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article. If you have a client who needs advice on energy tax credits, could you use this review (and the
article) as a research shortcut, to identify the Code sections and IRS guidance that you need to check for
updates.
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Brad Pitt
Renewable Energy Tax Credits: Green Energy Saving Greenbacks
Joshua D. Smeltzer
Taxes – The Tax Magazine, July 2021
In Taxes–The Tax Magazine article, “Green Energy Saving Greenbacks,” author
Joshua D. Smeltzer describes the increasing efforts to create renewable energy without hurting
the environment. Investment in the renewable energy sector is continuing to grow, which also
increases the need for tax advice in this area. Therefore, if tax compliance is not done properly
the benefits may no longer be offered. Smeltzer describes the two alternatives of tax credits as
well as the three primary business structures used to invest in renewable energy.
The Production Tax Credit (PTC) is primarily used for wind projects but can potentially be used by other electricity production projects if construction began in 2020 or 2021. The
PTC was extended by one year under Code Sec. 45. Section 45(a) explains the general rule for
taking a production tax credit. The amount of credit can be equal to 1.5 cents multiplied by the
kilowatt hours of electricity produced by the taxpayer. Section 45(a)(2)(A)(i) acknowledges that
the energy must be a qualified resource from a qualified facility (no older than 10 years) sold by
the taxpayer to an unrelated person during the taxable year. Unless a renewable energy production facility began construction between 2009 and January 1, 2022 they will elect to use the Investment Tax Credit (ITC). Under Code Sec. 48 the ITC is irrevocable once elected. The ITC is
primarily used for solar energy projects but can also be used for other technologies if construction begins before 2024. Section 48(a)(5) states that a facility must be a qualified investment
credit facility to accept the credit and must be treated as energy property for the purposes of this
section. Generally, a 30 percent ITC is allowed under §48(a)(5)(ii) but may be a different value
depending on the source of renewable energy. Construction must be started in 2021 to use the
Production Tax Credit, so we can assume that most new wind projects will move to use the Investment Tax Credit.
One of the most popular business structures used by renewable energy projects is the
partnership flip transaction. In this transaction, most tax credit benefits are allotted to the investor
until the benefits are flipped to the developer at a specified point. This transaction can only be
used by PTC partnerships that producing wind energy, so it is not always recommended. The
second most common structure is the sale-leaseback transaction. This is when the developer sells
the project to a tax equity investor and then leases it from the investor. The investors usually
claim tax credits until the project is complete and the developer will either purchase the project
back or extend the lease. The least common structure is the inverted lease structure which is almost opposite to the sale-leaseback structure, but other traditional options are usually recommended.
In conclusion, investment in renewable energy production will only continue to grow.
As a result, taxpayers and their advisors must follow the rules more carefully than ever to maintain the credits being offered.
TAXES – The Tax Magazine (2006 to Present), Renewable Energy
Tax Credits: Green Energy Saving Greenbacks, (Jul. 8, 2021)
TAXES – The Tax Magazine (2006 to Present)
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© 2021 J.D. Smeltzer.
By Joshua D. Smeltzer [*]
Joshua D. Smeltzer is a Counsel at Gray Reed & McGraw, P.C. and a former Department of
Justice, Tax Division Honors Attorney.
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Joshua D. Smeltzer examines renewable energy tax credits.
The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.
– William Arthur Ward
The world needs energy, and increasingly more of it, but people are becoming concerned that the production of energy be done responsibly. A growing trend involves efforts to create more energy from renewable sources
in hopes of both creating the energy we need without damaging the environment in which we live. The new Biden
administration is clearly signaling that renewable energy will be a key focus of its plan going forward. For example,
the Biden administration has set a goal to deploy 30 gigawatts of offshore wind generation capacity by the year
2030. Therefore, it can be expected that tax advisors will be seeing more questions about renewable energy tax incentives as investment in the sector increases.
A large driver of investment in renewable energy is caused by specific tax credits offered as part of the deal
structure. However, tax credits are strictly construed by both the IRS and the courts and must follow specific guidelines. Therefore, if the partnership, associated agreements, and negotiations and dealings among the investors and
developers of renewable energy are not done properly the tax benefits might disappear.
The Basics of Renewable Energy Tax Credits
Investment in renewable energy has been a tax incentive for many years now, but the benefits were approaching phase-out until they were renewed as part of the Consolidated Appropriations Act. The new legislation
provided both COVID pandemic relief and extended the tax credits associated with renewable energy such as solar,
wind, biomass, geothermal, and others. The primary tax credits involved for renewable energy are the Production
Tax Credit (PTC) and Investment Tax Credit (ITC). However, the new law also created a new stand-alone tax credit
for offshore wind projects. These changes are all designed to encourage more investment in renewable energy going
forward but, as with any tax benefit, taxpayers and their tax advisors must be careful to follow the rules carefully.
Production Tax Credit
The PTC is governed by Section 45 of the Internal Revenue Code (IRC). The PTC under Code Sec. 45 was
also extended for one year. Primarily used for wind projects, it also applies to production of electricity from other
reviewable sources that begins construction in either 2020 or 2021 ( i.e., biomass, geothermal, landfill gas, trash facilities, qualified hydropower and marine and hydrokinetic renewable energy facilities). If construction begins after
2021 then there is no eligibility for any PTC.
Recent IRS guidance has provided inflation-adjusted amounts for producers of electricity from renewable
sources. However, there are different percentages allowed depending on the renewable source used. The PTC is 2.5
cents per kilowatt hour (kWh) for 2021 for electricity produced from wind, closed-loop biomass, and geothermal
energy. The PTC is 1.3 cents per kWh for 2021 for electricity produced from open-loop biomass, landfill gas, trash,
qualified hydropower, and marine and hydrokinetic sources. The PTC is $7.384 per ton for 2021 for refined coal,
which is a modest increase from previous amounts. In all cases the electricity must be produced and sold to an unrelated third party.
Effective for renewable electricity production facilities placed in service after 2008, the construction of
which begins before January 1, 2022, taxpayers otherwise entitled to the PTC (determined on a cents per kWh basis)
may elect the ITC, under Code Sec. 48, in lieu of the PTC. The election is irrevocable. The energy percentage is
30% for such property making the election. Under the election, any qualified property that is part of a qualified ITC
facility is treated as energy property. If the taxpayer makes the election, no production credit for any year is allowed
for any qualified ITC facility.
To make the irrevocable election to treat a qualified facility as a qualified investment credit facility, the taxpayer must make a separate claim for the ITC on each qualified property that is an integral part of the facility using a
completed Form 3468 filed with the taxpayer’s timely filed (including extensions) income tax return for the year in
which the property is placed in service.
Investment Tax Credit
The ITC under Code Sec. 48 was extended by two years. This tax credit is popular for solar energy projects
as well as other technologies ( e.g., fuel cells, microturbines, small wind energy.) However, it is the solar energy
companies that appear to primarily be using the ITC. In general, solar projects beginning construction in years 2020
through 2022 are eligible for a 26% ITC, 22% ITC in year 2023, and 10% after 2023. The ITC is similar for other
technologies except that it drops to 0% if construction begins after 2023, or if the project is placed in service after
2025.
The new standalone ITC for offshore wind has different specifications. These are facilities located in the
inland navigable or coastal waters of the United States. Offshore wind projects are eligible for a 30% ITC for projects beginning construction before 2026 without any apparent phase-down provisions like contained in the other
renewable ITC projects. The extension of the PTC requires construction to begin in 2021, so it can be expected that
most wind energy investment will likely move to these new offshore wind ITC guidelines.
The property must be qualified energy property, construction must be done by the taxpayer, must be property that is allowed to be depreciated or amortized, must meet performance and quality standards, and must NOT be
part of a facility where production is taken into account in computing the credit for electricity produced from renewables or which the taxpayer receives a grant in lieu of the energy credit. This includes solar, geothermal, fuel cell,
microturbine, heat and power systems, and qualified small wind energy property that begins construction before
2024. Energy property also includes property that is part of a renewable electricity production facility placed into
service after 2008 and beginning construction before January 1, 2022 if the taxpayer makes an irrevocable election
to treat facility as energy property and no production credit has been allowed. It is important to note that the IRS indicated that it will NOT issue rulings on the application of the beginning construction requirement. [1] Beginning
construction is determined by two tests ( i.e., physical work test and a 5% safe harbor). [2] Both methods require that
a taxpayer make continuous progress towards completion once construction has begun. If a facility is placed in service by the end of a calendar year, that is no more than four calendar years after the calendar year during which construction of the energy property began, the energy property will be considered to satisfy the requirements.
Each type of renewable energy (solar, geothermal, etc.) has its own unique qualifications for which property qualifies for the credit. Therefore, tax advisors must look at each piece of specific property to ensure that it
qualifies for the tax credit. This includes the type of renewable energy involved and when it needs to be placed into
service. Also, if multiple properties are involved there are special rules for treating the property as a single project.
[3]
Taxpayers should also be aware that there is sometimes a risk of ITC recapture. This recapture usually occurs in two situations. First, when an unvested portion of the ITC is recaptured due to something that occurs after the
project is placed in service. The ITC usually vests 20% each year, after placed in service, and if the taxpayer disposes of the project or the project is otherwise no longer eligible for the ITC the unvested portion might be recaptured. A change of ownership ( e.g., lease or sale-leaseback) is unlikely to qualify as disposal, depending on the specific facts involved. The second situation involves an IRS determination that the credit was not allowed in the
amounts claimed ( e.g., inflated costs or costs misallocated to ITC eligible equipment). This IRS determination
might also cause recapture.
The Implementation of Renewable Energy Investments and Tax Credits
Developers and investors use a variety of business structures to invest in renewable energy. However, the
primary structures tend to be investment partnerships, sale-leaseback transactions, and inverted lease transactions.
Each structure has different benefits and detriments that should be carefully considered.
One of the most popular structures is a partnership flip transaction where a majority of the tax credit benefits are given to the investor until a specific point when the percentages then flip to the developer. This structure
mimics a similar structure used by the IRS as a safe harbor for PTC projects involving wind. [4] However, IRS Chief
Counsel Advice [5] has indicated that this structure is limited to PTC credits and wind. Therefore, although it provides guidance on what appears to be acceptable under the partnership rules, it should not be seen as a “safe harbor”
for anything other than PTC partnerships involving wind. If questioned by the IRS, this explanation can help provide
support for compliance with the applicable partnership rules but will probably not avoid IRS scrutiny entirely. In
this structure there is a capital infusion from the project developer and the tax equity investor, the partnership then
constructs the project, customers make payments for the power services, and then prior to the “flip” the partnership
distributes 99% profits/losses, most of the tax credits, and some cash to the tax equity investor and the remaining 1%
to the project developer. The “flip” is where the allocations of profit/losses, cash, and any tax credits between the
developer and investor change at either a pre-determined date or a target yield or other pre-determined condition.
The flip usually occurs after five years to avoid recapture and, after the flip, the developer usually has the option to
buy out the tax equity investor. There are several variations, but this is the basic structure and the further away from
this structure you get the less you will be able to claim its similarity to the safe harbor provisions of the PTC for
wind it is based on. The primary advantages of this structure are that it is easy to close and monetizes most or all of
the tax benefits available and allows the developer and investor to part ways relatively easily when the agreed benefit is reached. Its primary disadvantage is that the developer will need to contribute equity and at least a portion of
the losses and credits will be allocated to the developer that may not need such losses or credits.
Another fairly common structure is a sale-leaseback transaction. In this transaction, a project developer locates a customer and signs an agreement for services, the developer then builds the system and sells the system to a
tax equity investor. The developer leases the system from the tax equity investor and the developer incurs all costs
of operations. At the end of the project the developer may purchase the project or extend the lease. The tax equity
investor can usually claim the tax credits, depreciation, and receive the cash flow as owner of the energy property.
The lease term, again, usually exceeds five years in order to avoid recapture under the ITC. Although, if the costs
are high enough the lease term might be 10–15 years. The primary advantage of a sale-leaseback transaction is that
the investor finances the entire cost of the project through the purchase price. It may have some developer costs (
e.g., capital contributions during construction or lease pre-payments) but generally requires the least developer equity. Also, 100% of the tax benefits are absorbed by the investor instead of a part of the tax benefits being left with a
developer that may not need those benefits. The primary disadvantage is that there are stringent agreement rules
such as fixed rent schedules, indemnifications, and potential guarantees.
A less common structure is an inverted lease structure. In this structure, a tax equity investor leases the systems from the developer, the tax equity investor then makes an agreement to provide services with a customer, customer pays the tax equity investor for services and investor then pays the developer. This also allows for the investor
to take 100% of the ITC. There is sometimes a partnership variation on this inverted lease structure. [6] Similar issues
can be present in the inverted lease variant as both the sale-leaseback and partnership flip structures depending on
the details of the transaction. Therefore, unless this structure serves a specific purpose, other more traditional options
are probably a better option.
Potential Risks Involving Applicable Tax Rules
Tax benefits are considered a matter of legislative grace and are closely scrutinized by both the IRS and the
courts. Therefore, tax advisors must be aware of traditional tax principles, developed by the IRS to combat abuse of
the tax credits, and other rules in the IRC.
Passthrough ITC is based on the Fair Market Value (FMV) and that involves having a qualified appraisal
and all the rules surrounding a properly done appraisal. Partnerships passing through losses and credits must abide
by both the “at risk” [7] rules and the “passive activity rules” [8] when applicable. Also, in the lease context, the IRS
has specific rules that must be followed under Code Sec. 467. [9]
Beyond limitations specifically listed in the Internal Revenue Code, all transactions are subject to the judicial doctrines of substance over form, step-transaction doctrine, and the economic substance doctrine. The agreements and actions of the parties must document a clear business purpose outside of the tax benefits and show that all
parties have a meaningful upside and downside potential outside of any tax benefit. An investor may desire, and a
developer may be willing to provide, certain guarantees or indemnifications that could prove problematic if the tax
credits are later challenged by the IRS. For example, direct or indirect guarantees of the investor being able to claim
the credit, cash equivalents of the credits, guaranteed repayment of capital contributions because the credit can’t be
claimed, or guarantees of repayment or indemnification if the credit is challenged by the IRS all might cause problems. Just because Congress is encouraging the use of these benefits, does not prevent the IRS or the courts from
doing an economic substance analysis and disallowing benefits. [10] Therefore, the terms of the agreement must be
evaluated carefully for provisions that could raise questions about the parties having a real stake in the transaction.
Footnotes
*
Mr. Smeltzer can be reached by email at jsmeltzer@grayreed.com.
1
See Rev. Proc. 2021-3.
2
See IRS Notice 2018-59.
3
See id.
4
See Rev. Proc. 2007-65.
5
CCA 201524024.
6
See Rev. Proc. 2014-12.
7
See Code Sec. 465.
8
See Code Sec. 469.
9
See Code Sec. 467.
10 See Alt. Carbon Res., LLC, FC, 939 F3d 1320 (2019) (denying taxpayer argument that the benefits approval by
Congress prevented economic substance analysis).
VitalLaw®
TAXES – The Tax Magazine (2006 to Present), The Code Sec. 1202 Active
Business Requirement, (Nov. 7, 2022)
TAXES – The Tax Magazine (2006 to Present)
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© 2022 W.G. Antognini and V.R. Barrella.
By Walter G. Antognini and Vincent R. Barrella
Walter G. Antognini, CPA, J.D., LL.M., is a Professor at the Lubin School of Business, Pace University, New
York. Vincent R. Barrella, J.D., LL.M., is a Professor at the Lubin School of Business, Pace University, New
York.
Click below for a downloadable/printable version of this column. Click to Launch
Introduction
Code Sec. 1202 provides the possibility of enormous savings from sales of stock in small business corporations
if certain requirements are satisfied. More particularly, a taxpayer can exclude $10 million or more of gain. But
a number of hurdles must be surpassed in order to qualify. One such requirement is that the corporation must
have a qualified trade or business. [1]
Background [2]
Code Sec. 1202 has been in the code since 1993. [3] Its purpose is to provide an incentive to invest in startup
businesses. [4] It accomplishes this by allowing a taxpayer to exclude gain from the sale or exchange of qualified
small business stock held for more than 5 years. [5] Subject to a limit, the taxpayer may exclude 100% of the
gain. [6] The amount of gain which a taxpayer may exclude is generally the greater of 10,000,000 or 10 times
the taxpayer’s aggregate adjusted basis in the qualified business stock in this corporation. A recent article in the
popular press highlights the possibility of greatly increasing the 10,000,000 exclusion by gifting some of the stock
to friends and family. [7]
The exclusion applies only to dispositions of “qualified small business stock held for more than 5 years.” [8]
Qualified small business stock is stock of a regular (C) corporation that (1) at the time of issuance is a qualified
small business and (2) such stock was acquired at original issuance in exchange for money or other property
(but not including other stock) or as compensation for services provided to the corporation. [9] In order to be
considered a qualified small business, the corporation must generally satisfy the Code Sec. 1202(e) active
business requirement for substantially all of the shareholder’s holding period for such stock. [10] The active
business requirement is met for any period if (1) at least 80% of the value of the corporation’s assets is used
by the corporation in the active conduct of qualified trades or businesses and (2) the corporation is an eligible
corporation. [11] As perhaps the most important point of the above labyrinth of definitions and requirements (or at
least as pertains to this article), in order to qualify for the exclusion, a corporation must be engaged in a qualified
trade or business.
Code Sec. 1202(e)(3) defines the term “qualified trade or business.” As is not unusual in the tax law, the term is
defined in the negative— i.e., it is 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,
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(B)
(C)
(D)
(E)
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 employees,
any banking, insurance, … or similar business,
any farming business …,
any business involving the production or extraction of products [qualifying for a depletion deduction],
and
… operating a hotel, motel, restaurant, or similar business.
This article will focus on the first possibility.
Further Guidance on Qualified Trade or Business Requirement
As should be apparent, the determination of whether a corporation operates a qualified trade or business
can be hugely important to a taxpayer. Without this requirement being satisfied, the taxpayer could face what
would typically be a 23.8% tax at the federal level. [12] If the section is doing its job in providing an incentive for
investors to invest in a particular company, the taxpayers would presumably have done their due diligence to
assure that these requirements have been satisfied. It would therefore presumably come as quite a shock to
discover that the Internal Revenue Service (IRS) is challenging the existence of a qualified business. [13]
Several authorities have addressed the issue of what is a qualified trade or business, although many
uncertainties remain. [14] Most of these authorities involve a business that is associated with healthcare. Two
involve the insurance industry.
In Owen v. Commissioner, [15] the Code Sec. 1202(e)(3) qualified trade or business requirement was raised
through Code Sec. 1045. [16] The underlying corporation was engaged in the business of selling insurance
policies from insurance companies, generating premiums from the policies sold. The case provided minimal
rationale for its decision finding that a qualified trade or business did exist. The main issue was whether the
business was disqualified because one of its principal assets was the skill of Mr. Owen. The court disagreed with
the government’s argument on this point rationalizing that the corporation’s principal asset was its “training and
organizational structure” and that the corporation sold its policies through independent contractors, including Mr.
Owen, not through this individual’s personal capacity. Because there was no need to discuss the issue (the case
held against the taxpayers for other reasons), the court did not discuss whether the business was an insurance
business or, instead, involved brokerage services. [17]
In a 2014 letter ruling, [18] the IRS held that a pharmaceutical company was a qualified trade or business.
The IRS indicated that the thrust of Code Sec. 1202(e)(3) was to disqualify businesses that offer value to
customers primarily in the form of providing services. The IRS went on to indicate that the company was “not
in the business of offering service in the form of individual expertise.” Instead, the company’s activities involve
the deployment of assets (both manufacturing and intellectual property assets). The IRS observed that the
pharmaceutical industry was analogous to a parts manufacturer in the automobile industry. It further observed
that while the industry is certainly a component of the health industry, it “does not perform services in the health
industry within the meaning of Code Sec. 1202(e)(3).”
Approximately three years later, the IRS issued another letter ruling that also involved the healthcare industry.
This ruling [19] involved a company that provided healthcare providers a tool for the precise detection of a
medical condition. The issue presented was whether the company provided services in the fields of health.
The company performed tests to detect a certain condition and then provided a laboratory report to healthcare
providers. The company does not discuss diagnosis or treatment with the healthcare provider—it merely
provides the report, for which it receives compensation. The ruling noted that the taxpayer represented that,
with one exception, the company’s personnel are not subject to state licensing requirements or classified as
healthcare professionals under state or federal law or regulatory authority. The IRS concluded that the company
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did not engage in the performance of services in the field of health or that its principal asset was the reputation or
skill of one or more of its employees. Accordingly, the company did engage in a qualified trade or business.
LTR 202125004 (6/25/2021) was another instance raising the issue of whether the taxpayer provided services
in the health field. In this letter ruling, the company manufactured products prescribed by third-party healthcare
providers. The company employed specialists who “work on prescriptions referred by healthcare providers to
evaluate, measure, design, fabricate, manufacture, adjust, fit, and service” products for the referred individuals.
Its revenues were generated from the sale of these products. The company directly interacted with referred
individuals and their respective diagnoses. These interactions were determined to be incidental to ensuring an
appropriate form of the product—more akin to custom manufacturing than providing services. The IRS held that
the taxpayer was engaged in a qualified trade or business.
Also in 2021, the IRS issued another letter ruling that was like Owen case in that it involved an insurance agent.
[20]
The company involved generated revenues through two business models. The first model was that it had
contracts with insurance companies to sell insurance products. Under this model, the company generates
revenues directly from the insurance company through commissions or similar arrangements. The ruling noted
that the agent was required to perform certain administrative services for the insurance company, such as
promptly reporting incidents, claims, etc. In the second business model, the company had a contract with a
wholesaler (not an insurance company) and the wholesaler contracted with an insurance company. The taxpayer
selected an appropriate policy for the customer that was provided by the wholesaler. The wholesaler procures
the policy from the insurance company. The ruling noted that the taxpayer represented that at least 80% of its
assets were used in the conduct of business under the first model. The primary issue analyzed by the ruling
was whether the company was engaged in “brokerage services” (which is not a qualified trade or business
— Code Sec. 1202(e)(3)(A)). Because the legislative history did not address what is meant by “brokerage
services,” the IRS turned to the “ordinary, contemporary, common meaning,” noting the dictionary definition
for a broker was “one who acts as an intermediary: such as a: an agent who arranges marriages [obviously
irrelevant in the current context] b: an agent who negotiates contracts of purchase and sale (as of real estate,
commodities, or securities).” The IRS noted that as to the first business model, the company was not a mere
intermediary facilitating a transaction between two parties. The IRS then highlighted that the company performed
the administrative services noted above. The ruling did not address the treatment of the second business model.
[21]
LTR 202144026 (11/05/2021) is yet another letter ruling in the healthcare domain. The company developed
and commercialized software assisting medical providers in providing medical treatment to patients. The ruling
noted that the company did not practice medicine, had no patients, and was not licensed to issue prescriptions.
The ruling further noted that Code Sec. 1202(e) “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.” In contrast, this “[c]ompany is a technology company which develops software for medical providers
and patients to utilize as a tool” to optimize treatment. The software and associated reports do not diagnose
or recommend treatment, illustrating that the company “is not in the business of providing health services but
rather creating an asset to be utilized by their customers in the healthcare industry.” The ruling went on to hold
that the company does not provide value to customers primarily in the form of individual expertise. Further, the
IRS noted that “[a]lthough the software and applications developed by Company are allied or associated with
the healthcare industry … Company is not … performing services in the field of health.” It appears the IRS has
recognized that a business can qualify if it creates value in the form of technology that greatly aids one of the
excluded categories but not actually be in that category.
Six months later, the IRS issued another letter ruling involving the pharmaceutical industry. [22] In this instance,
the business was a retail pharmacy business. It would seem clear that a pharmacy is in the health field. And,
by necessity, it employs pharmacists subject to state licensing requirements. But the issue revolved around the
question of whether the company generated revenues from the performance of services. The ruling noted that
the pharmacists only interacted with physicians by receiving their prescriptions. And their interaction with patients
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was minimal—mostly to answer questions about a particular prescription. Company employees never diagnose
or recommend any treatment or drug to individuals or manage any aspect of any patient’s care. [23] Perhaps
most critical to the inquiry, the taxpayer generates revenues through sales of the drugs, not medical care per se.
Again, the IRS held that the business was not one involving performance of services in the health field or where
the business’s principal asset was the reputation or skill of one or more of its employees.
To summarize the above precedents, it would seem that only doctors (as well as dentists, physical
therapists, nurses, etc.) would be considered as providing services in the field of healthcare, not pharmacists,
pharmaceutical companies, or companies that create or provide tools to be used by doctors. Stated differently, it
appears that only those legally licensed to provide healthcare services will be considered to do so. This makes
sense—for this purpose, a person should not be considered to do something that the law forbids. A further
observation can be gleaned from the above authorities—they all held for the taxpayer. Chief Counsel Advice
(CCA) 202204007 (1/28/2022) stands in stark contrast to the authorities discussed above in that each of those
authorities decided the matter in favor of taxpayers while the CCA decided against the taxpayer.
In the CCA, the taxpayer operated a website on which potential lessees could make nonbinding reservations
for physical facilities (real estate) at specified rates from lessors. The website maintained a database of such
facilities from which potential lessees could choose. The company (maintaining the website and database) had
no authority to enter into or sign leases on behalf of either party. Instead, the parties would directly enter into a
rental agreement with each other. The company has no control over the listed facilities and does not guarantee
the accuracy of listings or whether a lessee is actually able to lease a listed facility. The company apparently
derives revenue primarily from two sources. First, it charges a fee to be listed, and second, it charges a fee
contingent upon the leasing of a facility, equal to a percentage of the rent paid. The CCA notes that, “Corporation
states that it is not responsible for, and does not engage in, brokering, selling, purchasing, exchanging, or
leasing posted properties.” And the company “… asserts that it is not a broker with respect to the leasing of the
facilities.” The IRS nonetheless concluded that the company engaged in brokerage services and, accordingly,
was not a qualified trade or business and, therefore, the company’s stock was not a qualified small business
stock. For a number of reasons, we do not agree.
In its analysis, the ruling first notes that “brokerage services” is not defined in Code Sec. 1202 or its legislative
history. The CCA then discusses other sections for which services are a key factor for purposes of determining
whether those sections (or the regulations or other authorities thereunder) might shed light of the meaning
of the term brokerage services. Code Sec. 6045(c)(1), imposing reporting requirements on brokers, defines
broker as including (A) a dealer (not relevant here), (B) a barter exchange (not relevant here), and (C) any other
person who, for consideration, regularly acts as a middleman with respect to property or services. This term was
nonetheless limited in regulations for purposes of the reporting requirements to transactions of financial interests,
such as securities, commodities, etc. [24] The CCA argues that while this regulation simply limits the reporting
requirement ( i.e., limits such requirement to those involved with financial interests), the regulation is nonetheless
instructive on what is more generally meant by the term “broker.” Reg. §1.6045-1(a)(1) indicates that a broker is
a person who “… in the ordinary course of a trade or business during the calendar year, stands ready to effect
sales to be made by others.” The IRS argues that this definition remains broad enough to apply to the company’s
website operations. We do not agree. The company does not stand ready to effect sales to be made by others.
The company does not effect sales—at best, based on the facts provided in the CCA, it puts the two parties in
contact with each other who then effect any transactions. The IRS further argues that, in revising Code Sec.
6045 to include others in the term “real estate reporting person,” “Congress understood that the term broker had
an expansive meaning.” Again, we disagree. We would argue just the opposite—that Congress felt compelled
to include others within the definition of real estate reporting person because Congress recognized that limiting
reporting requirements to brokers would not produce enough reporting, and so Congress imposed real estate
reporting requirements on more than just brokers. [25]
The CCA discusses Code Sec. 199A and the regulations thereunder, but seems to conclude that, ultimately,
those authorities do not add much to the issue of what is meant by the term “brokerage services.” [26]
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The CCA then notes that it found no case law that discusses the issue of what is meant by “brokerage services”
and therefore concludes that “… in the absence of evidence to the contrary, words in a statute are assumed to
bear their ordinary, contemporary, common meaning.” It then turned to a dictionary definition of broker, which
is “one who acts as an intermediary: such as an agent who negotiates contracts of purchase and sale (as of
real estate, commodities, or securities).” Another definition provided is that a broker is “[o]ne who is engaged
for another, usually for 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.” [27] Here, based on the facts provided, the company does not negotiate a contract between
the lessor and lessee. Instead, the company requires the parties to directly contract with each other. [28] The
common practice for real estate brokers is that one party (the owner of property) requests that a broker lists
their property for sale or rent at a particular price. A potential buyer (or lessee) may then make a counter-offer,
perhaps in terms of price, perhaps some other aspect of the transaction, such as requiring a repair in order to
move the transaction toward contract. The seller’s broker then contacts the seller to determine whether such
counter-offer is acceptable, perhaps discussing the issue with either or both parties in the process. That back
and forth does not appear present under the CCA’s facts. Indeed, it is not clear how the website would be
capable of performing these negotiations. It is, after all, a website. Such back and forth would, at a minimum,
seem to require implementation of artificial intelligence. [29] And so it would appear that the Company is more
akin to a vehicle for advertising than a broker. Hence, the company should not be considered engaged in
brokerage services.
The IRS in the CCA states that exclusions from gross income should be narrowly interpreted and that, therefore,
the term brokerage services should be interpreted broadly. But the IRS then analyzes Code Sec. 199A (which,
like Code Sec. 1202, grants benefits to taxpayers; the Code Sec. 199A benefit is in the form of a substantial
deduction) and, in doing so, concludes that narrowly limiting the definition of broker in Code Sec. 199A furthers
tax policy while doing so in the context of Code Sec. 1202 does not. [30]
The CCA recognizes that the company does not have the authority to enter into leasing agreements on behalf
of lessors, only the potential lessors and lessees do. Citing a Colorado state case, the IRS suggests that “…
brokerage activity can include simply bringing a potential buyer and seller together to work out a transaction.”
[31]
Surely, the IRS must be capable of distinguishing the typical finder’s fee from the company’s functions in
the CCA. One typically earns a finder’s fee for performing services beyond those suggested in the CCA. The
finder typically engages in significant analysis or at least judgment ( e.g., does this property make sense for
the potential buyer?), and discussions with the parties as part of the introduction. The company in the CCA
does none of that here. The potential lessee does all the analysis and the company engages in no discussions
with the parties—the website simply provides names and contact information—the company has no humans
engaging in discussions. The company does no more by way of introduction than does a newspaper providing
advertising. Also, the company has asserted that it is not a broker and does not engage in brokerage services.
Is the IRS nonetheless asserting that the company is in violation of state law by providing real estate brokerage
services while not being a licensed broker? That would seem to be the natural inference from the IRS reasoning.
We believe the IRS has gone too far in its reasoning.
The CCA concludes that, “[t]he fact that Corporation’s services are provided by software created by people
rather than directly by people does not change the functional nature of the services.” This statement is perhaps
the most troubling aspect of the CCA. Many extremely valuable companies exist largely because they use
software to replace functions previously performed by humans. An essential aspect of many if not most
technology startups (as well as those previous startups that are now enormously valuable) is that they use
software to replace human functions. Indeed, it seems that for our economy to prosper, we as a society must
continue to embrace this technological advance. The authors would argue that to suggest that these startups
would not qualify for the benefits of any section that incentivizes such startups would be contrary to tax policy.
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Leaving aside the theoretical concerns for the moment, the authors believe there is at least one practical factor
that distinguishes software-provided services from human-provided services—in order to create the software,
the startup must necessarily employ capital to hire the humans and create the working environment for creating
the software—indeed it is this enormous infusion of capital that is at the heart of the Code Sec. 1202 exclusion.
Code Sec. 1202 only becomes relevant because investors want to create the intellectual property that allows the
software to perform its functions. One must assume that capital and assets (including intellectual property) are in
contrast to services—a company largely provides value to others either through the provision of services or the
application of capital. In the case of a technology startup, it is the capital.
One should stop to consider the extent to which the IRS reasoning could apply to companies already in
existence and those future companies that might be thwarted as a result. Is not a company such as eBay
essentially a broker under the CCA reasoning? After all, it maintains a website that puts buyers and sellers
together and earns a fee upon the consummation of a transaction. Bear in mind that the IRS does not appear
to draw any clear distinction between a real estate broker and a broker of other physical products, or services
for that matter. Is Uber engaged in broker services? Airbnb? And, as described in a New York Times article
previously cited, Silicon Valley and its venture capitalists are keenly aware of the Code Sec. 1202 benefits. [32]
How many new technology (and other) companies will be thwarted as a result of the position taken in the CCA?
[33]
Conclusion
In conclusion, we believe that the Code Sec. 1202 carve-out for companies largely providing certain services
should be narrowly construed to include more traditional constructs of what is meant by services in the
designated areas, and we urge the IRS to reconsider its position and withdraw CCA 202204007. It should do
so soon because, inter alia, the issues it raises could put a significant damper on the development of further
technology companies and the generation of untold billions of gross domestic product (GDP) growth.
Footnotes
1
Code Sec. 1202(e)(3).
2
The authors do not intend to provide an exhaustive discussion of the Code Sec. 1202 details and its workings.
Instead, we will mostly focus on the qualified trade or business requirement. For a good discussion of the
detailed requirements and consequences, we recommend that the reader review a recent article in the J. TAX’N.
Yuhas and Radon, Section 1202—Hidden Gem or Paradise Lost?, 137 J. TAX’N 2 (2022). While we do not
necessarily agree with all the points made in that article, we do recognize that it provides a detailed description
of Code Sec. 1202.
3
See, Pub. L. No. 103-66, §13113(a).
4
This section, in some sense, complements Code Sec. 1244, which provides that the loss from the sale of small
business stock will be treated as ordinary. To be clear, Code Sec. 1244 has requirements that do not precisely
overlap with those of Code Sec. 1202. And, Code Sec. 1244 has limits to application ( Code Sec. 1244 is
generally limited to 50,000 of losses per taxable year) that are different than for Code Sec. 1202. But it is safe to
say that both sections are intended to provide incentives for investing in startups—the taxpayer can achieve the
best of both worlds—gains are excluded and losses will be treated as ordinary.
5
Code Sec. 1202(a)(1).
6
The exclusion of 100% of the gain is for stock acquired after September 28, 2010. Code Sec. 1202(a)(4). For
stock acquired prior to that date (but after August 10, 1993), the exclusion was limited to 50% or 75%. Also,
for stock acquired prior to September 29, 2010, Code Sec. 57(a)(7) created a preference equal to 7% of the
excluded gain. That preference does not exist for stock acquired after September 28, 2010. Code Sec. 1202(a)
(4)(C).
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7
Drucker and Farrell, A Lavish Tax Dodge for the Ultrawealthy is Easily Manipulated, N.Y. Times (December
28, 2021). In their article, the journalists deliver a stinging rebuke of the excesses of Silicon Valley. It is worth
noting, however, that the code specifically blesses this possibility by treating the donee as having acquired
stock in the same manner as the donor and also tacks the donor’s holding period for purposes of the minimum
5-year holding period, thus potentially affording each donee their own 10,000,000 exclusion. Code Secs.
1202(h)(1) and (h)(2)(A). Congress has had opportunities to curb the excesses complained of, but has to date
failed to act.
8
Code Sec. 1202(a).
9
Code Sec. 1202(c)(1). As suggested in endnote 7, there are exceptions to the acquisition at original issuance
requirement, including acquisition by gift, at death, in a Code Sec. 351 transaction where qualified small
business stock is exchanged for stock in a corporation that would not otherwise qualify as qualified small
business stock. Code Secs. 1202(h)(2)– (4).
We would also note, however, that it would be short-sighted to assume that this discussion, especially as
relates to the issue of what is meant by a qualified trade or business, only involves C corporations. Code Sec.
199A, involving the qualified business income deduction, applies to essentially every taxpayer other than a C
corporation. To qualify for that deduction, the taxpayer must be in a trade or business other than a specified
trade or business (or being an employee). A specified trade or business is largely defined by reference to Code
Sec. 1202(e)(3)(A). Code Sec. 199A(d)(2)(A). In sum, these service entities are at a disadvantage whether
operating as a C corporation or as another type of entity.
10
Code Sec. 1202(c)(2)(A). Code Sec. 1202(c)(2)(B) provides an exception for specialized small business
investment companies. As a further requirement, the corporation must have no more than $50,000,000 in
assets before and after this particular stock issuance, hence the “small” in “qualified small business.” Code
Sec. 1202(d)(1). While this requirement precludes further stock issuances from qualifying for the exclusion,
importantly, prior stock issuances continue to qualify, thus rewarding and incentivizing the early founder, angel,
and venture capitalist investors.
11
Code Sec. 1202(e)(1). Code Sec. 1202(e)(4) defines an eligible corporation as any corporation other than
DISCs, former DISCs, RICs, REITs, REMICs, or cooperatives.
In the not-unusual context in which startups operate, a tricky theoretical issue might arise—what if the
corporation would satisfy the requirements for using assets in the conduct of a qualified trade or business
except that the business has not actually started—instead the corporation is engaged in start-up activities or
research? Fortunately, Congress anticipated such a possibility by providing rules in Code Sec. 1202(e)(2) that
treat any such future trade or business as an active trade or business, even if the corporation has no gross
income.
12
Calculated as the Code Sec. 1(h)(1) 20% maximum tax on net capital gains plus the Code Sec. 1411 3.8%
tax on net investment income. While the tax might be lower than 23.8%, the authors hypothesize that in most
instances the tax would otherwise be 23.8% at the federal level plus additional taxes at the state and, perhaps,
local levels.
13
Naturally, it could come as a surprise to be challenged by the IRS on any tax matter. The authors believe that
this particular issue arises in circumstances that should not trigger a challenge by the IRS, which is why this
possibility is raised in the present context. In particular, if the section is doing its job, investors are investing in
a company due in no small part to the incentive provided by the section. If the tax break is not available (or if
the prospective investors sense that an issue might be raised by the government), the prospective investors
may back off from investing, in which instance the entire economy suffers. The possibility of obtaining a private
ruling is scant relief considering time constraints, expense, and diversion of efforts away from furthering the
underlying enterprise.
14
The uncertainties arise for at least two reasons. One is that the large majority of the authorities are in the form
of private letter rulings, which technically have no precedential value. See, Code Sec. 6110(k)(3). A second
reason is that, realistically, the authorities address only a small fraction of possible businesses that taxpayers
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may pursue. Indeed, it seems many of the rulings address very similar commercial pursuits, further reducing
any real guidance provided.
15
2012 RIA TC Memo ¶2012-021, 103 TCM 1135, Dec. 58,923(M), TC Memo. 2012-21.
16
Code Sec. 1045 provides that a taxpayer may rollover gains from the sale of qualified small business stock
held more than 6 months into other small business stock. Qualified small business stock is as defined in Code
Sec. 1202 (c) and hence includes the Code Sec. 1202(e)(3) qualified trade or business requirement.
17
We are not suggesting that the business would fail as a qualified trade or business for either of these reasons.
18
LTR 201436001 (Sep. 5, 2014).
19
LTR 201717010 (Apr. 28, 2017).
20
LTR 202114002 (Apr. 9, 2021).
21
The reason for not addressing the second business was not made clear. Perhaps the second model was not
addressed simply because it was not necessary to make the determination to reach the final conclusion—
the taxpayer represented that at least 80% of its assets was devoted to the first model which the IRS ruled
was a qualified trade or business, and so the company was a qualified small business regardless of any
determination made as to the second model.
22
LTR 202221006 (May 27, 2022).
23
Query, whether this remains (or ever was) true. For example, vaccines, such as those for COVID or shingles,
may be administered by a pharmacist without a prescription. Perhaps these can be distinguished by claiming
that vaccines are not drugs or that pharmacists are primarily providing goods—the vaccines—not services?
24
Reg. §1.6045-1(a)(9).
25
Code Sec. 6045(e) expands the reporting requirements for real estate transactions to (A) the person
responsible for closing the transaction, (B) the mortgage lender, (C) the seller’s broker, (D) the buyer’s broker,
or (E) such other person designated by the Secretary in regulations. The authors recognize that technically,
Code Sec. 6045(e)(2) then provides that any such person is considered a broker as that term is defined by
Code Sec. 6045(c). It seems fairly clear, however, that the expansion of the term broker under Code Sec.
6045(c) was done for purposes of having that section’s reporting requirements applied to persons that would
not otherwise be considered as brokers and that inference as to the meaning for other purposes should not
made.
26
The CCA seems to draw no inference largely because the regulation cited ( Reg. §1.199A-5(b)(2)(i)) limits
brokerage services to transactions in securities.
27
Citing Black’s Law Dictionary (11th ed. 2019).
28
The authors recognize that the CCA contains the following statement, “… a lessee’s use of the website
constitutes an acknowledgement that Corporation has pre-negotiated rental rates with the lessors ….” We view
this statement as irrelevant for this purpose for several reasons. First, if anything, this is a negotiation between
the company and potential lessors, not lessors and lessees. After all, the statement refers to the action taken
as a pre-negotiation, not a negotiation. Second, such a statement is probably put into the company’s boilerplate
agreement with lessees to prevent lessees from potentially taking some action. Third, this statement does
not actually indicate that the company has negotiated with any particular lessor, just that lessee cannot later
challenge whether there has been a pre-negotiation.
29
To be clear, the authors are not suggesting that if such artificial intelligence techniques were employed, then
the system would be considered engaged in brokerage services.
30
It might be kind to state that at this juncture the IRS is merely engaging in sophistry. We again must recognize
one point which the IRS makes in this regard—that a key purpose of Code Sec. 199A is to place non-corporate
taxpayers on parity with corporations with regard to tax rates imposed. But we strongly reject any notion that
Code Sec. 1202 does not have a tax policy (a strong policy) behind it.
31
Citing West Hotel Brokers v. Wu, 697 P2d 34 (Colo. 1985). Actually that case just lifted the concept from
another case, Brouughall v. Black Forest Development Co., 196 Colo. 503, 505 n. 1, 593 P2d 314, 315 at n. 1
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(1978), which in turn lifted the concept from Brakhage v. Georgetown Associates, 33 Colo. App. 385, 523 P2d
145 (1974), a case involving a finder’s fee for introducing a potential buyer and seller of real estate.
32
See endnote 7, supra.
33
We would also note that at the time Code Sec. 1202 was originally enacted (and the language precluding
brokerage services entered the section), in 1993, companies such as Uber and Airbnb did not exist. We submit
that Congress had a narrower view of the meaning of services than the IRS is suggesting in the CCA.
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AR6
Spring
Article Review—Extra Credit
After completing this assignment, you should understand the importance of using technical tax articles in
conducting tax research.
Assignment
Prepare a review of an article from a professional journal regarding federal taxation. This assignment
requires you to identify an appropriate article, obtain approval of it, read it, and write up your findings.
Both the article and the review should be submitted to the Article Review Assignment in Canvas as a
Word document by the due date in the Gradebook and the syllabus. A sample article review appears as
a Reading Assignment.
Requirements
Select an authored article from a professional tax journal that deals with a topic covered in the
introductory taxation text. The article should go one step beyond the information normally included
in an introductory text. It should focus on information that should in fact be incorporated in the text
or would be appropriate for class discussion.
 Note: An eligible authored article may be written by one or more professionals and will be several pages
in length (generally, at least 3,000 words). Most periodicals also publish columns that may be called
“departments” or “clinics.” These are not considered authored articles, even though they may include the
columnist’s name. Avoid articles that contain over 6,000 words. It is difficult to keep your review to one
page if the article is too long.
Please ensure that your article satisfies all of the following criteria:
 The article must have been published no earlier than 2022 (meaning 2022 or later).
 The title of the journal usually must contain the word tax, taxation, or some derivation thereof.
 Articles from the popular press, including the Wall Street Journal, Money Magazine, Time,
Business Week, and the like, are not acceptable. Although they provide useful insights to the general
public, they do not provide authoritative answers to tax questions.
 Do not select an article that deals with tax policy (e.g., should we have a flat tax, repeal the estate
tax, etc.).
 Avoid articles that review a wide range of topics (e.g., a comprehensive update on a new law).
 Avoid topics for which you have no background—for most students, this will include areas such
as international taxation, partnerships, corporations, trusts, and similar topics.
AR6
Spring
Be sure to include the following information regarding your proposed article:
• Title of the article
• Author
• Journal name and publication month/year
The article, with its important points underlined or highlighted, must be submitted with your review.
The review should be a brief summary explaining the pertinent information. The review should not
rehash basic rules governing your topics that can be found in an introductory text. Instead, the review
should focus on the additional information found in the article. The review should be about one page,
single-spaced. The format for the review is as follows:
Article Review
Name: Your name
Article: Why the Marriage Penalty in Federal Income Tax Continues to Increase
Author: By Wallace Hoffman and Rachel Price
Journal: Taxes–The Tax Magazine, July 1999
This article examines the federal income tax penalty incurred by married couples filing jointly and
offers some recommendations for eliminating this inequity. Part of the article concerned… … SEE A
SAMPLE OF A COMPLETE ARTICLE REVIEW UNDER READINGS
AR6
Spring
AR6
Spring
Article Review—Extra Credit
After completing this assignment, you should understand the importance of using technical tax articles in
conducting tax research.
Assignment
Prepare a review of an article from a professional journal regarding federal taxation. This assignment
requires you to identify an appropriate article, obtain approval of it, read it, and write up your findings.
Both the article and the review should be submitted to the Article Review Assignment in Canvas as a
Word document by the due date in the Gradebook and the syllabus. A sample article review appears as
a Reading Assignment.
Requirements
Select an authored article from a professional tax journal that deals with a topic covered in the
introductory taxation text. The article should go one step beyond the information normally included
in an introductory text. It should focus on information that should in fact be incorporated in the text
or would be appropriate for class discussion.
 Note: An eligible authored article may be written by one or more professionals and will be several pages
in length (generally, at least 3,000 words). Most periodicals also publish columns that may be called
“departments” or “clinics.” These are not considered authored articles, even though they may include the
columnist’s name. Avoid articles that contain over 6,000 words. It is difficult to keep your review to one
page if the article is too long.
Please ensure that your article satisfies all of the following criteria:
 The article must have been published no earlier than 2022 (meaning 2022 or later).
 The title of the journal usually must contain the word tax, taxation, or some derivation thereof.
 Articles from the popular press, including the Wall Street Journal, Money Magazine, Time,
Business Week, and the like, are not acceptable. Although they provide useful insights to the general
public, they do not provide authoritative answers to tax questions.
 Do not select an article that deals with tax policy (e.g., should we have a flat tax, repeal the estate
tax, etc.).
 Avoid articles that review a wide range of topics (e.g., a comprehensive update on a new law).
 Avoid topics for which you have no background—for most students, this will include areas such
as international taxation, partnerships, corporations, trusts, and similar topics.
AR6
Spring
Be sure to include the following information regarding your proposed article:
• Title of the article
• Author
• Journal name and publication month/year
The article, with its important points underlined or highlighted, must be submitted with your review.
The review should be a brief summary explaining the pertinent information. The review should not
rehash basic rules governing your topics that can be found in an introductory text. Instead, the review
should focus on the additional information found in the article. The review should be about one page,
single-spaced. The format for the review is as follows:
Article Review
Name: Your name
Article: Why the Marriage Penalty in Federal Income Tax Continues to Increase
Author: By Wallace Hoffman and Rachel Price
Journal: Taxes–The Tax Magazine, July 1999
This article examines the federal income tax penalty incurred by married couples filing jointly and
offers some recommendations for eliminating this inequity. Part of the article concerned… … SEE A
SAMPLE OF A COMPLETE ARTICLE REVIEW UNDER READINGS
AR6
Spring