Internal Revenue Code (IRC) Section 1202 provides a tax exclusion for certain gains from the sale of qualified small business stock (QSBS). The exclusion is $10 million or 10 times the taxpayer’s basis in the corporate stock, whichever is greater. The stock must meet certain requirements to qualify for this exclusion.
Generally, the primary qualifications under IRC 1202 are:
- The stock must be issued by a domestic C corporation (not an S corporation or partnership).
- The corporation must be a qualified small business at the time of issuance and during substantially all of the taxpayer’s holding period. To be considered a qualified small business, the corporation must have gross assets of $50 million or less at the time of issuance and throughout substantially all of the taxpayer’s holding period.
- The taxpayer must acquire the stock at its original issuance (not through a secondary market transaction) in exchange for money, property, or services.
- The taxpayer must hold the stock for more than five years.
- At least 80% of the corporation’s assets must be used in the active conduct of one or more qualified trades or businesses (defined below).
- The corporation must be engaged in a qualifying active trade or business, but not one involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, 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.
Because IRC 1202 isn’t available for corporations engaged in the field of health and/or corporations relying on the skills or reputations of one or more of its employees (e.g., pharmacists), it is critically important to approach it on a case-by-case basis, which requires examination of a taxpayer’s unique facts and circumstances.
In IRS Private Letter Ruling[1] 202221006 sought out to tackle this question by examining a proposed transaction between a pharmacy and an unrelated third party in which the pharmacy aspired to take advantage of IRC 1202. The hurdle faced by the pharmacy was whether or not it was engaged in a qualified trade or business under IRC 1202. The facts provided were:
- The business involves selling a limited number of drugs at retail under exclusive distribution arrangements with drug manufacturers.
- The taxpayer’s employees include pharmacists who fill prescriptions received from physicians and pharmacy clerks who process insurance forms related to the prescriptions and mail the filled prescriptions to patients’ homes.
- The pharmacists are the only licensed employees.
- None of the taxpayer’s employees diagnoses or recommends treatment for medical conditions.
- The taxpayer receives no payment for treating patients.
In its ruling, the IRS concluded that the pharmacy did, in fact, qualify for QSBS treatment under IRC 1202. The IRS focused on the fact that pharmacists’ patient interaction is incidental to the purchase of prescription pharmaceutical products. The pharmacy’s principal asset was its exclusive pharmaceutical distribution rights. The IRS did not hold that the pharmacy was in the business of performing services in the field of health.
The potential tax savings under IRC Section 1202 can be significant—not just for pharmacy owners, but for many small business owners considering the future sale of their company. However, the rules are complex, and eligibility depends on your business’s unique facts and circumstances.
If you’re thinking about selling your business, restructuring, or want to ensure you’re making the most of available tax benefits, now is the time to take a closer look at your options.
We encourage all business owners to review their corporate structure and long-term plans. Whether you own a pharmacy or another type of business, or are just beginning to consider succession planning, understanding the opportunities under IRC Section 1202 could be a game-changer.
Sources:
PLR202221006
[1] An IRS private letter ruling is issued by the IRS in response to a request for technical guidance from a taxpayer . While private letter rulings are binding only on the taxpayer who requested them and cannot be used or cited as precedent by other taxpayers, they often provide valuable insights on how the IRS is likely to view a similar transaction.
