PLR Interprets Brokerage Services for Section 1202 Qualified Trade or Business Requirement

On April 9, 2021, the Internal Revenue Service (IRS) issued Private Letter Ruling (PLR) 202114002, concluding that a company in the business of obtaining insurance for its customers (Company) is not performing “brokerage services” for purposes of whether it meets the qualified trade or business requirement under the rules for exclusion of gain on sales of qualified small business stock (QSBS). The QSBS rules, which are highly complex, are governed by Internal Revenue Code Section 1202.

Background on Section 1202

Section 1202 generally permits a noncorporate shareholder to exclude up to 100% of the gain from the sale or exchange of QSBS issued after September 27, 2010, and held for more than five years. A 50% or 75% gain exclusion is available for QSBS issued between August 10, 1993, and September 27, 2010. The overall gain exclusion per issuer is limited to the greater of $10 million or 10 times the aggregate adjusted basis of the disposed shares. Each partner in a partnership and each shareholder in an S corporation is entitled to their own $10 million limitation on dispositions of QSBS by the partnership or the S corporation. 

QSBS is stock of a C corporation that was received by the shareholder on original issuance for cash, property other than stock, or services. In addition, to be considered QSBS:

• The issuing corporation’s aggregate gross assets cannot exceed $50 million at any time up to and immediately after the issuance of the stock, and
• During substantially all of the shareholder’s holding period, at least 80% of the assets of the corporation must be used in the active conduct of a qualified trade or business.

Section 1202(e)(3) provides a list of trades or businesses that are not considered qualified trades or businesses, and presumably, any trades or businesses not on that list are considered qualified trades or businesses. “Brokerage services” is among the excluded trades or businesses that are generally ineligible for Section 1202 benefits. However, prior to PLR 202114002, no guidance existed for defining “brokerage services” for purposes of Section 1202.

 

About PLR 202114002

According to the PLR, Company’s business is working with its customers to obtain various types of insurance coverage. Company operates under two general business models. First, it contracts directly with insurance companies (or in some cases their representatives) to sell their products in return for commissions or similar compensation. Insurance companies use this model to select and control who can sell their products. In addition to containing the terms for the sales of insurance products, the contracts with the insurance companies require Company to perform certain administrative services, such as report incidents, claims, etc. to the insurance company or its designated claims adjuster; cooperate with investigations, adjustments and settlements; and maintain complete and accurate records of its business transactions, which the insurance companies may examine and audit. Company represents that for the duration of the time a certain shareholder held Company’s stock, at least 80% (by value) of Company’s assets were used in this first business model.

Second, Company also has contracts with insurance wholesalers. Under this business model, Company has a contract with a wholesaler and not an insurance company, and the wholesaler’s contract with multiple insurance companies. Company selects an appropriate policy for a customer provided by a wholesaler. If the customer accepts the policy, the wholesaler procures the policy from the insurance company.

The IRS was asked to determine if Company is engaged in a qualified trade or business for purposes of Section 1202. In considering its ruling, the IRS focused on whether Company, which the IRS notes has been referred to as an insurance agent and broker, is engaged in the business of providing disqualified brokerage services under Section 1202(e)(3).

Based on the facts presented, the IRS concluded that Company’s first business model is a qualified trade or business. In reaching its conclusion, the IRS relied on the common meaning of the term “broker” based on the Merriam-Webster dictionary definition of the term, which describes a broker as “one who acts as an intermediary.” The IRS reasoned that because the contracts require Company to perform administrative services that are beyond what a mere intermediary would provide, Company’s first business model is not brokerage services.