Stockholders must satisfy several eligibility requirements before they can claim Section 1202’s generous gain exclusion.[i] One of the more significant issuing-corporation level eligibility requirements is the 80% Test. In order to satisfy the 80% Test, a corporation must continuously use at least 80% of its assets (by value) in the pursuit of one or more qualified business activities. “Leasing” is included in Section 1202’s list of excluded activities. This article explores whether Professional Employer Organizations (PEOs), staffing firms, employer of record companies (EORs) and employee leasing companies (referred to in this article as “Co-Employers”) are engaged in excluded “leasing” activities for purposes of Section 1202.
The primary purpose of this article is to illustrate how a particular category of business activities can be analyzed for purposes of Section 1202. If an actual project involves issuing an opinion letter, seeing a private letter ruling or defending a taxpayer, the process necessarily involves first identifying all of the pertinent facts associated with the proposed or ongoing business activities, which are then considered within an analytical framework which could be similar to the one outlined below.
This is one in a series of articles and blogs addressing planning issues relating to qualified small business stock (QSBS) and the workings of Sections 1202 and 1045. During the past several years, there has been an increase in the use of C corporations as the start-up entity of choice. Much of this interest can be attributed to the reduction in the federal corporate income rate from 35% to 21%, but savvy founders and investors have also focused on qualifying for Section 1202’s generous gain exclusion. Legislation proposed during 2021 sought to curb Section 1202’s benefits, but that legislation has stalled in Congress.
Description of how Section 1202(e)(3) Functions (Satisfying the 80% Test Eligibility Requirement).
Section 1202 provides that in order for a stockholder to claim Section 1202’s gain exclusion, the corporation issuing the stockholder’s QSBS must have engaged in one or more qualified business activities, and those qualified activities must have used at least 80% (by value) of the corporation’s assets for substantially all of the stockholder’s QSBS holding period (referred to in this article as the “80% Test”). Qualified activities are any activities that are not excluded activities under Sections 1202(e)(3) or 1202(e)(7). Section 1202(e)(3) provides that the term “qualified trade or business” means any trade or business other than:
- 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, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees;
- any banking, insurance, financing, leasing, investing, or similar business;
- any farming business (including the business of raising or harvesting trees);
- any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A; and
- any business of operating a hotel, motel, restaurant, or similar business.
Section 1202(e)(7) provides that the “ownership of, dealing in, or renting of real property shall not be treated as the active conduct of a qualified trade or business.”
Identifying Excluded Activities That Are Potentially Applicable to Co-Employers.
A review of the excluded activities described in Sections 1202(e)(3) and 1202(e)(7) suggests that the activities of “leasing” or engaging in an activity similar to leasing are the two categories of excluded activities that appear to potentially fit the activities of Co-Employers.
Are PEOs, EORs and Staffing Firms Engaged in “Employee Leasing” Activities?
PEOs, EORs and staffing firms are likely to argue that they are not engaged in “employee leasing,” particularly if they have successfully avoided using that term. A survey of online industry sources suggests that employee leasing is generally considered to be a temporary employment arrangement where the company supplies a client with workers on a temporary basis, often for a specific project, timeframe or contract that has a start date and end date. Companies use “leased employees” because they do not want to be responsible for handling compensation and employment tax functions, HR administration (compliance with labor, employment and employee benefits laws), workers’ compensation insurance or other regulatory aspects of hiring contracts or temporary project-specific workers. Law Insider defines a staffing firm as “a person that provides PEO services or temporary help services.”[ii] The American Staffing Association notes that staffing firms “employ the employees they assign to clients, [so] they are responsible for paying wages, withholding and remitting employment taxes (including Social Security and unemployment), providing workers’ compensation insurance, and providing a variety of employee benefits. As employers, staffing firms are responsible for compliance with all applicable labor, employment, and employee benefits laws, including those pertaining to worker health and safety.”[iii] Based on these descriptions of the functions of staffing firms, their services appear to overlap with companies that describe themselves as engaging in “employee leasing” activities.
The relationship between clients and PEOs generally involves a co-employment arrangement described by the National Association of Professional Employer Organizations as “the contractual allocation and sharing of certain employer responsibilities between the PEO and the client.” Unlike employee leasing companies, PEOs generally do not supply workers to clients for particular projects. Instead, there is an ongoing relationship between the PEO and the client with respect to the client’s employees that is sometimes referred to as “co-employment.” The PEO assumes permanent responsibility for certain employer functions. The PEO often becomes the company of record for HR, payroll, benefits, employment taxes and other related employer functions. The PEO generally handles the administrative side of human resources, while the client retains responsibility for directing the employees’ work and making employment decisions.
EORs generally describe themselves as organizations that serve as the employer of record for tax purposes while the employee performs work at a different company. EORs often handle payroll functions, HR functions, depositing and filing and reporting employee-related taxes under its own EIN, unemployment and workers’ compensation. While PEOs are said to establish a co-employer relationship, EORs serve as the sole employer of record for employment tax purposes. EORs distinguish themselves from PEOs by noting that unlike PEOs, EORs are parties to employment contracts with the employees and in turn make those employees available to customers through service agreements. EORs take the position that their assumption of the employer function allows their customers to operate in states and often foreign jurisdictions through the EORs’ employees without causing the customer to be deemed to be engaging in business in those jurisdictions.
Although the activities of Co-Employers differ, those differences have not been considered particularly relevant to the IRS in connection with its focus on identifying the “employer” for employment tax and benefits purposes. Chief Counsel Advice (CCA) 200916024 states that PEOs are also known as employee leasing companies. In the preamble to regulations issued under Section 7705, which addresses a voluntary certification program made available to PEOs, the regulations begin their definition of PEOs by equating them to “employee leasing companies.”[iv] Section 414, which sets forth various definitions relevant to employee benefit statutes (ERISA statutes), references “employee leasing” (Section 414(n)(1)) and “leased employee” (Section 414(n)(2)). A review of tax authorities confirms that the term “employee leasing” has been adopted to broadly define an arrangement whereby a person is treated for at least some purposes (e.g., wages, benefits, employment taxes) as an employee of a Co-Employer, while at the same time the employee works under the direction of a customer of the Co-Employer. Obviously, a company that self-describes itself as engaging in “employee leasing” will have a difficult time arguing that it isn’t engaging in employee leasing. And for the reasons outlined above, the same end result will most likely hold true for PEOs, EORs and staffing firms that steer clear of the term “employee leasing.” It appears, based on the descriptions of the functions of PEOs, staffing firms and employee leasing companies, that all of these Co-Employers must stand ready to defend against the possible IRS argument that they are engaged in “leasing” for purposes of Section 1202.
Does “Employee Leasing” Fall Within the Scope of “Leasing” for Section 1202 Purposes?
Assuming for purposes of this discussion that all Co-Employers are all engaged in “employee leasing,” the pertinent question is whether the functions of a “leasing company” fall within the scope of “leasing” for purposes of Section 1202. “Leasing” is not defined by any tax authorities interpreting Section 1202. The phrase “banking, insurance, financing, leasing or investing” is not used elsewhere in the Internal Revenue Code and no tax authority has addressed what activities, if any, are similar to banking, insurance, financing, leasing or investing for purposes of Section 1202. The IRS has recently stated that where there are no tax authorities specifically defining a Section 1202 excluded activity (e.g., what constitutes engaging in brokerage services), the scope of that activity should be analyzed based on commonly available “dictionary definitions” and “statutory and regulatory definitions” (i.e., generally how a term is used by tax authorities interpreting other provisions of the Internal Revenue Code).”[v] The next two sections of this article apply this IRS approach to help define the scope of the activity of “leasing.”
Exploring dictionary definitions of “leasing.” The IRS believes that “words in a statute generally are presumed to bear their ordinary, contemporary, common meaning” and “to ascertain the plain meaning of terms, courts have consulted the definitions of those terms in popular dictionaries.”[vi] Also, in cases where the interpretation and meaning of a specific, albeit undefined term found in the Internal Revenue Code is being scrutinized, the United States Supreme Court has stated that it is appropriate to look to leading authorities such as Black’s Law Dictionary and Webster’s Dictionary for support.[vii]
The Merriam-Webster online dictionary has been an IRS favorite for defining Section 1202 activities. Merriam-Webster defines the noun “lease” as “a contract by which one conveys real estate, equipment, or facilities for a specified term and for a specified rent” and the verb “leasing” as engaging in the activity described in the preceding sentence pursuant to a lease.[viii] The Merriam-Webster online dictionary does not mention “employee leasing.”
The online free legal dictionary by Farlex defines a lease as a “contractual agreement by which one party conveys an estate in property to another party, for a limited period, subject to various conditions, in exchange for something of value, but still retains ownership.” The dictionary further states that “a lease contract can involve any property that is not illegal to own. Common lease contracts include agreements for leasing real estate and apartments, manufacturing and farming equipment, and consumer goods such as automobiles, televisions, stereos, and appliances.”[ix] The Farlex dictionary does not mention “employee leasing.”
The Collins online dictionary defines the noun “lease” as “a legal agreement by which the owner of a building, a piece of land, or something such as a car allows someone else to use it for a period of time in return for money” and references “the property that is leased” and further refers to the verb “lease” as “leasing property or something such as a car.” This dictionary uses the term “leasing” in sentences as follows: “There’s a lady here to see you about leasing a piece of property owned by Mr. Osborne” and “the Zimbabwe Government is interested in leasing and or buying four airships!” The Collins online dictionary also states that the term “lease” is used “in connection with contracts for the hiring of equipment or other chattels for a specified period,” and then further references equipment leases and finance leases.[x] The Collins dictionary does not mention “employee leasing.”
The dictionaries referenced above focus on the activity of providing a lessee with the use of a lessor’s property for consideration. These dictionaries do not mention “employee leasing,” and certainly do not link “employee leasing” with “leasing.” In both common and legal usage, the parties to a lease are universally referred to as “lessors” and “lessees.” The Merriam-Webster online dictionary defines a lessor as “one that transfers property (such as a house or a car) by a contract” and a “lessee” as “one that holds real or personal property under a lease.”[xi] Needless to say, a Co-Employer’s employees are not considered to be the “property” of Co-Employers. Agreements among Co-Employers and their clients do not refer to the leasing of “property.” It seems reasonable to conclude that Co-Employers should not be considered to be engaging in the activity of “leasing” if, as the IRS asserts, the common dictionary usage of terms is a significant factor in defining the scope of an excluded activity under Section 1202.
How tax authorities use the term “leasing” outside of Section 1202. The terms “employee leasing,” “leasing” and associated words are used by tax authorities in several different contexts.
Until Congress repealed the underlying tax credits, there were several statutes and proposed regulations referencing “leasing” in the context of the ownership and leasing of personal property.[xii] In a similar vein to the former equipment leasing tax credit provisions, current Section 469(j)(8), dealing with passive activity loss and credit rules, refers to “rental activity” as “any activity where payments are principally for the use of tangible property.” Although Section 1202 lacks any legislative history that would confirm this observation, it seems reasonable to conclude that when the drafters of Section 1202 created this list of activities: “banking, insurance, financing, leasing, investing, or similar business,” the term “leasing” was associated with the activity of equipment leasing.[xiii]
A review of additional tax authorities confirms that the terms “employee leasing company,” “leasing company,” “lessor” and “lessee” have historically been used by not only the Co-Employer industry but also by tax authorities to describe the activities of Co-Employers.[xiv] Online industry sources confirm that there is a movement away from using this outdated nomenclature that refers to leasing people the same way you would lease owned property. Encylopedia.com notes that “employee leasing became a visible economic model in the 1980s, when the phrase ‘employee leasing’ also first occurred. But the phrase is being used less and less in the mid-2000s. In its stead, people refer to ‘outsourcing human resources’ or simply ‘working with a PEO.’ Terminology continues to be murky because a milder form of this type of outsourcing . . . also exists. It is called ‘administrative services outsourcing’; companies that offer this service are known as ASOs. An ASO takes over the administrative functions only of the human resources activity but does not become a co-employer. Businesses also avoid the word “leasing” of late because, apparently, it has negative connotations—you lease a car, not a person.”[xv]
Given the absence of legislative history or on-point tax authorities addressing the scope of “leasing”, it doesn’t seem possible to determine with certainty what Congress intended when Section 1202 was enacted in the early 1990s. Obviously, terminology associated with “leasing” has historically been used by tax authorities to describe the activities of Co-Employers. But the mere fact that “leasing” was repurposed to describe the functions of Co-Employers shouldn’t be sufficient to support the conclusion that “employee leasing” falls within the scope of “leasing” for purposes of Section 1202. A perhaps subtle but important point is that most tax authorities use the term “employee leasing” rather than “leasing” when they want to refer to the type of activities of Co-Employers. Also, given that observation and the fact that the activity of “employee leasing” is entirely distinct from the activity of leasing owned property, it seems reasonable to assume that Congress would have referred specifically to “employee leasing” if its intention was to exclude the activities of Co-Employers from the benefits of Section 1202. Another point is that the activities of an equipment leasing company are compared with the activities of a Co-Employer, those of the equipment leasing company are more consistent with “banking, insurance, financing, leasing, investing, or similar business.” Finally, if the Co-Employer industry had not repurposed the word “leasing” to describe its activities, but instead had adopted term such as “co-employment”, “outsourcing human resources” or “working with a PEO,” would anyone think to ask whether Co-Employers engage in activities that are functionally equivalent to “leasing” for purposes of Section 1202? The fact is that the functions of Co-Employers and property leasing companies are unrelated.
As discussed above, dictionary definitions of “leasing” are heavily weighed against equating “employee leasing” with “leasing.” Tax authorities and the Co-Employer industry have used leasing terminology to describe the functions of Co-Employers. But on the other hand, the use of the term “leasing” by tax authorities to describe equipment leasing arrangements fits more closely from a functional standpoint with companies engaging the activities of “banking, insurance, financing, leasing, investing, or similar business.” On balance, there is stronger support for the conclusion that Co-Employers are not engaged in the activity of “leasing” for purposes of Section 1202.
Could the activity of “employee leasing” be considered a “similar business” to banking, insurance, financing, leasing, or investing? If “employee leasing” is not “leasing”, could it nevertheless be a “similar business” for purposes of Section 1202(e)(3)(B)? A review of how banking, insurance, financing and investing are defined in tax authorities suggests that the answer should be “no.” Section 581 defines a “bank” as a company whose business in substantial part consists of receiving deposits and making loans. Tax authorities generally define the activity of insurance in terms of underwriting and/or assuming risk. The Oxford Lexico dictionary defines “financing” as providing funding, and “investing” as a person or organization putting money into a financial plan, property, etc., with the expectation of achieving a profit. While comparing the nature of activities necessitates the making of certain judgment calls, it appears reasonable to conclude that the activities of Co-Employers are not similar in nature to those of companies engaged in banking, insurance, leasing, financing or investing, as those elements are defined through common usage or tax authorities.
Exploring the Possibility of Seeking a Private Letter Ruling Addressing the Scope of “Leasing” for Purposes of Section 1202.
A Co-Employer could choose to seek a private letter ruling (PLR) addressing whether the company is engaged in excluded leasing activities for purposes of Section 1202. A PLR is a written opinion from the IRS addressing a specific tax issue with respect to a particular taxpayer, and is based on that taxpayer’s representations and statement of fact. A favorable ruling is generally thought to ensure that the IRS will not challenge the taxpayer’s position, so long as the facts upon which the PLR is based haven’t materially changed. A PLR can only be relied upon by the taxpayer obtaining the ruling, but redacted versions of PLRs are publicly available and are carefully scrutinized by tax professionals as indicators of IRS positions. Recent PLRs are considered tax authorities for purposes of issuing “substantial authority” and “reasonable basis” opinions.[xvi]
Only a few PLRs addressing Section 1202 issues have been issued during the past several decades. During 2021, the IRS did issue PLR 202114002 (4/9/2021), which looked at whether a company was engaged providing excluded brokerage services for purposes of Section 1202. The IRS determined that in spite of the fact that the company was clearly engaged in insurance brokerage activities, those activities did not result in the company being treated as engaging excluded brokerage services. The IRS based its conclusion on the fact that services provided by the company’s employees were broader in scope than merely acting as an intermediary between insurance underwriters and customers. On March 3, 2022, the IRS determined in PLR 202221006 that a business was not engaged in the provision of medical services to patients, in spite of the fact that the business employed licensed pharmacists. The IRS concluded that the pharmacists’ interaction with patients was incidental to the principal source of the company’s revenues, selling prescription drugs. PLRs 202114002 and 202221006 suggest that a taxpayer-favorable PLR might be obtained with respect to the scope of excluded leasing activities. But there are several reasons to avoid seeking a PLR beyond the typical concerns about the lengthy timeline and expense. A PLR can only be relied upon to the extent that facts set forth in the PLR don’t materially change. A legitimate concern might be that the activities of a company could evolve to the point where reliance on a PLR would be questionable. A practical issue is presented by the fact that most Co-Employers are engaging in activities that fall within the scope of “employee leasing,” and will do so regardless of whether the IRS issues a favorable PLR.[xvii] For these Co-Employers, an unfavorable ruling could increase audit risk. Also, it may be better not to bring attention to the issue if there is a concern that the IRS will adopt an unfavorable position, particularly given the expression of the IRS’s attitude in Chief Counsel Advice (CCA_ 202204007 (11/4/2021). In that CCA, the Chief Counsel’s office appears to throw as much cold water as possible on the taxpayer-favorable result in PLR 202114002 by taking an expansive view of “brokerage services” in the context of a technology company whose business model was sourcing customers online and referring them to brick and mortar real estate agents. The CCA concluded that any taxpayer required to report broker activities under Section 6045 was deemed to be engaged in brokerage activities for purposes of Section 1202 and expressly stated that its position was driven by a goal of fashioning the broadest possible scope of excluded activities for purposes of Section 1202.[xviii] Against this backdrop, a taxpayer could hardly be faulted for assuming that the courts would take a more even-handed approach if asked to define the scope of “leasing.”
In spite of the potential for extraordinary tax savings, many experienced tax advisors are not familiar with Section 1202 and Section 1045 planning. Venture capitalists, founders and investors who want to learn more about Section 1202 and Section 1045 planning opportunities are directed to several articles on the Frost Brown Todd website:
Contact Scott Dolson if you want to discuss any Section 1202 or Section 1045 issues by video or telephone conference.
[i] References to “Section” are to sections of the Internal Revenue Code of 1986, as amended.
[ii] Staffing firm, Law Insider, https://www.lawinsider.com/dictionary/staffing-firm (last visited July 5, 2022).
[iii] What Staffing Firms Do, Am. Staffing Ass’n, https://americanstaffing.net/staffing-industry/what-staffing-firms-do/#:~:text=Because%20staffing%20firms%20employ%20the,a%20variety%20of%20employee%20benefits (Last visited July 5, 2022).
[iv] TD 97689, Certified professional employer organization – voluntary certification program; Code Section 7705 (5/4/2016).
[v] See PLR 202114002 (4/9/2021) and CCA 202204007 (1/28/2022).
[vi] Walters v. Metropolitan Educational Enterprises, Inc., 519 U.S. 202 (1997) and Metro One Telecommunications, Inc. v. Commissioner, 704 F.3d 1057, 1061 (9th Cir. 2012).
[vii] See, e.g., Holywell Corp. v. Smith, 503 U.S. 47 (1992); U.S. v. Home Concrete & Supply, LLC, 566 U.S.478 (2012); and Colony, Inc. v. C.I.R., 357 U.S. 28 (1958).
[viii] Lease, Merriam-Webster, https://www.merriam-webster.com/dictionary/leasing (last visited July 5, 2022).
[ix] Lease, The Free Dictionary, https://legal-dictionary.thefreedictionary.com/lease (last visited July 5, 2022).
[x] Lease, Collins Dictionary, https://www.collinsdictionary.com/dictionary/english/lease (last visited July 5, 2022);
Leasing, Collins Dictionary, https://www.collinsdictionary.com/dictionary/english/leasing (last visited July 5, 2022).
[xi] Lessor, Merriam-Webster, https://www.merriam-webster.com/dictionary/lessor (last visited July 5, 2022); Lessee, Merriam-Webster, https://www.merriam-webster.com/dictionary/lessee (last visited July 5, 2022).
[xii] The Tax Court noted that Proposed Regulation Section 1.57-3(d)(1) defined the term “lease” in an extremely broad manner, i.e., “any arrangement or agreement, formal or informal, written or oral, by which the owner of property (the ‘lessor’) receives consideration in any form for the use of his property by another person. See Amerco v. Commissioner, 82 T.C. 654, 692 (1984) and Treasury Regulation Section 1.46-4(d)(1).
[xiii] The leasing of real property is addressed as an excluded activity in Section 1202(e)(7).
[xiv] Treasury Regulation Section 1.274-2, dealing with expense reimbursement, references employee leasing companies. Revenue Ruling 2008-23, 2008-1 CB 852, dealing with Section 274(n) entertainment expense issues, references the leasing of drivers, leasing companies, and employee leasing contracts. The Eighth Circuit Court of Appeals references “lessors” and “lessees” in the context of PEOs in a Section 274(n) case dealing with the deductibility of mean and entertainment expenses. Section 7705’s regulations state that PEOs are the same as “employee leasing companies.”
[xv] Employee Leasing Programs, https://www.encyclopedia.com/entrepreneurs/encyclopedias-almanacs-transcripts-and-maps/employee-leasing-programs (last visited July 5, 2022).
[xvi] See the Section 6664 Treasury Regulations.
[xvii] One situation where an advance PLR would work in the Section 1202 context is where the business is operating as a partnership and is undertaking a planning process to determine whether to convert to a corporation in part for the purpose of taking advantage of Section 1202.
[xviii] The Chief Counsel office supported its position by arguing that courts have directed that exclusions from gross income must be narrowly interpreted. See Commissioner v. Schleier, 505 U.S. 323 (1995) and Commissioner v. Jacobson, 336 U.S. 28 (1949).