Managing QSBS status and working capital

Portfolio companies looking to diversify working capital should understand QSBS implications and Section 1202 guidelines, as they redeploy cash.

In brief

• Portfolio companies can diversify cash holdings and meet the qualified small business stock (QSBS) Section 1202 definition without jeopardizing QSBS status.
• Corporations that plan working capital needs and and avoid certain investments could redeploy cash into other deposit instruments and meet QSBS guidelines.
• Stock have to pass many tests to meet the QSBS definition, including two that reference assets: active trade/business test and corporate securities limitations.

Active trade or business test

Stock in a corporation will be treated as QSBS only if at least 80% (by value) of the corporation’s assets are used in the active conduct of one or more qualified trades or businesses during “substantially all” of the taxpayer’s holding period.

Generally, cash, cash equivalents and marketable securities are, for US federal income tax purposes, considered as held for investment and not as used in the active conduct of a trade or business. Importantly, however, for purposes of the active trade or business test, assets that 1) are held as part of the reasonably required working capital needs of a qualified trade or business of a corporation, or 2) are held for investment and are reasonably expected within two years to finance research and development (R&D) or increases in the working capital needs of a qualified trade or business, are treated as used in the active conduct of a trade or business.

For periods after the corporation has been in existence for at least two years, no more than 50% of the assets of the corporation may qualify as used in the active conduct of a qualified trade or business by reason of this provision (the 50% limitation).

Because the fair market value of the assets, rather than tax basis of the assets, is used in determining if a corporation satisfies the active trade or business test, the value of any off-balance sheet intangible assets, including self-created goodwill, should be taken into account for purposes of this requirement.

For purposes of the active business requirement, stock and debt in any subsidiary corporation is disregarded and the parent corporation is deemed to own its ratable share of the subsidiary’s assets and to conduct its ratable share of the subsidiary’s activities. For this purpose, a corporation is considered a subsidiary if the parent owns more than 50% of the combined voting power of all classes of stock entitled to vote, or more than 50% in value of all outstanding stock of the corporation.

Corporate securities limitation

A corporation is treated as failing the active business requirement for any period during which more than 10% of the value of its assets (in excess of its liabilities) consist of stock or securities in other corporations that are not subsidiaries of such corporation, as defined above. The statute does not define the term “corporate stock or securities” for purposes of the corporate securities limitation; however, cash, certificates of deposit, Treasury bills and bonds, commercial paper, and most money market accounts should not be treated as corporate stock or securities.

As discussed as part of the active trade or business test, a corporation is permitted to treat as an asset used in the active conduct of its trade or business any investments that are reasonably expected to be used within two years to finance research and experimentation or increases in working capital needs. Similarly, when applying the corporate securities limitation, any investment in non-subsidiary stock or securities that are earmarked for these purposes will not be taken into account in determining if the 10% limitation is violated.

With these two tests now understood, it becomes apparent that the considerations around the deployment of working capital are no different now than they were prior to the bank failures. Stated in another manner, it was never advisable for a corporation seeking to qualify as QSBS to invest in stock or securities of non-subsidiary corporations that were not earmarked for use to fund increases in working capital needs or R&D over the following 24 months, because these investments would not count toward satisfying the active trade or business test and would be counted toward the corporate securities limitation. As best practices, however, the corporation should consider the following practical points:

Practical considerations

• The corporation should keep detailed projections of the amounts it will need to fund increases in working capital needs and R&D over the succeeding 24 months. Investments made in noncash deposit instruments should have liquidity terms that align with these cash needs.
• Regular valuations will help to support the intangible value and provide the denominator for both the active trade or business test and corporate securities limitation.
• Be mindful that it will be difficult to argue that any investment with a maturity date of longer than 2 years is held for increases in working capital or R&D needs over the next 24 months.
• Avoid direct investments in stock or securities of less-than-50-%-owned corporations and indirect investments in such corporations via mutual funds or money market accounts that invest in mutual funds to the extent these investments cannot be earmarked for use in funding working capital needs or R&D over the following 24 months.
• Recognize that the two tests described above must be satisfied for “substantially all” of a shareholder’s holding period in the stock. To date, the IRS has not defined “substantially all” for this purpose, but the use of this term would suggest that a corporation can fail either or both tests for some period of time, provided the corporation satisfies the test for “substantially all” of a shareholder’s holding period. As a result, it’s never too late to deploy cash or reconfigure investments to comply with the active trade or business test and corporate securities limitation.