The Active Business Test
Here’s a summary of how the qualified small business stock (QSBS) rules limit the types and amounts of passive assets a corporation can hold while maintaining QSBS eligibility.
1. General Rule
The Active Business Test restricts how much of the corporation’s assets can be held in “inactive” or passive forms—like cash, stocks, and real estate not used in operations. However, there’s meaningful flexibility built in. The corporation only needs to meet this test during “substantially all” of the shareholder’s holding period (generally interpreted as around 4 out of 5 years). Temporary deviations typically do not disqualify the stock.
- Cash and Cash Equivalents
- A corporation can generally hold up to 20% of its assets in cash or cash equivalents (like T-bills) if those are its only inactive assets.
- If the corporation has been operating for more than two years, it can hold an additional 50% in cash or equivalents if those funds are reasonably needed for working capital or R&D.
- In that case, the effective limit could reach 70% (20% + 50%).
3. Investments in Stock or Other Securities
- If more than 10% of the corporation’s assets are invested in stock or securities of a non-subsidiary, it fails the active business test—unless those holdings qualify as working capital.
- In combination with the cash limits above, this generally caps non-operating equity investments at:
- 10% if not covered by working capital needs, or
- 60% (50% + 10%) if they are.
- Money market or sweep accounts are a gray area—they may qualify as cash if they simply provide interest on idle funds, but not if they represent temporary equity positions overnight.
- Real Estate
- A corporation also fails the test if more than 10% of its assets are held in non-operating real estate.
- Unlike cash or securities, real estate holdings do not benefit from the working capital exception.
- Example
Assume Company ABC is worth $10 million and has been operating for over two years:
- It could hold $2 million in cash and still meet the test if that’s its only inactive asset.
- Or, it could hold $1 million in stock plus $1 million in cash.
- If additional liquidity is needed for operations, it could hold up to $6 million in cash or stock (for working capital/R&D) plus $1 million in other cash.
- It cannot hold more than $6 million in non-subsidiary equity or $1 million in passive real estate.
In short, the company can maintain substantial liquidity for operational needs—especially in cash or T-bills—but should avoid large allocations to equity securities or non-operating real estate unless clearly tied to working capital or R&D. See also IRC 1202(e)(6), below. [1]
About the Author
Mike Baker frequently advises with respect to qualified small business stock. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] IRC 1202(e)(6) Working capital. For purposes of paragraph (1)(A), any assets which—
(A) are held as a part of the reasonably required working capital needs of a qualified trade or business of the corporation, or
(B) are held for investment and are reasonably expected to be used within 2 years to finance research and experimentation in a qualified trade or business or increases in working capital needs of a qualified trade or business,