Qualified Trade or Business Under Section 1202

John, a white man with dark brown hair, wears a pale blue shirt, lime green and blue tie, and black suit. By John G. HodnetteSavannah, a white woman with lon gblond hair, wears a pale grey blouse and a black jacket. and Savannah Rankich

The general rules for qualified small business stock (“QSBS”) were discussed previously in “Gain Exclusion for Section 1202 Stock” and updated in “Expanded Benefits for Qualified Small Business Stock Under the OBBB.” For taxpayers to qualify for this gain exclusion, the issuing C corporation must meet the active business requirement, which requires at least 80% of the issuer’s assets be used in the active conduct of one or more qualified trades or businesses. Determining whether a trade or business is qualified can be difficult because there is little guidance from the IRS.

Section 1202(e)(3) excludes a number of businesses from qualified trades or businesses. These include: (i) the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services or brokerage services; (ii) any trade or business where the principal asset is the reputation or skill of one or more of its employees; (iii) banking, insurance, financing, leasing, investing or similar businesses; (iv) farming businesses; (v) any business involving the production or extraction of products deductible under section 613 or 613A (generally, oil, gas and minerals); and (vi) the business of operating a hotel, motel, restaurant or similar business.

The Treasury Department has not promulgated regulations clarifying these restricted businesses. Two sources of useful guidance are private letter rulings (“PLRs”) regarding Section 1202 and regulations promulgated under Section 199A. PLRs are written determinations issued by the IRS to a taxpayer addressing the tax consequences of that taxpayer’s specific facts. PLRs are not binding on the IRS as to any other taxpayer. However, they provide insight as to how the IRS may approach similar situations.

Section 199A provides a deduction of up to 20% of qualified business income for eligible non-corporate taxpayers and, like Section 1202, excludes certain trades or businesses from qualifying. Section 199A cross-references Section 1202 and borrows its excluded business list, with the exception that engineering and architecture remain qualified. Unlike Section 1202, the Treasury Department has promulgated regulations under Section 199A that interpret the excluded categories of businesses and provide examples. While those regulations are not binding on the IRS for QSBS, the Section 199A regulations provide guidance on similar rules. Until the Treasury Department promulgates regulations under Section 1202, the PLRs and the Section 199A regulations are the most helpful resources on 1202 qualified trades or businesses.

 John G. Hodnette is a partner with Fox Rothschild, LLP in Charlotte. 

Savannah Rankich is an associate with Fox Rothschild, LLP in San Francisco. 

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