The “qualified small business stock” (QSBS) tax exemption under Section 1202 of the Internal Revenue Code[1] allows non-corporate founders and investors in certain emerging growth companies organized as corporations to potentially exclude up to 100 percent of the U.S. federal capital gains tax incurred when selling its stake in the business.[2] QSBS is a useful tool for founders and investors in life sciences companies, but care must be taken to ensure that such companies continue to meet the eligibility requirements of a qualified small business. This article focuses on the requirement that the company must use at least 80 percent of its assets towards the active conduct of one or more “qualified trades or businesses,” and specifically, the meaning of qualified trade or business in the context of a life sciences company. The article further explores the potential implications of utilizing a friendly PC/MSO-PC structure on QSBS eligibility.
For purposes of QSBS, a “qualified trade or business” is generally defined to exclude certain businesses, including (of particular relevance to life sciences companies) any trade or business involving the performance of services in certain fields, such as health … or any other trade or business where the principal asset is the reputation or skill of one or more of its employees. Neither Section 1202 nor the Treasury Regulations promulgated thereunder further explains what activities are regarded as health services. While it is generally accepted that a company that provides medical care or treatment to patients, such as a doctor’s office, would be excluded from QSBS eligibility, the extent to which this rule applies to emerging growth life sciences companies is unclear.
Defining Health Services: IRS Guidance
Over the past 10 years, the Internal Revenue Service (IRS) has issued a number of private letter rulings[3] (PLRs) that helpfully clarify that the exclusion for health services is meant to be limited, not expansive. In PLR 2014-36-001 (Sept. 5, 2014), the company helped its clients commercialize experimental drugs by researching drug efficacy, conducting other pre-commercialization testing procedures, and manufacturing drugs. The IRS ruled that the company was akin to a manufacturing company that offered value by deploying physical and intellectual property assets rather than individual expertise and so was engaged in a qualified trade or business for purposes of the QSBS rules. Similarly, in PLR 2021-12-5004 (June 25, 2021), the company evaluated, measured, designed, fabricated, manufactured, adjusted, fit, and serviced prescriptions for referred patients. The IRS concluded that the company’s business is more analogous to custom manufacturing than health services.
In PLR 2017-17-010 (Apr. 28, 2017), the company had developed proprietary technology to detect a specific condition. The company conducted the tests ordered by health care providers and provided a lab report to the provider, which included a summary of whether a given condition was detected. The IRS concluded that the diagnostic testing services of the company were a qualified trade or business for purposes of Section 1202 because the company did not itself diagnose patients, recommend medical treatment, or otherwise provide medical care to patients, and, aside from a licensed lab director, none of its employees were subject to state licensing requirements or developed transferable skills during employment.
The lack of employees subject to state licensing requirements was also important in PLR 2022-21-006 (May 27, 2022), in which the company filled and distributed prescription orders for a limited number of drugs. The IRS ruled that the principal asset of the company was its exclusive right to distribute pharmaceuticals, and the sale of the drug generated all revenues. The IRS emphasized that the company did not diagnose, treat, or manage any aspect of care for the patients, any interaction with patients was primarily conducted by non-pharmacist employees who were not regulated under state or federal law, and such interaction was merely incidental to the services provided (e.g., ensuring receipts and answering questions).
In PLR 2021-44-026 (Nov. 5, 2021), the company developed and commercialized software to be used by medical providers to individualize patient treatment. The IRS ruled that the company created tools to be utilized by customers in the health services industry but did not provide health services itself. Similarly, in PLR 2024-18-001 (May 3, 2024), the company conducted medical testing using specialized equipment and software and delivered reports to medical service providers. The IRS ruled that the company’s medical testing service was a qualified trade or business for purposes of Section 1202 because the company did not diagnose or provide medical advice, and its licensed physicians only developed policy and procedure and did not interact with customers.
The PLRs issued by the IRS generally focused on one or more of the following factors:
(1) the QSBS-eligible company does not diagnose, treat, or manage any aspect of care for patients—any interaction with the patients is incidental;
(2) the source of revenue for the QSBS-eligible company is either from the sales of a product or from a medical provider or third party, not the patient directly;
(3) the employees of the QSBS-eligible company often are not required to be specially licensed, meet specific education requirements, or have prior experience; and
(4) the employees of the QSBS-eligible company often develop skills unique to the company’s business that cannot be easily transferred.
Notably, not all factors need to be met, but two guiding themes stand out: either the company has developed proprietary IP to sell and manufacture assets, or the company provides a service that is not highly specialized or technical and does not involve the diagnosis or treatment of patients.
What About Friendly PC/MSO-PC Structures?
While the PLRs and guidance issued by the IRS are helpful for a number of life sciences companies, one difficult fact pattern is where a company engages medical providers, either directly (or through wholly owned subsidiaries) or through a “friendly PC” or “MSO-PC” structure.
First, as evidenced by PLR 2024-18-001, engaging medical care providers who do not provide services to patients (e.g., a chief medical officer at a medical device company) is not sufficient to disqualify a company from QSBS. Second, the relevant question is whether the company uses 80 percent of its assets towards the active conduct of one or more qualified trades or businesses. Accordingly, a company can use up to 20 percent of its assets towards the conduct of non-qualified trades or businesses, including health services. For example, a company that sells diagnostic equipment directly to medical providers as its primary business could engage medical providers to provide a limited amount of diagnostic services if the 20 percent threshold is not crossed. In light of such guidance, the difficulty is ensuring that the assets used towards the non-qualified activities stay well below that 20 percent threshold.
In a typical “friendly PC” structure, the medical providers are generally employed by a separately owned professional corporation (PC), usually to accommodate the corporate practice of medicine rules. The company (usually called the “management company”) and the professional corporation enter into a number of agreements to transfer economic benefits and voting control (to varying degrees) to the management company. The question of whether the management company is an eligible qualified small business may turn on whether it is considered to own the PC for U.S. tax purposes. The IRS has issued private letter rulings addressing when PCs were regarded as members of a consolidated group (e.g., PLR 2014-51-009 (Dec. 19, 2014)) such that they could join in the filing of a consolidated tax return.
While there is no guidance on the application of QSBS to the friendly PC structure, one school of thought is that if the PC is included in the consolidated tax return of the management company, stock issued by the management company is unlikely to be QSBS eligible (unless the less-than-20-percent threshold described above is met). However, if the PC is not included (or not eligible to be included) in the consolidated tax return of the management company, arguably, the activity of the PC does not taint the trades or businesses in which the management company is engaged. Accordingly, companies that are considering engaging medical providers or forming a friendly PC or MSO/PC structure should consult with counsel regarding the impact of doing so on QSBS.
[1] All “Section” or “Treasury Regulations Section” references are to sections of the Internal Revenue Code, 1986, as amended (the Code), and the Income Tax Treasury Regulations, respectively, as of [December 10, 2024].
[2] For more information on QSBS eligibility requirements and benefits, see “Understanding Section 1202: The Qualified Small Business Stock Exemption.”
[3] While private letter rulings generally apply only to the taxpayer to whom they are written, they often are viewed as an indication of the IRS's current position on issues.
