Active Business Requirement FAQ

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 during substantially all of the taxpayer’s holding period for such stock.” Section 1202 (2)(A) 

The general intent of the “Active Business Requirement” is to ensure that the corporation is applying its assets primarily towards the “qualified trade or business” and devoting most of its resources towards that effort.  

Some additional portions of this requirement include:

• 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)
• 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.

“Aggregate gross assets” are defined in Section 1202 (d)(2)(A) as “the amount of cash and the aggregate adjusted basis of other property held by the corporation.”

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.
• 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.
• Sale of “substantially all” of the assets of a business requires majority (i.e. 51%) approval from shareholders.

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 during which portions of your holding period the company appeared to meet the Active Business Requirement.

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 qualified trade or business activities and met the other portions of the “Active Business” requirements.  

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.”

Such a covenant is not a guarantee that the Company will continue to meet the Active Business requirements during your holding period, so it is best to perform a QSBS assessment of the Company during your holding period.  The best form of evidence will come from an analysis of the Company’s historical tax returns, however as a minority investor it is unlikely that you would have access to the Company’s tax returns.  You may be able to leverage certain company reporting to help support your assertion that the company satisfies the Active Business requirements, however it is best to first see if the company will make such information available or request that they perform a Qualified Small Business assessment at the company level and share it with you.