Navigating what constitutes a “Qualified Trade or Business” under section 1202(e)(3) can be tricky.  Regarding service businesses, the code identifies certain excluded fields and provides a potential catch-all for other potential service businesses, noting that Qualified Small Businesses exclude “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.”1

Section 1202 uses an ambiguous phrase “performance of services in the fields of…” when referring to unqualified service industries, which include ‘health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services.’  

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 cases.

IRS Determinations

  • One case 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. 2
    • 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 another case, the IRS reviewed a Company that works with pharmaceutical companies to help commercialize experimental drugs.  The IRS concluded that despite the Company’s proximity of its business activities to the field of health, it does not perform services in the health industry within the meaning of § 1202(e)(3).1
    • The ruling examined the Company’s activities as involving ‘the deployment of specific manufacturing assets and intellectual property assets to create value for customers’ as opposed to ‘offering service in the form of individual expertise’.  The IRS effectively noted that the types of activities performed by the Company are not “services” as per Section 1202.  

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.  

Section 1202(e)(3) specifically excludes 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 1  or  more of its employees.”

1 Private Letter Ruling 201717010

2 Private Letter Ruling 201436001

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