Qualified Small Business Requirements for QSBS: Corporate Eligibility Rules

Qualified Small Business Stock (QSBS) offers significant tax advantages under Section 1202 of the Internal Revenue Code (IRC), encouraging investment in small businesses. However, to capitalize on these benefits, strict eligibility criteria must be met by the issuing corporation. These criteria span across corporate status, asset limitations, active business requirements, and exclusions pertaining to specific types of businesses. This guide provides a detailed analysis of these complex requirements necessary for a corporation to qualify as a "qualified small business."

Corporate Status Requirements

Must Be a C Corporation

The foundational requirement for QSBS eligibility is that the issuing entity must be a domestic C corporation, as stipulated by [IRC §1202(d)(1)]. This excludes S corporations, partnerships, limited liability companies (LLCs), and other pass-through entities from issuing qualified stock. The rationale behind this exclusion is rooted in the nature of QSBS benefits which are specifically designed for corporate stock, aligning with the traditional corporate structure where stock issuance is a common practice.

Must Be a Domestic Corporation

Further tightening the eligibility criteria, the corporation must be organized under the laws of the United States or any state. This requirement excludes foreign corporations, reinforcing the policy objective of promoting domestic investment.

Eligible Corporation Requirements

In addition to being a domestic C corporation, the entity must not fall into certain excluded categories such as DISCs, RICs, REITs, REMICs, and cooperatives, as outlined in [IRC §1202(e)(4)]. These exclusions ensure that the benefits of QSBS are directed towards operational companies rather than those primarily involved in investment or passive income activities.

Asset Test: The $75 Million Threshold

A critical financial criterion for QSBS eligibility is the limitation on the corporation's aggregate gross assets, which must not exceed $75 million at specific times before and after the issuance of the stock. This asset cap is set to increase from $50 million to $75 million for stock issued after July 4, 2025, reflecting adjustments for economic inflation and growth in business scales.

Gross Asset Limitation

The corporation's aggregate gross assets are examined at two pivotal moments:

1. Before Issuance: The assets must not have exceeded $75 million at any time from August 10, 1993, until the stock issuance.
2. After Issuance: The assets must not exceed $75 million immediately following the stock issuance, accounting for the capital received during the issue.

Definition and Treatment of Aggregate Gross Assets

"Aggregate gross assets" include both the amount of cash and the aggregate adjusted bases of other property held by the corporation. Significantly, for contributed property, the adjusted basis is treated as equivalent to its fair market value at the time of contribution ([IRC §1202(d)(2)(B)]). This treatment prevents strategic undervaluation of contributed assets, which could otherwise be used to circumvent the asset limitation.

Aggregation Rules

For corporations that are part of a parent-subsidiary controlled group, the assets of all group members are aggregated to determine compliance with the asset threshold. This aggregation, defined more stringently than general controlled group rules, underscores the intent to limit QSBS benefits to genuinely small corporate groups ([IRC §1202(d)(3)]).

Inflation Adjustment

Starting in 2027, the $75 million threshold will be subject to inflation adjustments, ensuring that the monetary criteria remain relevant over time.

Active Business Requirement

For the duration of the taxpayer's holding period, at least 80% of the corporation's assets must be actively employed in the conduct of one or more qualified trades or businesses ([IRC §1202(e)(1)(A)]). This requirement underscores the policy goal of fostering active, operational businesses rather than passive investment entities.

Qualified Trade or Business

The definition of a "qualified trade or business" excludes several sectors, notably professional services (like health and law), financial services, farming, natural resources extraction, and hospitality. These exclusions are strategic, focusing QSBS benefits on sectors perceived to drive innovation and economic growth while excluding those that are capital-intensive or fundamentally different in nature from what Section 1202 aims to promote.

Special Rules for Certain Activities

Activities such as start-up operations, research and development, and in-house research are deemed active business pursuits even if they do not immediately generate revenue. This favorable treatment encourages investment in innovation-driven businesses at their nascent stages, aligning with broader economic objectives of fostering technological advancement and entrepreneurship.

Continuous Compliance

To maintain QSBS status, the corporation must continuously satisfy the active business requirement and retain its C corporation status throughout substantially all of the taxpayer's holding period. This continuous compliance is crucial as any deviation may lead to a retroactive loss of QSBS benefits, underscoring the importance of strategic planning and diligent corporate governance.

Key Takeaways

1. Must be a C corporation: Excludes S corps, partnerships, and LLCs.
2. $75 million asset test: Ensures benefits are targeted at truly small businesses.
3. 80% active business: Promotes active engagement in eligible business activities.
4. Excluded businesses: Focuses benefits on specific economic sectors.
5. Controlled groups aggregate: Ensures small business character of the group.
6. Continuous compliance: Essential for retaining QSBS benefits over time.
7. Portfolio and real estate limits: Restricts passive investment activities.

Sources and Citations

• IRC Section 1202(d): Qualified small business definition
• IRC Section 1202(e): Active business requirements

Verification Date: January 2025

Note: This page reflects the law as of January 2025. Tax law changes frequently, and corporate qualification requirements are complex. This information should not be construed as legal or tax advice. Consult with qualified tax counsel regarding corporate structure and QSBS eligibility.