January 4, 2024
Staffing agency satisfied qualified-trade-or-business requirement for purposes of IRC Section 1202 gain exclusion
In PLR 202352009, the IRS ruled a that company providing interim staffing and executive search services was engaged in a qualified trade or business as defined in IRC Section 1202(e)(3). This conclusion was based on the finding that the company did not (i) perform services in the field of consulting; or (ii) operate a trade or business where its principal asset was the reputation or skill of one or more of its employees. The IRS, however, did not rule on whether the company satisfied any other statutory and regulatory prerequisites for the exclusion of capital gain under IRC Section 1202, but required the company's owner to represent more than 80% of the company's assets were used in its staffing business.
Taxpayer owned a C corporation (Company) that provided interim staffing services and executive searching for its clients. The interim staffing services included matching professionals with the Company's clients for positions or projects. Company's clients identified their staffing needs for particular positions or projects. The staffing needs were often determined with the aid of third-party consultants. The clients then provided the detail of their staffing needs to Company. Company billed its clients at an agreed-upon rate for (1) the time the temporary or interim employees spent on projects, (2) engagement oversight provided by its own employees, and (3) project communication conducted by its own employees.
The executive searching services involved placing permanent professionals with its clients. The clients developed criteria and specifications for desired executives. Company then used the provided criteria and specifications to perform an executive search. The clients paid Company a total fee equal to a percentage of the executive's first-year compensation. Company received a portion of the fee upon the signing of the agreement before it began its search services. Company was not involved in the analysis or business plan development for its clients.
While Company processed the payroll for the professionals who filled the clients' staffing needs, the clients were the professionals' employers for state law and federal income tax purposes. The clients also directed and supervised the professionals, as well as reviewed the quality of the professionals' work product. Additionally, the clients provided the workstations, resources and other tools for the professionals, and monitored and controlled the engagements.
An unrelated third-party buyer acquired all of Company's shares, including Taxpayer's shares, in a stock sale. Company used more than 80% of its assets in its staffing business.
IRC Section 1202(a) allows a taxpayer other than a corporation to exclude a certain percentage of gain from the sale or exchange of qualified small business stock held for more than five years. During substantially all of a taxpayer's holding period, a corporation must meet the active business requirements in IRC Section 1202(e) and be a C corporation for the corporation's stock to be treated as qualified small business stock.
Under IRC Section 1202(e)(1), the active business requirements are met if the corporation uses at least 80% of its assets in the active conduct of a trade or business, and is an eligible corporation. IRC Section 1202(e)(3) defines a qualified trade or business as "any trade or business other than (A) a 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 one or more of its employee."
Based on the facts, the IRS ruled Company was engaged in a qualified trade or business as defined in IRC Section 1202(e)(3). The IRS, however, also concluded Company was not engaged in a trade or business (1) related to the performance of consulting services, or (2) in which "the principal asset of the trade or business was the reputation or skill of one or more of its employees."
Generally, this ruling serves as a reminder that not all service-oriented companies are per se ineligible for the IRC Section 1202 gain exclusion.
In finding favorably for the taxpayer, the IRS seems to focus on the fact that the staffing agency was provided specific criteria to find eligible candidates for its clients, and did not, as a result, conduct any ineligible trade or business activities. If, for instance, Company was asked by its clients to help them identify criteria for an eligible candidate and then conducted a search based on that criteria, the IRS might have hesitated to find that Company was not engaged in a trade or business (1) related to the performance of consulting services, or (2) in which "the principal asset of the trade or business was the reputation or skill of one or more of its employees." This scenario, however, is just a hypothetical, because those were not the facts provided to the IRS as part of the ruling submission.
Another interesting aspect of the ruling is that the clients were the professionals' employers for state law and federal income tax purposes, while Company processed the payroll for the professionals who filled the clients' staffing needs. It is less clear whether the IRS would have ruled favorably if, for example, Company employed the placed staff members under state law and for federal income tax purposes. The IRS could have taken the position that Company was engaged in a trade or business in which the principal asset of its trade or business was the skill of its employees (i.e., the temporary staff). Again, however, those were not the facts provided to the IRS as part of the ruling submission.