Does the Business Qualify? The Five Tests Every QSBS Issuer Must Satisfy (Part II of IV)

Qualified Small Business Stock Under IRC §§1202 and 1045 — Part II of IV

Part I of this series addressed what a qualified small business stock exit is worth after the 2025 amendments and why the answer now depends on a date. This installment addresses the threshold question that precedes any valuation exercise: whether the issuing company qualifies at all.

When a client asks whether their shares are QSBS, the question has two halves that fail in different ways. The company must satisfy tests about what it is and what it does. Separately, the particular block of stock must satisfy tests about how it was acquired and what has happened since. This Part II addresses the company; Part III addresses the stock.

I. A C Corporation — Throughout, Not Merely at Issuance

QSBS must be stock in a C corporation. The requirement that trips practitioners is not the initial one but the durational one: under IRC §1202(c)(2)(A), the issuer must be a C corporation during substantially all of the taxpayer’s holding period, not merely on the date of issuance. A subsequent S election is therefore fatal to QSBS status for stock that would otherwise have qualified, and it is a decision often made years later by a different advisor for unrelated reasons.

Certain corporations are ineligible regardless of their activities. IRC §1202(e)(4) excludes DISCs and former DISCs, regulated investment companies, real estate investment trusts, real estate mortgage investment conduits, and cooperatives. These rarely arise in venture-backed companies but are worth confirming in diligence on operating businesses and holding structures.

II. A Domestic Corporation

The issuer must be a domestic corporation. For a state-law corporation, this is trivial. For an LLC that has elected to be taxed as a C corporation, it is a source of persistent and unnecessary confusion — addressed at length in Part IV. The short answer is that such an entity is a domestic corporation and can issue valid QSBS.

III. The Gross Asset Test

The issuer must be a “qualified small business” at the time of each stock issuance, meaning its aggregate gross assets must not have exceeded the applicable ceiling at any time before the issuance or immediately after taking the issuance proceeds into account. IRC §1202(d)(1). The ceiling is $50 million for stock issued on or before July 4, 2025, and $75 million for stock issued thereafter. Several mechanics matter in practice.

• Gross assets means cash plus the adjusted basis of all other property. For property contributed to the corporation as paid-in surplus or in a §351 exchange, the adjusted basis is determined as if it were equal to fair market value immediately after the contribution. IRC §1202(d)(2)(B). A parallel rule governs the computation of the 10x-basis alternative to the dollar cap. IRC §1202(i)(1)(B). This is why converting an appreciated LLC or S corporation to C corporation status can produce a materially larger exclusion than the historical basis would suggest.
• The test applies on an aggregate basis, taking into account all corporations treated as a single employer with the issuer under IRC §1202(d)(3), applying the parent-subsidiary controlled group rules of §1563 with a greater-than-50% threshold substituted for 80%.
• The test is measured immediately after the issuance, which means the round itself can break it. A company sitting at $72 million in gross assets that raises $10 million issues non-qualifying stock in that round.
• Once the ceiling is crossed, no new QSBS can be issued, but stock issued earlier is unaffected. Investors in a Series B or later round frequently discover that they hold non-QSBS while the founders hold QSBS in the same company.

IV. The Active Business Test

Throughout substantially all of the taxpayer’s holding period, at least 80% of the corporation’s assets by value must be used in the active conduct of one or more qualified trades or businesses. IRC §1202(e)(1). This is a continuous requirement, not a one-time test at issuance, and it is the requirement most likely to fail quietly as a company matures. Three statutory refinements bear on the test in practice.

• Assets held for the reasonably required working capital needs of a qualified trade or business, or held for investment and reasonably expected to be used within two years to finance research or working capital, are treated as used in the active conduct of that business. After the corporation’s first two years, however, no more than 50% of its assets may be so treated. IRC §1202(e)(6).
• A corporation fails the test outright if more than 10% of the total value of its assets consists of real property not used in the active conduct of a qualified trade or business. IRC §1202(e)(7).
• The corporation looks through to any subsidiary more than 50% owned by vote or value, taking into account its ratable share of that subsidiary’s assets and activities. IRC §1202(e)(5).

The failure modes are predictable. A profitable company accumulates cash well beyond any defensible working capital need. A software company begins offering implementation services that look increasingly like consulting. A company buys its own building and holds surplus land. Any of these can push the asset mix past the threshold without anyone noticing until diligence.

V. Excluded Trades or Businesses

IRC §1202(e)(3) enumerates activities that do not constitute a qualified trade or business: services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; any trade or business whose principal asset is the reputation or skill of one or more employees; banking, insurance, financing, leasing, investing, and similar businesses; farming; any business involving the production or extraction of products subject to depletion under IRC §§613 or 613A; and the operation of a hotel, motel, restaurant, or similar business. Software, technology, and manufacturing companies are generally eligible.

One trap deserves specific mention. Section 1202’s list is not coextensive with the “specified service trade or business” definition in IRC §199A. Engineering and architecture are excluded under §1202 but are expressly carved out of the §199A SSTB definition. Advisors who are fluent in the §199A analysis routinely and incorrectly import that carve-out into §1202, with the result that engineering firms are told their stock qualifies when it does not.

VI. What Guidance Actually Exists

Practitioners should understand how little authority there is here. Treasury has never issued regulations under §1202 beyond a single set addressing the effect of redemptions on QSBS status, so the excluded-business analysis is largely an exercise in reading statutory text. The Service has issued a small number of private letter rulings that illuminate the boundaries: PLR 201436001 concluded that a pharmaceutical company commercializing experimental drugs was engaged in a qualified trade or business rather than the “health” business, and PLR 202114002 concluded that an insurance agency was not performing “brokerage services.”

Both rulings are useful for their reasoning, and each is “authority” for purposes of the substantial-authority standard under Treas. Reg. §1.6662-4(d)(3)(iii). Neither may be used or cited as precedent. IRC §6110(k)(3). For a hybrid business — one that combines a clearly qualifying product with a services component, or that sits near a line the statute draws imprecisely — the right approach is a documented, activity-by-activity analysis prepared before any QSBS representation is made, not after a buyer’s counsel raises the question.

Coming next in this series: Part III — Does the Stock Qualify, and Will It Still? Original issuance, eligible holders, the per-issuer cap, the redemption rules, and transfers at gift and death.

For further information on this topic, please reach out to Filip M. Rams at frams@smgglaw.com

Disclaimer

This article is provided for general informational and educational purposes only. It does not constitute legal or tax advice and does not create an attorney-client relationship. The law in this area is complex and fact-specific. Readers should consult qualified legal and tax counsel before taking any action based on the information contained herein. Prior results in similar matters do not guarantee a similar outcome.

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