Our laws have long said that taxpayers are free to structure their legal affairs to minimize their taxes. Congress has even provided very specific provisions to accomplish this.
Section 1202 stock is an example. This provision is intended to encourage start-ups to take business risks by rewarding those who are successful by allowing them to sell their business and incur no tax or significantly-reduced tax (Section 1244 stock is a similar provision that can help if the venture fails).
Whether Section 1202 stock accomplishes this goal is debatable, but there is no doubt that there is a lot of planning put into trying to qualify for the tax benefit. There are numerous rules that have to be met to qualify.
That brings us to the IRS’s recent ruling in PLR 202221006. The PLR considers whether a pharmacy can qualify for Section 1202 stock treatment. This highlights a few of the tax planning opportunities available to pharmacists.
Facts & Procedural History
The taxpayer is a retail pharmacy. It employs licensed pharmacists who fulfill prescriptions from doctors. The pharmacists have limited interaction with clients who take the prescriptions.
The pharmacy also employs other workers who work with insurance providers to secure payment and follow up with clients regarding prescriptions and refills.
The pharmacy is organized as a C corporation and the owners were planning on selling the business. The pharmacy submitted a private letter ruling request to ask the IRS whether it qualifies as Section 1202 stock.
About Section 1202 Stock
Section 1202 is an exclusion provision. It says that the sale of “qualified small business stock” or QSBS can be tax free if certain conditions are met.
These conditions generally require that:
- The stock is issued by a corporation when it was a small business:
- It was taxed as a C corporation and
- Had less than $50 million of gross receipts;
- The stock has to be for an active business (with less than 10% of their assets being real estate);
- The stock was received in exchange for property (not stock) or cash or for performing services; and
- The stock has to be held for five years.
The conditions do not stop there. The code also provides that the following types of businesses are excluded:
a business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employee.
There is also a limitation, which usually limits the excluded gain to $10 million.
What Does “Field of Health” Mean?
The question in this ruling is whether a pharmacy is a business in the “field of health.”
Before getting to the answer, let’s take a detour to consider the Section 199(a) deduction. The Section 199(a) tax deduction is part of the Trump Tax Cuts. It allows flow through businesses, i.e., not C corporations, a 20% deduction. This deduction is limited if the business is a “specified services trade or business” or SSTB. A SSTB includes businesses in the “field of health.” This is the same phrase that we are considering for Section 1202 stock.
Treasury Regulation § 1.199A-5(b)(2)(ii) confirms that a pharmacy and other medical-related businesses are generally not SSTBs. It says that SSTBs do not include businesses involved in:
the performance of services in the field of health means the provision of medical services by individuals such as physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals performing services in their capacity as such. The performance of services in the field of health does not include the provision of services not directly related to a medical services field, even though the services provided may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or the research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.
This language does not necessarily apply to Section 1202 stock, but it provides the reasoning for why a pharmacy qualifies for Section 1202 stock. A pharmacy qualifies for Section 1202 stock as long as it does not provide medical services. Thus, the medical practice that prescribes medicine would not qualify for Section 1202 stock (or maybe not even for the Section 199(a) deduction), but a pharmacy could.
Choice of Entity Considerations
The IRS did not address Section 199(a). The answer from the IRS is simply that pharmacies are not in the field of health law.
We mention Section 199(a) because pharmacies have to factor in these rules in deciding whether to be taxed as a C corporation or a flow through entity.
Tax planning should consider the applicability of the 199(a) deduction and Section 1202 stock and whether the pharmacy can qualify for one or even both tax breaks.
This ruling shows that pharmacies are not subject to some of the limitations that impact others, such as hospitals and doctors.
The decision to be a flow through business and qualify for the 199(a) deduction or a C corporation qualify for Section 1202 stock (or a combination of both), are just part of the analysis.
Pharmacies also have to consider accounting methods, the inventory rules, employee benefits, and other tax laws. Taken together, these laws can produce significant tax savings. This is an area where advanced tax planning is really needed.