Executive summary
IRS ruling holds company’s stock may qualify for section 1202 capital gain exclusion since its data services business was not a “consulting” business
Capital gain on a sale of qualified small business stock (QSBS) may be excluded from federal income tax under section 1202. Only the stock of a corporation engaged in a qualified trade or business (QTOB) can be QSBS. A “consulting” business does not qualify. In PLR 202342014, the IRS ruled that a data migration and management services company conducted a QTOB, as any advice and counsel provided by the company was ancillary to its data management implementation services. The section 1202 capital gain exclusion could therefore apply to its stock.
Introduction
Section 1202 excludes some or all of the capital gain on the sale of qualifying stock from federal income tax. For a summary of key provisions and requirements of section 1202, see our article Understanding the qualified small business stock gain exclusion. One of the requirements is that the stock-issuing company must conduct a qualified trade or business (QTOB).
The QTOB requirement applies to the issuing corporation and provides that the corporation must conduct a QTOB and must use at least 80% of its assets, measured by value, in the active conduct of the QTOB for substantially all of the shareholder’s holding period.
Section 1202(e)(3) states that a QTOB includes all trades and businesses other than those explicitly listed as not qualifying. “Consulting” is one of the nonqualifying business types listed.
“Consulting” is not defined or interpreted in the section 1202 Code or regulations, or by any court addressing section 1202. For the first time, the IRS has provided non-precedential guidance addressing it in PLR 202342014.
We have discussed previously other items of guidance the IRS has issued on the meaning of some of the QTOB terms. You can read our articles discussing: (1) brokerage services here Business connecting lease parties not qualified under section 1202 and (2) the QTOB “reputation or skill” clause here IRS rules software company's stock constituted qualified small business stock.
PLR 202342014
The company addressed in the PLR offers data migration and management services to businesses. It does not sell software or technical equipment as part of the services it provides. To understand its customers' needs, the company creates an assessment plan, and its service delivery team determines an optimized data transformation roadmap. The company team members then integrate into the customer's team, often on a full-time basis, to orchestrate and troubleshoot the data migration, as well as provide limited advice and counsel when working with a customer’s team. The company also provides post-migration managed technical services, which include monitoring and resolving incidents. The company's clients are billed for implementation services and embedded advice; the company does not separately bill for advice and counsel. Further, the taxpayer represented that more than 80% of the company's assets are used in its data migration and management business.
Based on these facts, the IRS ruled that the company was not engaged in consulting. The PLR noted that (i) the company’s employees provide advice and counsel as part of the process of determining a client’s data management needs but the advice and counsel is ancillary to and supports the sale of the implementation work performed by the company employees and (ii) the company does not separately bill for advice and counsel, but only for its final product of implementing data management solutions.
RSM observations
The PLR concludes that a company’s advice and counsel that is ancillary to and which supports a company’s other services does not cause the company to be engaged in consulting. It does not cite or provide direct authority for that conclusion. That conclusion, however, is supported by authorities interpreting the word “consulting” outside of section 1202.
We previously discussed the section 1202 meaning of consulting in this article: What does "consulting" mean for purposes of Sec. 1202?. In that article, we noted that regulations under sections 448 include an example that supports this proposition.
The section 448 temporary regulations state that “consulting means the provision of advice and counsel.” Those regulations then provide ten examples illustrating the meaning of "the provision of advice and counsel." One example in the “not engaged in consulting” list 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 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. Reg. section 1.448-1T(e)(4)(iv)(B), Example (6).
In that example, 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 treated as a mere initial step in the delivery of the product or performance of the service and is not independently treated as consulting. The section 448 temporary regulations therefore are consistent with the conclusion reached by the IRS in this PLR.
Concluding thoughts
The IRS has included section 1202 on its 2023-2024 Priority Guidance Plan (the list of tax issues Treasury and the IRS plan to prioritize when issuing regulations, rulings and guidance). Moreover, IRS officials stated in recent years that the IRS is considering issuing guidance regarding the meaning of the QTOB terms. PLR 202342014 is one of several items of non-precedential guidance the IRS has recently provided in this regard. We welcome further clarifying guidance on these and other section 1202 issues.
Taxpayers looking to exclude capital gain on the sale of stock under section 1202 should ensure, among other items, that the stock issuer conducts a QTOB. It is important to consider that the line between a qualified business and a nonqualified business is sometimes unclear. Some of the other various requirements for section 1202 eligibility are also complex and nuanced. Some apply to the stock issuer and some to the stockholder. Taxpayers considering claiming the section 1202 capital gain exclusion benefit should therefore consult with a tax advisor.
