Two New Private Letter Rulings Inform Qualified Code Section 1202 Trade or Business Analysis | Keating Muething & Klekamp PLL

Section 1202 of the Internal Revenue Code offers entrepreneurs and savvy investors the opportunity to realize significant tax savings. In fact, if the entity and exit is properly structured, upon an exit, founders and investors holding qualifying small business shares are eligible for a gain exclusion equal to the greater of 10,000,000 $ or 10 times the investor’s initial investment in the stock.[1] However, the devil of the Section 1202 exclusion lurks in its convoluted requirements, many of which have no published guidance from the IRS and leave taxpayers guessing at their meaning.

One of the requirements of Section 1202 that practitioners have struggled with is what constitutes a qualifying trade or business for the purposes of Section 1202. Indeed, Section 1202(e) defines a a qualified business by listing a plethora of activities that do not be a qualifying trade or business.

Whether a business qualifies under section 1202(e) is critical, because failure to qualify means the business does not meet the “active business” requirement of the Act. article 1202 which requires at least 80% of the capital of company C.[2] assets are used in one or more qualified trades or businesses. Therefore, the taxpayer would lose the earnings exclusion.

Section 1202(e)(3) lists activities that are excluded from qualified trades or businesses, including, but not limited to, “any trade or business involving the rendering of services in the fields of health, law, engineering, architecture, accounting, actuarial, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the primary asset of such trade or business is the reputation or skills of one or more of its employees[.]”[3]

Included in the Tax Cuts and Jobs Act, enacted December 2017, Section 199A[4] was added to provide a deduction for income from qualifying trades and businesses. Section 199A references section 1202(e)(3) to exclude these same activities from qualified trades and businesses (except for an amendment to allow “engineering” and “architectural ”) for the purposes of Section 199A. Although Section 199A is separate and distinct from Section 1202 and the regulations to Section 199A specify that the rules thereunder apply only for purposes of determining a trade or qualified business for the purposes of Section 199A, practitioners have speculated that the Section 199A regulations shed light on what constitutes a trade or business for the purposes of Section 1202(e)(3)(A) by due to almost identical excluded businesses and businesses.

To the dismay of many practitioners, 2021 saw the release of private letter rulings 202114002 and 202125004 which both showed the IRS had a different route in mind. In both of these private letter rulings, the taxpayers asked the IRS to rule that the activities in which they were engaged constituted a qualifying trade or business under Section 1202. Although the facts of each ruling private letter form differ, the IRS’ analysis in both rulings relied exclusively on the clear definition of the words listed as ineligible trades and businesses under section 1202(e)(3) and did not reference to Section 199A and its regulations.

The takeaway from these two Private Letter Rulings is clear: pursuant to the specific provisions of the Section 199A regulations, the IRS does not plan to apply these regulations to clarify the definition of Section 1202(e) (3)(A) of a qualifying trade or business for purposes of Section 1202. Given this message, taxpayers should be careful when redirecting other regulations to also inform their interpretation of the requirements of section 1202.

When assessing eligibility for the Section 1202 exclusion, taxpayers should ensure that each of the Section 1202 requirements is met. Unfortunately, the IRS has not facilitated this with the issuance of Private Letter Rulings 202114002 and 202125004. Therefore, taxpayers are strongly advised to contact their tax representatives to strategically analyze the requirements of Section 1202 and the latest guidelines.


[1] IRC § 1202(b)(1).

[2] Or an LLC taxed as a C corporation for federal income tax purposes.

[3] IRC § 1202(e)(3)(A).

[4] IRC § 199A targets flow-through entities and allows eligible taxpayers to deduct up to 20% of their qualified business income (which is a defined term in the section).