The QSBS “Active Business Requirement” requires that “at least 80 percent (by value) of the assets” of the corporation are used in the “active conduct of one or more qualified trades or businesses”1 “during substantially all of the taxpayer’s holding period for such stock” (Section 1202 (2)(A)).  Refer to this post regarding trades or businesses which qualify for QSBS.

The general intent of the “Active Business Requirement” is to ensure that the corporation continued the path set out when the QSBS shares were initially issued, devoting most of its resources towards that effort.  However, there are some challenges and questions in how best to know and demonstrate that the corporation met this requirement and understanding what is meant by some of the more vague terminology, such as the meaning of “substantially all”.

Which assets count towards the Active Business Requirement?

“Aggregate gross assets” are defined in Section 1202 (d)(2)(A) as “the amount of cash and the aggregate adjusted bases of other property held by the corporation”.  Some considerations regarding the assets included in the Active Business Requirement include:

  • Cumulatively if over 20% of the company’s assets are investments, cash minus cash for working capital needs, non-operating real estate, and non-operating assets than the company will not qualify.
  • The Company can not have more than 10% of its assets allocated to (i) real property that is not used within operations and/or (ii) portfolio stock or securities in third-party corporations with less than 50% ownership. If the securities are considered a controlling value, 50% or greater ownership, the securities will not be considered in the 10% test (Section 1202(e)(5) & (7)).
  • There is a special consideration for assets that are being held to finance research and experimentation or in-house research activities (Section 1202(e)(6). Also, special consideration for assets being held for future investments or increases in working capital that are planned to be used within two years (Section 1202(e)(6). If the corporation has been in business for two years it must use at least 50% of the assets held for investments or research activities.
  • Another special consideration includes rights to computer software that receive royalties, falling within the meaning of section 543(1)(D). That software will be considered an active trade or business asset.
  • A specialized small business investment company (SBICs) operating under section 301(d) of the Small Business Investment Act of 1958 will be considered an active trade or business. An SBIC is an alternative to venture capital as a source of capital for startups. Generally, QSBS investments are not through an SBIC.
How Much is “Substantially All”?

The term “substantially all” is used several times in the QSBS criteria per Section 1202, but how long is “substantially all”, could it be a simple majority of the time held, or does it need to be longer? 

While “substantially all” is not defined in terms of a specified time period, past interpretations by the US tax court may help demystify what “substantially all” refers to.  There have been numerous legal proceedings where the term “substantially all” has been used with the conclusions ranging from as low as 51% to as high as 90%, for example:

  • Real Estate Opportunity Zone regulations refer to “substantially all” of an eligible entity’s holding period for owned or leased tangible property as 90% of the holding period.2
  • For certain research expenditures to qualify for tax purposes, “substantially all” of the activities must constitute elements of a process of experimentation that relates to a qualified purpose.  Here, substantially all is defined as 80% of the activities.3
  • Sale of “substantially all” of the assets of a business requires majority (i.e. 51%) approval from shareholders.4

While Section 1202 does not define “substantially all”, in the context of QSBS these cases demonstrate how the term, “substantially all” has been used and interpreted in different ways.  Given the current ambiguity in how “substantially all” relates to elements of QSBS, it is imperative to maintain documentation to substantiate your rationale for concluding that your stock and gains qualify for QSBS tax treatment. 

How to tell If The Corporation Passed the “Active Business Requirement” During Your Holding Period

It is not easy for an investor, especially as a minority investor with limited, if any, visibility into the Company’s operations, to know if the Company has used at least 80% of its assets towards activities that qualify for QSBS. 

Unless the Company changed directions in a significant way during the time you held your shares, the best support for the Active Business Requirement may be the corporation’s representation they may have made at the time the shares were issued.  Your Share Purchase Agreement may include a QSBS clause, which may contain language where the corporation represents that they will aim to maintain the securities QSBS eligibility, such as the corporation stating that it,

 “will use its reasonable efforts to cause such shares to qualify as Qualified Small Business Stock; provided, however, that “reasonable efforts” as used in this Section shall not be construed to require the Company to operate its business in a manner which would adversely affect its business, limit its future prospects or alter the timing or resource allocation related to its planned operations or financing activities.”

1 Section 1202(c)(2)(A)

2 Section 1.1400Z2(d)-2(d)(3)

3 Treasury Regulation Section 1.41-4(a)(6)

4 Katz v. Bregman, 431 A.2d 1274 (Del. Ch. 1981)

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