Does your company really pass the QSBS 80% test?

The 80% active-business test sounds simple: during most of your holding period, the company generally must use at least 80% of its assets in a qualified business. In practice, this is often one of the hardest parts of a QSBS analysis.

It is not enough to say, "We are an operating company," or point to the business code on the company's tax return. The test looks at what the company owned, what those assets were worth, and how they were used over time.

Why can't you just use the balance sheet?

A balance sheet is a good starting point, but it may not answer the important questions. For example:

• Why was the company holding a large cash balance?
• When did it expect to spend that cash?
• Was intellectual property included at a realistic value?
• What was happening inside the company's subsidiaries?
• Did the company hold investments or unused real estate?
• Did the company operate more than one type of business?

The test is based on asset value, not just tax basis, revenue, expenses, or employee headcount. A company can look active on paper and still need a closer review.

Does having a lot of cash cause a problem?

Not necessarily. Cash may count toward the 80% test if it is reasonably needed to operate the business or is expected to be used within two years for qualifying research or increased working-capital needs. That can include money raised for hiring, product development, research, equipment, expansion, and other planned operating needs.

But the company should be able to explain the amount it retained and how it expected to use it. Budgets, board materials, hiring plans, and development timelines can be helpful.

Once a corporation has existed for at least two years, no more than 50% of its total asset value can qualify as active solely under the working-capital rule. IRC §1202(e)(6)

What about startups that do not have revenue yet?

A pre-revenue company does not automatically fail. Certain assets used in startup and research activities can count as active-business assets before the company begins generating meaningful revenue. This is especially relevant for software, biotechnology, and other product-development companies. IRC §1202(e)(2)

The question is not simply whether the company had revenue. It is whether its assets were being used to build and develop a qualified business.

Which assets deserve extra attention?

A few categories regularly create questions:

• Large or long-held cash balances
• Marketable securities and other investments
• Stock in other companies
• Subsidiaries
• Intellectual property
• Real estate
• Assets connected to consulting, financial services, health, or another excluded field

Portfolio investments and nonbusiness real estate also have separate 10% limitations. IRC §1202(e)(5)(B), (e)(7)

What records should you look for?

Helpful records may include periodic balance sheets, general-ledger detail, cash and investment schedules, budgets and hiring plans, board presentations and minutes, research and product-development records, subsidiary financial information, real-estate schedules, and information about each business line.

Do not worry if you do not have all of these records. The first step is identifying what exists and where the gaps are.