity has been offered by certain case rulings by the IRS.
What if You Are Not Sure Whether the Corporation Qualifies?
It is possible to challenge / dispute the IRS’s determination regarding the eligibility of your business.
For example, in a ruling letter issued on May 22, 2014, Ruling 201436001, the IRS examined whether a corporation which provides products and services primarily in connection with the pharmaceutical industry, helping to commercialize experimental drugs, meets the “qualified trade or business” criteria.
The IRS noted,
“the thrust of Section 1202(e)(3) is that businesses are not qualified trades or businesses if they offer value to customers primarily in the form of services, whether those services are the providing of hotel rooms, for example, or in the form of individual expertise (law firm partners).”
Further, the IRS noted that this particular company
“is not in the business of offering service in the form of individual expertise. Instead, the Company’s activities involve the deployment of specific manufacturing assets and intellectual property assets to create value for customers.”
The IRS determined that the Company “does not perform services in the health industry within the meaning of Section 1202(e)(3)” and is therefore engaged in a qualified trade or business.
Another case (Private Letter Ruling 201717010) involved a company that provides health testing services and laboratory services, using a proprietary product and tools. The IRS reviewed this case and ruled that the company is engaged in a qualified trade or business under §1202(e)(3), suggesting that there are healthcare-related businesses that could still qualify as Qualified Small Businesses.
The IRS noted:
“Although Company’s laboratory reports provide valuable information to healthcare providers, Company does not provide health care professionals with diagnosis or treatment recommendations for treating a healthcare professional’s patients nor is Company aware of the health care provider’s diagnosis or treatment of the healthcare provider’s patients. In addition, the skills that Company’s employees have are unique to the work they perform for the Company and are not useful to other employers.”
In evaluating if a business may qualify it may help to start by asking whether the company’s customers ultimately receive a product or service. If the ultimate product is a service, is the provision of the service attributable to the skills and/or reputation of certain employees, or more so through the company’s intangible or tangible assets.
While there is no one answer to the question “what service businesses do or do not qualify for QSBS“, various cases offer guidance to consider. As these cases demonstrate, the ambiguity of the tax code is not necessarily as unpleasant as one might think because it provides individuals an opportunity to provide an argument to their reasoning.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.