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An Internal Revenue Code provision (the “Clause”) offers a capital gain exclusion for the sale of qualified small business stock (QSBS) that is applicable only to corporations involved in particular businesses, known as a qualified trade or business (QTOB).

The Clause allows for the exclusion of capital gains greater than $10 million or 10 times basis when selling QSBS. In order to qualify, the issuing corporation must conduct a QTOB, using at least 80% of its assets for this purpose. The Clause stipulates that a QTOB encompasses all businesses except for those that are explicitly identified as ineligible. An example of a non-qualifying business is a “business where the principal asset of such trade or business is the reputation or skill of one or more of its employees” (referred to as the reputation or skill condition). Notably, the Clause does not offer a specific definition or interpretation for this “reputation or skill” provision. It is worth noting that in a Private Letter Ruling (PLR), the IRS issued non-precedential guidance that sheds light on the understanding of this particular clause.

The PLR addressed a software company whose employees use their technical skills and unique methodology to provide tailored solutions for clients. The company’s workforce is equipped with technical expertise and knowledge acquired through training in the company’s exclusive service delivery processes and methodology packages. These processes and packages are distinctive to the company and are not accessible to employees at similar companies. The company has the capability to hire and educate new personnel with the necessary technical skillset to deliver services that closely align with its methodology packages. The ruling clarified that the company’s principal asset is not its employees’ reputation or skills, but the intellectual property held by the company itself in its proprietary service delivery processes and methodology. The sale of the company stock was, therefore, eligible for the Clause gain exclusion.

Despite this ruling, certain questions remain regarding the reputation or skill clause. The IRS regulations provide some guidance regarding the reputation or skill clause, focusing on specific types of services that may be excluded. Yet, the IRS is considering issuing further guidance on this matter as well as other issues related to QSBS. Companies that would like to provide guidance to their shareholders looking to exclude should make sure the business conducts a QTOB.

To learn more about this IRS ruling and how it may affect you, please contact Edward Kim, Tax Partner in the Private Client group, or your Anchin Relationship Partner.