June 3, 2022
Pharmacy business constitutes a qualified trade or business under IRC Section 1202(e)(3), IRS rules
In a private letter ruling (PLR 202221006), the IRS has ruled a C corporation that operates pharmacies is engaged in a qualified trade or business defined in IRC Section 1202(e)(3). Specifically, the IRS concluded that, for IRC Section 1202(e)(3) purposes, the taxpayer is not in a trade or business (1) involving health services or (2) relying on the reputation or skill of its employees as its principal asset.
The taxpayer's 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.
The taxpayer has informed the IRS that its shareholders are currently negotiating the sale of their stock to an unrelated third party.
Law and analysis
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 (QSBS) held for more than [five] years." The amount of the gain exclusion varies depending on when the QSBS was acquired, ranging from 100% if acquired after September 27, 2010, to 50% if acquired on or before February 17, 2009.
Under IRC Section 1202(c)(2), stock is not treated as QSBS unless the corporation is a C corporation and meets the active business requirements of IRC Section 1202(e) for substantially all the taxpayer's holding period for the stock. To fulfill the active business requirements, the corporation must use at least 80% (by value) of its assets in the active conduct of one or more qualified trades or businesses and the corporation must be an "eligible corporation." A qualified trade or business is defined under IRC Section 1202(e)(3)(A) as any trade or business other than 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 trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employee[s]."
Therefore, the question is whether the taxpayer performs services in the field of health or whether its trade or business involves the reputation or skill of one or more employee. The IRS concluded that the taxpayer is not involved in providing health services and its employees are not providing health services, noting that interaction with patients is "merely incidental to ensuring receipt of their required prescriptions and answering the patient's questions about them." Further, the IRS found the taxpayer's "principal asset is not the reputation or skill of one or more employees, but its exclusive pharmaceutical distribution rights."
The IRS's conclusion in PLR 202221006 is not surprising, as the agency had previously taken a narrow view of the definition of the field of health in PLRs 201436001, 201717010 and 202125004.
What makes the ruling interesting, however, is that it comes on the heels of CCA 202204007, in which the IRS looked to the plain meaning of the word "broker" to determine that a corporation that connected lessors and lessees of rental properties was engaged in the disqualified business of brokerage (see Tax Alert 2022-0226). Had the IRS taken a similar approach in PLR 202221006, it is possible to envision an outcome where a corporation that employs licensed pharmacists is determined to be engaged in the disqualified business of "health."
In addition, the IRS went to great lengths in CCA 202204007 to distinguish the definitions of disqualified businesses for purposes of IRC Section 1202 from the definitions of those same fields that apply for purposes of the 20% IRC Section 199A deduction. The IRS contended that because the former is an exclusion provision, all disqualified fields must be interpreted broadly, whereas in the case of the latter, policy considerations require that the disqualified fields be interpreted narrowly. Regulations under IRC Section 199A, however, specifically list the provision of medical services by pharmacists as being included in the disqualified field of health; as a result, one would think that those services would fall within the definition of the field of health for purposes of IRC Section 1202 as well.
In reaching the conclusion that the corporation was not in the field of health, the IRS appears to focus on the presence of non-licensed employees, as well as the fact that the pharmacists do not provide diagnostic services or medical care to either patients or physicians — a welcome approach for the taxpayer, but possibly at odds with CCA 202204007.