The IRS recently published private letter ruling (PLR) 202319013 regarding the application of internal revenue code (IRC) Section 1202 to a software company. In a taxpayer favorable ruling, the IRS determined that an enterprise cloud application services software company could be eligible for the gain exclusion under Section 1202 as a qualified small business. More specifically, the IRS ruled that the software company was not engaged in a (disqualified) trade or business where the principal asset of such trade or business was the reputation or skill of one or more of its employees. Instead, the IRS found that the principal asset of the company was the intellectual property held by the company itself.

As explained in Taft’s “The ABCs of I.R.C. Section 1202 Qualified Small Business Stock” article, in order to be an eligible corporation under Section 1202, the corporation must use at least 80% of the fair market value of its assets in the active conduct of one or more qualified trades or businesses. Under Section 1202(e)(3)(A), qualified trade or business is defined to include any business other than a trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, athletics, financial services, brokerage services, consulting, or any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

The final category of business in 1202(e)(3)(A) (underlined above) is perhaps the vaguest and is what the IRS considered in PLR 202319013. The company in question was an enterprise cloud application services software company. The company’s employees possess “technical skills and knowledge” for the implementation of the company’s services. They are trained on the company’s proprietary processes and methodology packages that are unique to the company. The company can train new employees to perform the same services as any other employee. The IRS considered these factors and held that the principal asset of the company was its own intellectual property, not the reputation or skill of any particular employee.

This ruling follows another recent PLR from 2021 (PLR 202144026) in which the IRS determined that a company that developed software used by health care professionals was engaged in a qualified trade or business under Section 1202. These two PLRs together demonstrate a consistent position from the IRS: in each case, a software company was found not to be a business whose principal asset is the reputation or skill of one or more employees.

While this latest PLR should provide some comfort to software and cloud-based services businesses, taxpayers should recognize the limitations of this guidance. First, as with all PLRs, the ruling is directed only to the taxpayer requesting it and cannot be formally used or cited as precedent. Second, the taxpayer only requested — and received — guidance on the narrow question of whether the company was in a trade or business where the principal asset is the reputation or skill of one or more of its employees. The PLR expressly stated that “no opinion is expressed or implied concerning whether Company meets the requirement under section 1202(e)(1)(A) that at least 80 percent (by value) of the assets of such corporation are used by such corporation in the active conduct of 1 or more qualified trades or businesses or whether the Company is engaged in a trade or business involving the performance of services in the field of consulting as defined in section 1202(e)(3)(A).”

If you have questions regarding your company’s qualification for the benefits under Section 1202, please contact your tax advisor, the author of this article, or any other member of Taft’s Tax practice group.