QSBS Active Business Requirement: Which Businesses Qualify?

A company can be small enough for QSBS and still operate the wrong kind of business. It can operate the right kind of business and still hold too many assets outside that business.

The 80% active-business test

During substantially all of the shareholder's relevant holding period, at least 80% by value of corporate assets generally must be used in active conduct of one or more qualified trades or businesses.

This is not simply an issuance-date test.

Some businesses are expressly excluded

Section 1202 excludes categories including health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, businesses whose principal asset is the reputation or skill of employees, banking, insurance, financing, leasing, investing or similar businesses, farming, certain extraction businesses, hotels, motels, restaurants, and similar businesses.

A label does not settle an ambiguous business

"Software company," "fintech," "health-tech," "marketplace," "AI company," "SaaS," or "platform" is not a Section 1202 safe harbor. Analyze actual activities and what generates economic value.

Consulting is a facts question

Relevant facts can include what customers buy, whether revenue comes primarily from advice or product, standardized technology versus individualized professional judgment, employee activities, and the business's principal value driver.

The same caution applies to health and financial services

Serving doctors, hospitals, banks, or financial institutions does not automatically mean the company itself conducts an excluded business. Marketing labels do not control either.

Pre-revenue does not automatically mean inactive

Section 1202 accommodates certain startup and research activity. Assets used in qualifying startup activities and research and experimental activities described in Section 174 can receive active-business treatment.

Research activity can count

For a research-heavy startup, assets supporting product development, experimentation, engineering, technical development, and other qualifying research can matter.

Cash is not automatically bad

Section 1202 contains a working-capital rule for assets held to meet reasonably required working-capital needs and certain assets reasonably expected to be used within two years for research or increased working-capital needs.

The working-capital rule narrows after two years

Once the corporation has existed for at least two years, no more than 50% of assets can qualify as active-business assets solely through the working-capital rule.

Investment portfolios can create a problem

Section 1202 limits holdings of portfolio stock and securities. A corporation can fail for a period when more than 10% of asset value, net of liabilities, consists of nonqualifying portfolio stock/securities, subject to statutory treatment.

Subsidiaries can be looked through

Where the parent owns more than 50% of a subsidiary's vote or value, Section 1202 generally looks through to subsidiary assets and activities.

Real estate has its own limitation

If more than 10% of total asset value consists of real property not used in active conduct of a qualified trade or business, the requirement can fail for that period. Owning, dealing in, or renting real property is not itself treated as active conduct of a qualified trade or business for this purpose.

Intellectual property requires context

IP can be central to a qualifying operating business. The useful question is how it is used and whether it supports the company's qualified operating business.

Business pivots matter

A company can begin in a qualifying product business and later become primarily individualized consulting, or vice versa. The full holding-period history matters.

"Substantially all" is not a percentage PRISM should invent

The statute does not provide a universal percentage that can safely be turned into "80% of the years," "90% of the years," or another public safe harbor. The 80% number belongs to asset use.

Example: pre-revenue startup

A new C corporation raises capital to develop a medical-device software platform, has no commercial revenue, employees conduct product R&D, and cash is expected to fund the work over 18 months. No revenue does not automatically mean failure. But "medical" does not automatically prove qualification either.

Example: excess capital after several years

An established company has $20 million operating assets and $80 million cash/investments with no near-term operating plan for most excess capital. It cannot safely say all cash counts because it is a startup.