Summary
Section 1202 provides a valuable benefit—exclusion of capital gain on the sale of qualified stock. Qualifying for this benefit involves satisfying many requirements. One of those requirements is that the corporate stock issuer must conduct “a qualified trade or business” (QTOB). The IRS concluded in CCA 202204007 that a web-based business that connects lessors to lessees was a “brokerage service” and therefore not a QTOB.
Some requirements for section 1202 eligibility pertain to the corporation that issued the stock, and others apply to the (direct or indirect) shareholders that seek to exclude capital gain recognized on a sale of the corporation’s stock. The QTOB requirement applies to the issuing corporation. The corporation must conduct a QTOB, and generally also must use at least 80% of its assets, measured by value, in the active conduct of a QTOB for substantially all of the shareholder’s holding period.
The Internal Revenue Code’s definition of a QTOB includes all trades and businesses other than those explicitly listed in section 1202(e)(3). One of the excluded business types is “brokerage services.” The IRS set out a view on what a brokerage service business is in CCA 202204007.
Brokerage business
A brokerage services business, like many of the business types listed in section 1202(e)(3), lacks precise definitions and parameters. There is no clear dividing line that places qualified businesses on one side of the line and nonqualified businesses on the other.
The CCA addressed a corporation that operated a website. The website facilitated the leasing of real property between lessors looking to rent property they owned and lessees looking to pay to rent property. The corporation operating the website did not itself enter into the lease agreements. Rather, (i) lessees used the site to make reservations for the use of facilities listed on the website’s database, (ii) lessors and lessees executed lease agreements through the website and (iii) lessees made lease payments through the website. The website charged lessors a recurring periodic fee for simply being listed in the database as well as a contingent fee based on a percentage of the rent paid by a lessee. The company also provided other fixed-fee services to lessors; for example, the company sometimes built and hosted a website for the lessor designed to facilitate the leasing of the lessor’s facility.
The company argued that it did not provide brokerage services, characterizing its services as advertising lessors’ properties to lessees. The IRS, however, concluded the company’s services did constitute brokerage services. The IRS concluded because the corporation did not conduct a QTOB, its shareholders could not exclude the capital gain generated on sale of their stock.
IRS’ analysis
In reaching its conclusion, the IRS first looked at rules under sections 199A, 448 and 6045 of the Code, as well as dictionary definitions of “broker.”
The IRS appropriately noted that, under case law, undefined terms in the Code should be assumed to bear their ordinary, contemporary, common meaning. The CCA emphasized that the company’s website carried out the classical functions of a broker—it acted as an intermediary, bringing lessors and lessees together, and it charged a commission contingent upon the execution of a leasing transaction. The CCA further noted that although the company’s services were provided by software rather than by people, the answer remained the same because the functional nature of the services remained the same.
In addition to the plain meaning of the Code, the CCA says its conclusion rests in part on Reg. section 1.6045-1, the regulations that require securities brokers to file Forms 1099-B to report their customers’ proceeds from the sale of securities. It is disappointing that the CCA chose to cite those regulations as a basis for its conclusion, since they define “broker” in a manner that is partially inconsistent with the CCA’s focus on a broker’s role as an intermediary in a transaction.
Applying Reg. section 1.6045-1 for purposes of section 1202 seems inappropriate for multiple reasons. First, the section 6045 regulations include within the category of “broker” both an obligor that regularly issues and retires its own debt obligations and a corporation that regularly redeems its own stock. These parties are brokers under the regulation even though they are not acting as intermediaries. Second, the section 6045 regulations include as a broker’s customers any seller that receives payment from the broker, without regard to whether the broker helps arrange the sale or acts as an intermediary. Applying this aspect of the regulations for purposes of section 1202 might categorize payment processing services as brokerage services, which would appear inconsistent with the plain meaning of the term “broker.” Third, a “broker” under Reg. section 1.6045-1 includes only persons who act with respect to sales or dispositions of securities, commodities and related instruments. The CCA does not apply this aspect of the regulations when determining that matching parties to a leasing transaction constitutes brokerage services. The CCA’s departure from the section 6045 regulations definition of “broker” on this point appears appropriate, and it is disappointing that the CCA simultaneously cites the same regulations as a basis for its conclusion.
Additional observations
Although there are a handful of nonprecedential IRS rulings addressing the definition of a QTOB, the CCA is unlike those rulings in that it is the first one to conclude a particular business was not a QTOB.
Just last year, the IRS analyzed whether a corporation conducted a brokerage services business under section 1202 and provided a taxpayer-friendly ruling. The IRS held in PLR 202114002 (Apr. 9, 2021) that a company’s business of obtaining insurance for its customers did not constitute brokerage services for purposes of section 1202. In that case, the company’s primary business involved working with individuals to obtain insurance coverage; the company would contract directly with insurance companies to sell their products in return for commissions. The company’s contracts with insurance companies, aside from containing the terms for the sales of insurance products, also required the company to perform certain administrative services—such as to report claims to the insurance company, cooperate with investigations and maintain complete records of its business transactions. In reaching its conclusion, the IRS reasoned that because the contracts required the company to perform these administrative services, which go beyond what a mere intermediary typically provides, the insurance-related business was not a brokerage services business.
Does the CCA perhaps indicate an IRS shift in perspective? It is hard to tell. In the PLR, the IRS stated that the business’s administrative services (reporting claims, cooperating with investigations and maintaining records) sufficed to make it more than a broker; it was not a “mere intermediary.” Although the corporation discussed in the CCA received revenue from lessors irrespective of whether a potential lessor succeeded in entering into lease agreements as a result of using the corporation’s website, it also received commissions based on actual leasing transactions.
Because of the section 1202 requirement that 80% of a corporation’s total assets must be used in its QTOB, it would be reasonable when analyzing a corporation’s business to consider the value of the services provided by the business and their associated revenue streams. Nonetheless, this consideration is not expressly discussed in either the CCA or the PLR (with regard to the primary business model of the taxpayer in the PLR).
IRS officials have recently stated that the IRS receives many questions relating to the meaning of the terms in section 1202(e)(3), and the IRS is considering issuing guidance. This CCA might be a signal of increased IRS attention.
Conclusion
Taxpayers looking to exclude capital gain under section 1202 should ensure that the stock issuer’s business 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 pertain to the corporation that issued the stock, and others apply to the (direct or indirect) selling shareholders that seek to exclude capital gain recognized on a sale of the corporation’s stock. As a result, taxpayers considering claiming the section 1202 capital gain exclusion benefit should consult with their tax advisors.
