After issuing a series of taxpayer-friendly rulings, the IRS recently issued guidance limiting the scope of section 1202. Section 1202 is the tax provision that enables taxpayers to exclude capital gain on the sale of qualified small business stock (QSBS) if certain conditions are met. As summarized in a prior article, section 1202 allows individuals to exclude from gross income the greater of $10 million or 10 times their initial investment in their company, with the potential to exclude up to $500 million of gain. This is one of the most powerful gain exclusion provisions in the Internal Revenue Code.
The most recent guidance came in the form of a Chief Counsel Advice Memorandum, CCA 202204007 (November 4, 2021), which was released on January 28, 2022. This type of advice comes from the National Office of the IRS Office of Chief Counsel, which is headquartered in Washington, D.C. It is written advice that is issued to employees of the IRS, and while it does not technically have the force and effect of law, i.e., it is not “precedential” in tax jargon, it conveys the legal interpretation of the Office of Chief Counsel.
Most important for our purposes is that this type of advice constitutes “authority” for purposes of determining whether there is substantial authority for the tax treatment of an item. This is important because taxpayers need to have at least “substantial authority” for the tax treatment of an item in order to avoid penalties. Substantial authority generally equates to a 40% chance of success. In the absence of substantial authority, taxpayers must have a reasonable basis (about 25% chance of success) for the position and affirmatively disclose it to the IRS on Form 8275 in order to avoid penalties. Filing that form with a tax return is like running through the lobby of the IRS while waiving a red flag and asking to be audited.
The CCA
The taxpayer in the CCA sold appreciated stock in a company and sought to exclude capital gain under section 1202. The issue addressed in the CCA is whether the company is engaged in a qualified trade or business (QTB). Recall that any business is a QTB except for the ones specifically listed in section 1202(e)(3). The exclusion relevant here is the exclusion for “brokerage services.”
The IRS addressed the “brokerage services” exclusion back in January 2021 when it issued a favorable private letter ruling for an insurance broker that provided administrative services to its clients. The IRS ruled that the taxpayer was not engaged in brokerage services because it did more than a traditional broker, which it defined as a mere intermediary. The ruling had the effect of narrowing the brokerage services exclusion, which expanded the number of taxpayers eligible for a QSBS exclusion. That ruling was summarized in a prior article.
The company in the CCA operates a website that facilitates the leasing of real property between lessors (those with property to rent) and lessees (those who want to rent property). Potential lessees use the site to make nonbinding reservations for the use of certain facilities that are in the website’s database. Once a lessor and lessee reach an agreement, they execute a lease agreement through the website and all lease payments are made through the website as well. Although the company operating the website has no authority to enter into lease agreements, it collects from the lessor a fixed fee to maintain its listing on the website and a percentage of the lease payments for facilitating the lease transaction. The website also provides other fixed-fee services to lessors such as hosting websites to be used in conjunction with the leasing of the lessor’s facility. In its terms of service (you know, the small print that no one reads), the company stated that it is not engaged as a broker, and it asserted to the IRS that it was not a broker even though it “may hold a real estate broker license in one or more states.”
Based on these facts, it shouldn’t come as a surprise (except the taxpayer, perhaps) to learn that the IRS ruled the company’s business of operating the website constitutes “brokerage services.” The company does, after all, act as an intermediary between lessors and lessees, and that activity fits squarely within the definition of a broker under any reasonable interpretation of the word.
In reaching its conclusion, the IRS observed that neither section 1202 nor any caselaw defines the phrase “brokerage services.” It therefore proceeded to analyze the dictionary meaning of the word “broker” as well as authority under other provisions of the Internal Revenue Code that have similar exclusions for brokerage services.
The dictionaries consulted by the IRS generally refer to a broker as (i) one that acts as an intermediary and (ii) one who is engaged for another, usually on a commission, to negotiate contracts or to act as an intermediary, especially between prospective buyers and sellers. The IRS acknowledged there can be many kinds of brokers, and stated its view that just because a party is not commonly referred to as a broker does not, in an of itself, foreclose the possibility that it is a broker.
The IRS also consulted analogous tax provisions. Under one section dealing with information reporting, the term broker was defined broadly to include “any person who (for a consideration) regularly acts as a middleman with respect to property or services.” Even though regulations under that section limit information reporting to brokers who deal only in certain types of financial assets, the IRS noted that nothing limits the types of “brokers” subject to the reporting obligation; in other words, the definition of a broker remained broad enough to apply to the company’s website operations. Further, when Congress added real estate transactions to the types of transactions subject to information reporting, it included a broker ordering rule that applies to various types of brokers. The definition of a real estate broker for purposes of this rule includes (i) the person responsible for closing the transaction, (ii) the seller’s broker, and (iii) the buyer’s broker. The IRS viewed this as evidencing Congressional intent to apply an expansive meaning to the definition of a broker, and certainly one that includes the company’s lease facilitation operations.
Under another tax provision dealing with methods of tax accounting, the regulations provide that whether a person’s services constitute brokerage services is based on all the facts and circumstances, including the manner in which the person is compensated (e.g., whether the compensation is contingent on consummation of the transaction that the services were intended to effect). In an example, the regulation concludes a taxpayer is providing brokerage service when it executes transactions for customers and its compensation is based on actual trades made by clients.
The last tax provision examined by the IRS has regulations that define brokerage services to include “services in which a person arranges transactions between a buyer and a seller with respect to securities . . . for a commission or fee, including stock brokers and other similar professionals but does not include services by real estate agents and brokers, or insurance agents and brokers.” The IRS disregarded this definition of brokerage services because the regulation applies only for purposes of that specific section and because the tax policy goal of that section is not similar to the tax policy goal of section 1202.
After considering the above authorities, the IRS ruled that the operations of the company’s website are “brokerage services” under the common meaning of that term, even though the company asserts it provides advertising services rather than brokerage services. The company acts as an intermediary, bringing buyers and sellers together, which fits within the classic definition of a broker, and it does more than just passively publish advertisements on its website. Further, it is unlike a search engine that provides content and targeted advertising to users based on their search history. The company’s website is devoted solely to effectuating agreements between potential lessors and lessees of real property, and it charges a commission contingent upon the execution of a leasing transaction. Last, the IRS was unmoved by the fact that the services are provided by software rather than by people because the functional nature of the services remains the same.
The CCA is the sixth pronouncement from the IRS addressing the QTB issue, and this is the first one that concludes the business under consideration is not a QTB. One would be hard pressed to argue this guidance represents some sort of paradigm shift by the IRS, however, because the facts of the CCA are not particularly favorable to the taxpayer. The takeaway here seems to be that the IRS is examining returns asserting a QSBS exclusion and it will not shy away from challenging taxpayers’ positions. Taxpayers claiming a QSBS exclusion should document their entitlement to the exclusion and work with their advisors to ensure their positions will stand up to IRS scrutiny.