Checklist for Meeting QSBS Active Business Rule

Qualified Small Business Stock (QSBS) offers a major tax break: up to 100% of capital gains can be excluded after holding the stock for five years. But to qualify, your company must meet the 80% active business rule - at least 80% of assets must be actively used in operations. This guide breaks it down:

• Step 1: Confirm C Corporation Status
  • Only C corporations qualify. Review your Articles of Incorporation and IRS Form 1120.
  • Stock must be issued directly by the corporation, not purchased on secondary markets.
• Step 2: Ensure Asset Usage Compliance
  • At least 80% of assets must be actively used in business operations.
  • Cash treatment changes over time:
    • Years 1-2: All raised capital counts as active.
    • Years 3-4: Only 50% of cash qualifies unless deployed.
    • After Year 4: Cash must be actively used for business growth.
• Step 3: Manage Real Estate and Investments
  • Non-qualifying real estate and portfolio investments together cannot exceed 10% of total assets.
  • Actively used properties (e.g., offices) qualify; rental or investment properties don’t.
• Step 4: Address Special Cases
  • Startups must carefully track cash deployment as rules evolve.
  • Parent companies must include proportional shares of subsidiaries’ assets.

Key Tip: Regularly review your asset allocation, cash usage, and compliance with QSBS rules to avoid disqualification. Proper documentation is critical.

This checklist ensures you're on track to maximize QSBS benefits while staying compliant.

Step 1: Confirm C Corporation Status

Verify C Corporation Status

Making sure your company is a C corporation is the first step in the QSBS compliance process. This is crucial because only C corporations are eligible for QSBS benefits. Other business structures, like S corporations, partnerships, or sole proprietorships, don’t meet the requirements.

To confirm your status, review these key documents:

• Articles of Incorporation: Should clearly state your company is a C corporation.
• IRS Form 1120 filings: This is the tax return form specifically for C corporations.

If your company isn’t currently a C corporation, you can convert. However, keep in mind that QSBS benefits will only apply to stock issued after the conversion. Be sure to consult a tax advisor to handle the timing and compliance properly.

Check Stock Issuance Date

When the stock was issued plays a major role in QSBS eligibility. Here’s what to know:

• The stock must be issued directly by the corporation.
• Stock purchased on the secondary market, like in private transactions, typically won’t qualify.
• The company must maintain its C corporation status from the time the stock is issued until it’s sold.

Here’s a quick checklist to help with verification:

Once you’ve confirmed your C corporation status and stock issuance details, the next step is to focus on meeting the 80% active business rule by managing your assets effectively.

Step 2: Assess Asset Usage for Compliance

Confirm Your Business Qualifies

Before diving into asset usage calculations, make sure your business activities align with QSBS requirements. Here's a quick breakdown:

Industries That Don’t Qualify:

• Professional services like law, health, accounting, or consulting
• Financial services such as banking, insurance, or investing
• Hospitality businesses like hotels or restaurants
• Natural resource-related activities like farming, mining, or extraction

Industries That Do Qualify:

• Manufacturing, including product development and production
• Technology, such as software development or IT services
• Retail, covering product sales and distribution

Ensure 80% Asset Usage

QSBS rules require that at least 80% of your company's assets (by value) are actively used in qualified business operations. Here’s how to confirm:

• Calculate your total asset value, including both tangible assets (like equipment and inventory) and intangible ones (like goodwill or patents).
• Separate assets actively used in business operations from non-qualifying assets.
• Divide the value of active assets by the total asset value to ensure you meet the 80% threshold.

Example: If your total assets are valued at $100 million, at least $80 million must be actively engaged in qualified business activities. Once you’ve sorted this out, managing cash effectively becomes essential to staying compliant.

Handle Cash and Investments Wisely

Cash treatment under QSBS rules changes over time:

• Years 1-2: All raised capital counts as active.
• Years 3-4: Only 50% of cash qualifies unless deployed.
• After Year 4: Cash must be actively used for working capital or business growth to count.

To stay on track, allocate funds to areas like:

• Working capital needs
• Research and development
• Business expansion initiatives

Keep a close eye on how you deploy your cash to maintain compliance and avoid losing your QSBS eligibility.

Step 3: Control Real Estate and Portfolio Stock

Classify Real Estate

Properly categorizing real estate is a key step for staying compliant with QSBS rules. The main factor? Determining if the property is actively used for business purposes.

Examples of Real Estate That Qualify:

• Offices, warehouses, or R&D facilities actively used in daily operations.

Examples of Real Estate That Do Not Qualify:

• Properties held for investment, rental income, or future development.

Keep in mind, non-qualifying real estate and portfolio investments together can't exceed 10% of your total assets. For instance, if your total assets are valued at $10 million, the combined value of these holdings must stay below $1 million. This is essential for meeting the 80% active business rule tied to QSBS eligibility.

Limit Portfolio Investments

Portfolio investments include assets like:

• Stocks in other companies (unless they're subsidiaries)
• Corporate or government bonds
• Mutual funds
• Other marketable securities

Example: Managing Assets for Compliance

For parent companies, the proportional asset inclusion method comes into play. If a parent company owns more than 50% of a subsidiary, they must account for their proportional share of the subsidiary’s real estate and investments when calculating compliance with QSBS rules.

To ensure compliance:

• Regularly review your real estate and investment holdings.
• Keep detailed records showing how real estate is used in business operations.
• Reassess these holdings before making any acquisitions or significant changes.

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Step 4: Address Special Cases for Startups and Parent Companies

Startup Asset Rules

Startups need to adjust their strategies as cash qualification rules evolve over time. Here's a breakdown of how cash treatment impacts QSBS compliance:

To stay eligible for QSBS, startups should:

• Keep a close eye on cash deployment timelines.
• Clearly document the intended use of funds.
• Strategically plan asset purchases within the first two years.

By staying on top of fund usage and cash deployment, startups can ensure they remain compliant as they grow beyond the early stages.

Rules for Subsidiaries and Parent Companies

Parent companies need to factor in their subsidiaries when managing QSBS compliance. If ownership exceeds 50%, they can include a proportional share of the subsidiary's assets in their calculations. For instance, if a parent company owns 80% of a subsidiary with $10 million in active assets, $8 million can be counted toward compliance.

Steps for Parent Companies to Stay Compliant:

• Track ownership levels, assets, and activities, and calculate proportional shares correctly.
• Keep detailed records for all entities involved.
• Perform regular audits and financial reviews.
• Align operations between parent and subsidiary companies.

Maintaining thorough records and conducting regular audits helps parent companies meet QSBS requirements across all entities. While IRS guidelines on documentation are limited, consistent monitoring is key to meeting the active business requirement.

Conclusion: Maintaining QSBS Compliance

Key Points for Compliance

Staying compliant with QSBS regulations requires constant attention to your C corporation status and adherence to the 80% active business rule. Keeping track of key areas is essential, and regular monitoring ensures you're on the right path. Here's a quick breakdown:

It's especially important to review these areas after major transactions or operational changes. Detailed documentation of your decisions and activities is your best defense in maintaining compliance.

Support from Phoenix Strategy Group

Phoenix Strategy Group offers specialized services to help businesses meet QSBS requirements. Their expertise includes:

• Strategic planning for cash usage during critical compliance periods.
• Fractional CFO services to oversee asset management and compliance efforts.
• Custom monitoring systems designed specifically for QSBS tracking.

For companies in growth mode, balancing complex QSBS rules with scaling operations can be tough. Phoenix Strategy Group simplifies this process, helping you stay compliant while minimizing risks. Their services are especially helpful for businesses with intricate asset portfolios or multiple compliance needs.

FAQs

Understanding the 80% active business rule is key for QSBS eligibility. Below, we address some common questions to clear up important details.

What is the 80% rule for QSBS?

The 80% rule means at least 80% of a corporation's assets (by value) must be actively used in qualified business operations during most of the time the stock is held. For example, if a corporation has assets worth $100,000, at least $80,000 must be tied to active business activities.

Here’s how to meet the 80% rule:

• Working capital needed for operations doesn’t count against the calculation.
• Real estate not used in business operations must stay below 10% of total assets.
• Investments in non-subsidiary corporations should be kept minimal.
• For subsidiaries owned at 50% or more, a proportional share of their assets contributes to compliance.

Some businesses are excluded from qualifying, such as:

• Professional services
• Consulting firms
• Banking and insurance companies
• Businesses heavily dependent on employee expertise

For more details on asset classifications and compliance tips, check out Steps 2 and 3 of this checklist.

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