Cloud-software company is not a "reputation or skill" business, so its stock can qualify for the section 1202 gain exclusion

Plain-English summary

A founder who sold his stock in an enterprise cloud-software company asked the IRS to confirm that the company is not the kind of business disqualified from the section 1202 tax break for "qualified small business stock" (QSBS). Section 1202 lets shareholders exclude a large portion of their gain when they sell stock of a qualifying C corporation held more than five years, but the company must be in a "qualified trade or business." That definition excludes service businesses whose principal asset is the reputation or skill of one or more employees. The IRS ruled the company does not fall into that excluded category: although its employees have technical skills, those skills come from training on the company's own proprietary, unique service-delivery processes and methodology packages, and the company can hire and train new employees to do the same work. So the company's principal asset is its intellectual property, not any employee's reputation or skill. The IRS stressed it was ruling only on this narrow point and expressed no view on the other section 1202 requirements (such as the 80% active-business asset test, or whether the company is a "consulting" business).

Ruling snapshot

• Question: Is a cloud-software company a trade or business whose principal asset is the reputation or skill of its employees, which would disqualify its stock under section 1202(e)(3)(A)?
• Outcome: Approved (favorable ruling: the company is not such a business)
• Key authorities: IRC § 1202(a), § 1202(c)(2), § 1202(e)(1), § 1202(e)(3)(A)

Full text (IRS public release)

Internal Revenue Service                                    Department of the Treasury
                                                            Washington, DC 20224

Number: 202319013                                           Third Party Communication: None
Release Date: 5/12/2023                                     Date of Communication: Not Applicable
Index Number: 1202.00-00                                    Person To Contact:
                                                            ----------------------, ID No. -----------------
----------------------------------------------------        Telephone Number:
-----------------                                           --------------------
-------------------------------                             Refer Reply To:
                                                            CC:ITA:05
                                                            PLR-118594-22
                                                            Date:
                                                            February 14, 2023


TY: -------

Legend:

Taxpayers = ---------------------------------------------------------------------------------------------------
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Taxpayer Husband = --------------------
Company = -----------------------------
Date 1 = ---------------------------
Year 1 = -------
Year 2 = -------
A =----------
B = -----
C = ---
D = ---
E = ---------------

Dear --------------:

This is in response to a letter sent on your behalf by your representatives dated -----------
---------------------------. In the letter, your representatives requested on your behalf
a ruling that Company was not engaged in a trade or business where the principal asset
of such trade or business is the reputation or skill of 1 or more employees within the
meaning of section 1202(e)(3)(A) of the Internal Revenue Code (Code) for purposes of
qualifying for the exclusion of gain under section 1202(a)(1).

FACTS

Taxpayer Husband founded the Company on Date 1 as a C corporation. On the date of
its formation, the Company issued A shares constituting B% of the Company’s stock to
Taxpayer Husband in exchange for a $B capital contribution. Taxpayer Husband
continuously held these shares until Year 1, when he sold C% of his interest in the
Company. During Year 2, Taxpayer Husband sold the remaining D% of his interest in
the Company for $E. Taxpayers have not yet filed their Form 1040, U.S. Individual
Income Tax return for Year 2.

Company is an enterprise cloud application services software company, which provides
solutions tailored to the operating functions and industry-specific challenges of their
clients. The Company's employees possess technical skills and knowledge which allow
for effective implementation and the quality of the Company's services. However, they
are trained on one or more of the Company's proprietary service delivery processes and
methodology packages that are unique to the Company and may not be utilized by the
employees at any other employers that may provide the same or similar service. The
Company can recruit and train new employees with the required technical skillset to
perform substantially identical services using its methodology packages.

LAW AND ANAYLSIS

Section 1202(a) of the Code provides that gross income does not include 50 percent of
any gain from the sale or exchange of qualified small business stock held for more than
5 years.

Section 1202(c)(2) provides that stock in a corporation is not treated as qualified small
business stock unless, during substantially all of the taxpayer's holding period for such
stock, the corporation meets the active business requirements of section 1202(e) and
the corporation is a C corporation.

Section 1202(e)(1) provides that a corporation meets the active business requirement
for purposes of section 1202(c)(2) if at least 80 percent of the assets of the corporation
are used by the corporation in the active conduct of one or more qualified trades or
businesses.

Section 1202(e)(3)(A) provides that a qualified trade or business means any trade or
business other than a trade or business involving the performance of services in the
fields of health, law, engineering, architecture, accounting, actuarial science, performing
arts, athletics, financial services, brokerage services, consulting, or any other trade or
business where the principal asset of such trade or business is the reputation or skill of
one or more of its employees.

The Company's employees possess technical skills and knowledge due to training
received on one or more of the Company's proprietary service delivery processes and
methodology packages. Such processes and packages are unique to Company and
may not be utilized by the employees at other similar companies. The Company can
recruit and train new employees with the required technical skillset to perform
substantially identical services using its methodology packages. Therefore, the
principal asset of the Company is not the reputation or skills of one or more employees,
but the intellectual property held by the Company itself in its proprietary service delivery
processes and methodology packages.

CONCLUSION

We conclude that for the purposes of section 1202(e)(3), Company is not in the trade or
business where the principal asset of the trade or business is the reputation or skill of
one or more of its employees.

Except as expressly provided herein, no opinion is expressed or implied concerning the
federal income tax consequences of any aspect of any transaction or item discussed or
referenced in this ruling including whether the other statutory and regulatory
prerequisites for exclusion of capital gain under section 1202 were satisfied.
Specifically, no opinion is expressed or implied concerning whether Company meets the
requirement under section 1202(e)(1)(A) that at least 80 percent (by value) of the assets
of such corporation are used by such corporation in the active conduct of 1 or more
qualified trades or businesses or whether the Company is engaged in a trade or
business involving the performance of services in the field of consulting as defined in
section 1202(e)(3)(A).

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.


                                           Sincerely,

                                           Erika C. Reigle
                                           Senior Technician Reviewer, Branch 5
                                           (Income Tax and Accounting)

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