What Is a Qualified Active Business (QAB)?
Understand the specific corporate and operational standards a business must meet to be considered a Qualified Active Business for tax purposes.
A Qualified Active Business, or QAB, is a company that meets specific operational criteria outlined in the U.S. Internal Revenue Code. This designation is not a standalone status but is fundamentally linked to the tax treatment of Qualified Small Business Stock (QSBS). For investors and founders, determining if a company operates as a QAB is a necessary step to unlock significant tax advantages associated with their stock. The entire framework exists to encourage investment in smaller, growing U.S. companies.
The Role of a QAB in QSBS Tax Treatment
The primary reason to determine if a corporation is a QAB relates to Section 1202 of the Internal Revenue Code. This section provides a tax incentive by allowing non-corporate taxpayers to exclude a large portion of the capital gains realized from the sale of Qualified Small Business Stock. For stock to be considered QSBS, the issuing C-corporation must meet the active business requirement, making QAB status a foundational element of the QSBS framework.
For QSBS acquired after September 27, 2010, a shareholder who holds the stock for more than five years can potentially exclude 100% of the capital gains from federal income tax. This exclusion is generally capped at the greater of $10 million or 10 times the shareholder’s aggregate adjusted basis in the stock. Without the issuing corporation meeting the QAB requirements, its stock cannot be classified as QSBS, and this tax exclusion is unavailable to its investors upon a sale.
Core Requirements for a Qualified Active Business
The main QAB definition is the “active business requirement,” which is a quantitative measure of how a company uses its assets. To satisfy this, at least 80% of the corporation’s assets, measured by value, must be used in the active conduct of one or more qualified trades or businesses. This is often referred to as the 80% Test and must be met during substantially all of the taxpayer’s holding period for the stock. The test ensures the tax benefit is directed toward genuine operating companies rather than passive investment vehicles.
Assets considered “active” are those integral to the company’s day-to-day operations. This includes tangible assets like machinery and facilities, inventory held for sale, and intangible assets such as patents and trademarks used in revenue-generating activities. Conversely, non-qualifying assets are passive, such as investment securities, real estate not used in the trade or business, and cash holdings that exceed reasonable working capital needs.
The rules provide some flexibility for early-stage companies. Assets held for start-up activities, including research and experimentation conducted before revenue generation begins, can be counted toward the 80% threshold. This provision acknowledges that new ventures require time and capital to develop their products. While assets held for reasonable working capital needs are considered active, for an established company, no more than 50% of its assets can be investments held to fund future research or working capital.
Specifically Excluded Business Types
Even if a company satisfies the 80% asset test, it cannot be a QAB if its principal activity falls into certain excluded categories. A primary group of exclusions involves services where the principal asset is the reputation or skill of one or more employees. This includes professional services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, and athletics.
The list of ineligible businesses extends to any trade or business involved in financial services, brokerage services, banking, insurance, financing, leasing, or investing. The rationale is to prevent investment-oriented companies from benefiting from a provision aimed at active, operational businesses.
Other prohibited fields include any farming business, which also covers the raising or harvesting of trees. The extraction of natural resources is also targeted, with any business involved in mining being ineligible. Finally, companies whose primary business is the operation of a hotel, motel, restaurant, or similar establishment are also barred.
The Gross Assets Test
A separate but related financial hurdle for QSBS eligibility is the gross assets test, which limits the size of the corporation at the time of stock issuance. To qualify, the corporation’s aggregate gross assets must not have exceeded $50 million at any point before the stock was issued. The company’s gross assets must also be at or below the $50 million threshold immediately after the specific stock issuance in question.
This test is performed on a tax basis. “Gross assets” are defined as the sum of cash plus the aggregate adjusted bases of all other property held by the corporation. The use of tax basis, rather than fair market value, means that a company with highly appreciated assets might still qualify if the original cost basis of those assets is low.
It is important to distinguish this from the 80% active business requirement. The gross assets test is a snapshot in time, measured at the moment of stock issuance, and it assesses the total size of the company. The 80% test, in contrast, is an ongoing requirement that evaluates how the company’s assets are being used over the shareholder’s holding period. A company must satisfy both of these distinct tests for its stock to receive the benefits of QSBS treatment.