In PLR 202221006[1] a corporation whose shareholders were negotiating a sale of their stock to an unrelated third party asked the IRS to rule that the business is a qualified trade or business under IRC §1202(e)(3).

§1202 Status and Benefits

IRC §1202 provides for a full or partial exclusion of gain from the disposal of qualified small business stock held for more than five years.  The amount of the exclusion varies depending on when the stock was acquired, with stock acquired after September 27, 2010 being eligible for a 100% exclusion of gain on the sale[2] of up to the greater of $10 million or 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year.[3]

Only certain types of businesses can qualify as a qualified trade or business, something necessary for gain on the sale of the stock to qualify for a §1202 exclusion.  IRC §1202(e)(3) contains the definition of a qualified trade or business and reads:

(3) Qualified trade or business

For purposes of this subsection, the term "qualified trade or business" means any trade or business other than--

(A) any trade or business 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 trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,

(B) any banking, insurance, financing, leasing, investing, or similar business,

(C) any farming business (including the business of raising or harvesting trees),

(D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and

(E) any business of operating a hotel, motel, restaurant, or similar business.[4]

In this case the question was whether the business of the corporation was performance of services in the field of health or the principal asset of the business was the skill or reputation of one or more employees.[5]

Facts as Represented in the Ruling Request

The taxpayer in this case is involved in the sale of certain drugs:

Taxpayer is only involved in the retail sale of a limited number of drugs and does not manufacture them. The manufacturers of these drugs prefer entering into exclusive distribution arrangements with companies such as Taxpayer.[6]

The employees involved in the business are both pharmacists and various other employees:

Employees of Taxpayer include several pharmacists who fill prescriptions received from physicians. Other employees coordinate the insurance coverage with respect to such prescription orders. Once the insurance process is complete and the prescription is filled by the pharmacist, Taxpayer mails the prescription to the patient’s home. The non-pharmacist employees will also occasionally contact individuals receiving prescriptions to inquire as to any side effects of the prescriptions and to schedule refills. Such non-pharmacist employees are not subject to state licensing requirements or classified as healthcare professionals by any applicable state, Federal or regulatory authority.[7]

The nature of the employees’ interactions with the patients and physicians is outlined as follows:

Pharmacists and other employees of Taxpayer have no contact or interaction with physicians, other than to receive prescriptions from them. With respect to patients, pharmacists interact with patients only if a patient has a question about a particular prescription. Employees are never involved in diagnosing any medical issues or recommending any treatment or drug to individuals. Their interaction with patients is limited to the filling and maintenance of prescriptions as ordered by a physician. Therefore, none of Taxpayer’s employees diagnose, treat or manage any aspect of any patient’s care. Taxpayer’s revenues are strictly related to the sale of such drugs, and Taxpayer earns no revenues in connection with the medical care of patients.[8]

Analysis and Ruling

The analysis section of the ruling begins with a discussion of the two categories that the taxpayer was concerned the IRS might on exam argue their business falls into that would bar treatment as a qualified trade or business, making their gain on sale fully taxable:

Section 1202(e)(3) excludes businesses from being a qualified trade or business if they offer value to customers primarily in the form of certain specified services, or in the form of individual expertise. A question arises as to whether Taxpayer is (i) involved in the performance of services in the field of health or (ii) where the principal asset of the trade or business is the reputation or skill of one or more of its employees.[9]

The ruling concludes that this business is not a health business as contemplated by IRC §1202(e)(3)(A) since the employees actions don’t rise to the level of diagnostic services or medical care provided to either patients or physicians:

Taxpayer’s employees are not engaged in the provision of medical services. Other than the pharmacists, such employees are not certified healthcare providers and are not otherwise regulated under state or Federal law. Taxpayer’s pharmacists fill prescriptions provided by health care professionals, and other employees help manage the insurance process and occasionally communicate with patients regarding prescription issues and timely refill requests. Any interaction with patients regarding their prescriptions is merely incidental to ensuring receipt of their required prescriptions or answering a patient’s question about them. Taxpayer’s employees do not provide any diagnostic services or medical care to either patients or physicians, and all revenues are generated by the sale of the drugs.[10]

The IRS also found that the principal asset of the business was not the employees’ reputation or skill:

Also, Taxpayer’s principal asset is not the reputation or skill of one or more employees, but its exclusive pharmaceutical distribution rights.[11]

[1] PLR 202221006, May 27, 2022, https://www.irs.gov/pub/irs-wd/202221006.pdf (retrieved May 27, 2022)

[2] IRC §1202(a)(4)

[3] IRC §1202(b)(1)(A)

[4] IRC §1202(e)(3)

[5] IRC §1202(e)(3)(A)

[6] PLR 202221006, May 27, 2022

[7] PLR 202221006, May 27, 2022

[8] PLR 202221006, May 27, 2022

[9] PLR 202221006, May 27, 2022

[10] PLR 202221006, May 27, 2022

[11] PLR 202221006, May 27, 2022