In a recently published chief counsel memorandum (CCA 202204007), the IRS concluded that a business that facilitates property rentals between lessors and lessees is providing brokerage services within the meaning of IRC Section 1202(e)(3)(A).

Facts

The taxpayer sold stock in a corporation that operates a website through which potential lessees may make reservations with lessors on the website database to use certain facilities for unspecified rental rates. These facilities include real property. The corporation is not authorized to sign leases on either party’s behalf. The website allows a potential lessor to see facilities in the database according to geographic location.

Potential lessees do not pay to use the website and the corporation states in its terms of service that it has no control over the leased facilities and does not guaranty the accuracy of the listings. Lessors pay the corporation a recurring periodic fee for including their properties in the website database, plus a contingent fee based on a percentage of rent received. Lessees must pay the rent through the corporation’s website. For an additional fee, the corporation also provides website-building and hosting services for some lessors in conjunction with leasing the lessors’ facilities.

In its terms of service, the corporation states that it is “not responsible for, and does not engage in, brokering, selling, purchasing, exchanging, or leasing posted properties” and, even if it holds a real estate broker license in one or more states, is not a broker with respect to leasing the facilities.

Law and analysis

QSB stock

IRC Section 1202(a) provides that gross income “shall not include a certain percentage of any gain from the sale or exchange of qualified small business stock (QSB stock) held for more than [five] years.” The amount of the gain exclusion varies depending on when the QSB stock was acquired, ranging from 100% if acquired after September 27, 2010, to 50% if acquired on or before February 17, 2009.

For its stock to qualify as QSB stock, the issuing corporation must, among other requirements, satisfy the active-trade-or-business requirement under IRC Section 1202(e) by using at least 80% of its assets (by value) in the active conduct of a “qualified trade or business”  during substantially all of the taxpayer’s holding period for the stock. A qualified trade or business is any trade or business, other than a trade or business listed in IRC Section 1202(e)(3). Under IRC Section 1202(e)(3)(A), any trade or business involving the performance of services in the field of brokerage services is not a qualified trade or business.

Brokerage services

The corporation maintains that it does not provide brokerage services, but rather advertising services. Because IRC Section 1202 does not define “brokerage services,” the Service, in CCA 202204007, looks to IRC Sections 6045, 448, and 199A. Under IRC Section 6045(a), anyone doing business as a broker must file information returns regarding its customers and provide each customer with a statement (IRC Section 6045(b)). IRC Section 6045(c)(1) broadly defines a broker to include a dealer, a barter exchanger or anyone who regularly acts as a middleman with respect to property or services. Changes to the tax law in 1986 added real estate transactions to the types of transactions that require broker reporting under IRC Section 6045(e). In the CCA, the IRS concludes that the definition of a broker under IRC Section 6045 and regulations thereunder “remain broad enough to apply to [the corporation’s] website operations.”

Under IRC Section 448(a), a C corporation or partnership with a C corporation partner must use the accrual method of accounting if the entities meet a gross receipts test. Because IRC Section 448(b)(2) treats a qualified personal service corporation (QPSC) as an individual, a C corporation or a partnership with a QPSC as its only C corporation partner is excepted from the accrual-method requirement. Activities that can qualify a C corporation as a QPSC include “services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting” (IRC Section 448(d)(2)) – but not brokerage or sale services, or services that are economically similar to brokerage services. The pertinent regulations apply a facts-and-circumstances test to determine whether services at issue constitute sales or brokerage services; the most important factor is what exactly triggers the taxpayer’s right to payment. If the taxpayer is paid for advising and counseling a client, the services constitute consulting. If the taxpayer is only paid if the client engages in a transaction (e.g., buys a house), however, the services are not considered consulting. The CCA observes that the regulations under IRC Section 448(d)(2) do not clearly distinguish brokerage services from sales services or services that are economically similar to brokerage services.

Under IRC Section 199A(d)(2)(A), the term “specified service trade or business” means any trade or business described in IRC Section 1202(e)(3)(A) (applied without regard to the words “engineering, architecture”), or that would be so described if the term “employees or owners” were substituted for “employees.” In 2019, Treasury issued regulations that expressly define the performance of brokerage services solely in the context of IRC Section 199A. Specifically, the performance of brokerage services includes arranging securities transactions for a fee, including acting as a stockbroker or similar professional, but does not include acting as a real estate agent or broker or an insurance agent or broker (Treas. Reg. Section 1.199A-5(b)(2)(x)). Treas. Reg. Section 1.199A-5(b)(2) explicitly states that definitions under Treas. Reg. Section 1.199A-5(b)(2) “apply solely for purposes of [IRC Section] 199A and therefore may not be taken into account for purposes of applying any provision of law or regulation other than [IRC Section] 199A and the regulations thereunder, except to the extent such provision expressly refers to [IRC Section] 199A(d) or this section.”

After finding no case law defining “brokerage services” for federal tax purposes, the IRS considers the dictionary definitions found in the Meriam-Webster and Black’s Law Dictionaries. The latter defines a broker as “one who is engaged for another, usually on a commission, to negotiate contracts to property in which he or she has no custodial or proprietary interest, or an agent who acts as an intermediary or negotiator, especially between prospective buyers and sellers.”

IRS conclusion

The IRS asserts that the term “brokerage services” should be broadly construed and its meaning, as used in IRC Section 1202(e), can be distinguished from IRC Section 199A by policy considerations.  IRC Section 199A defines “broker” narrowly as meaning only those dealing in securities; in this context, the CCA states, “interpreting ‘broker’ narrowly furthers the overall purpose of the provision to provide nonincorporated businesses with a lower effective rate of tax following the reduction of the corporate rate.” For purposes of IRC Section 1202, however, the IRS notes that interpreting the term “brokerage services” broadly, in order to provide a narrow construction of the exclusion, would further policy goals of that particular provision. Likewise, the relatively broad definition of broker in IRC Section 6045, which includes anyone who acts as a middleman with respect to property or services, furthers public policy “because limited third-party information reporting to the IRS is an important factor contributing to the tax gap,” the CCA states.

Further, the IRS notes that IRC Sections 448(d)(2) and 1202(e)(3)(A) both define businesses in terms of the services they perform. The regulations under IRC Section 448 differentiate between consulting services (providing advice and counsel) and “services similar to brokerage services, which involve compensation for the client engaging in a specific transaction,” the CCA notes.

Rejecting the corporation’s assertion that it merely provides advertising services, the IRS concluded the corporation should be classified as a broker for IRC Section 1202(e)(3)(A) purposes, based on the common meaning of the term and the definition provided in IRC Section 6045 – rather than on the narrower definition under IRC Section 199A. The IRS distinguishes the services the corporation offers from that of a search engine and notes that the corporation is paid commissions on the leasing transactions; it does not “just passively publish advertisements.”

Implications

Since IRC Section 1202 came into effect in August 1993, the IRS has issued only a handful of private letter rulings addressing the meaning of some of the trades or businesses listed in IRC Section 1202(e)(3)(A). Before publishing CCA 202204007, the IRS provided favorable guidance on what constitutes a qualified trade or business. In PLR  202114002, the Service ruled that an insurance agent was not engaged in “brokerage services,” but rather was engaged in a qualified trade or business within the meaning of IRC Section 1202(e)(3). In PLR 202114002, the Service did not address the meaning of the term “brokerage services” under IRC Sections 6045, 448(d)(2), or 199A. Instead, the Service relied upon the dictionary definition of the terms “brokerage services” and “broker” to conclude that the taxpayer’s role was not that of a mere intermediary. Because the taxpayer provided additional administrative services “beyond those that would be performed by a mere intermediary facilitating a transaction between two parties,” the taxpayer was not a broker.

In contrast, CCA 202204007 looks to guidance under IRC Sections 6045 and 448(d)(2) to inform the broad interpretation of “services” in the field of brokerage services under IRC Section 1202(e)(3)(A). This is also the first IRS ruling or advice on IRC Section 1202 that acknowledges the existence of the IRC Section 199A regulations, which provide a far more detailed definition of disqualified businesses than those found in either IRC Section 6045 or 448. While many have wondered if the Service would look to leverage those regulations for purposes of IRC Section 1202, CCA 202204007 seems to foreclose that possibility by distinguishing the two provisions based on policy considerations.

Just months after issuing a favorable PLR on the definition of “brokerage services” for purposes of IRC Section 1202, the Service has reversed course with the broad interpretation of the term in CCA 202204007. This apparent shift in the Service’s position could stem from the different circumstances under which the CCA and the PLR were created. As part of the taxpayer’s audit, CCA 202204007 would have been generated unilaterally by the exam agent and IRS Office of Chief Counsel. In contrast, the taxpayer requesting a ruling in PLR 202114002 would have had more input into the description of facts and the ability to discuss the legal analysis with the Service before it issued the ruling.

Furthermore, the Service in PLR 202114002 appears to have relied on the fact that the taxpayer provided additional administrative services and was not merely facilitating transactions between two parties. In CCA 202204007, the Service briefly mentions that the company also derived a recurring periodic fee from lessors for being listed in the company’s database, and that it may also provide other services to lessors for a fee, such as building and hosting websites for the lessors, but does not address these facts in its analysis. Apparently, providing any services in addition to facilitating a transaction between two parties is not sufficient to avoid characterization as “brokerage services.” Instead, it appears that the additional services must be imbedded in the fee derived for facilitating the transaction. If a separate fee is charged for providing additional services (like in CCA 202204007), the Service may conclude the separate services do not carry weight when determining whether the taxpayer’s trade or business involves services in the field of brokerage services.

CCA 202204007 highlights the importance of identifying trade or business activities based on revenue streams for purposes of the IRC Section 1202(e)(3) analysis. Sometimes the public perception of a company’s trade or business may not align with how the company derives revenue (e.g., platform for gig economy); for purposes of IRC Section 1202(e)(3), the focus on revenue streams may carry significant weight.

It will be interesting to see whether the taxpayer subject to audit in CCA 202204007 litigates this issue. The Service relies heavily on its position that the rules provided under Treas. Reg. Section 1.199A-5(b) apply solely for purposes of IRC Section 199A, even though the statute defines a specified service trade or business to mean any trade or business described in IRC Section 1202(e)(3)(A).

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