Active Trade or Business Test: Section 355 and QSBS Rules

The active trade or business test asks whether a corporation is genuinely operating a business through its own people, rather than holding investments or collecting passive income, and it decides whether two valuable tax breaks are available: tax-free treatment of a corporate spin-off under Section 355 and the qualified small business stock (QSBS) gain exclusion under Section 1202. The core standard is the same in both places. The specifics diverge sharply.

What Active Conduct Actually Requires

A corporation satisfies the active conduct requirement when it performs substantial management and operational functions through its own officers and employees. The IRS looks at whether the corporation’s people are making day-to-day decisions and doing the work that generates revenue, rather than pushing everything out to third parties.¹

Independent contractors generally do not count toward this standard. A corporation can outsource some functions and still qualify, but its own employees have to handle the heavy lifting. If the only people running the business are outside contractors, the test fails. The IRS and the courts look at payroll size, the nature of duties performed in-house, and whether the corporation’s employees exercise meaningful control over operations.²

The line between managerial and ministerial work matters. A corporation that simply collects rent checks and forwards maintenance requests to a management company is doing ministerial work. A corporation whose employees negotiate leases, seek tenants, oversee renovations, and make capital improvement decisions is performing the kind of active management the test requires. The Treasury regulations illustrate this directly: a bank that transfers an office building to a subsidiary qualifies if the subsidiary’s employees manage the building, negotiate leases, and handle maintenance, but a similar transfer fails if the subsidiary simply collects rent under a net lease.³

Farming can look passive but often qualifies. In Revenue Ruling 73-234, the IRS held that a farming corporation met the active business test where its employees performed substantial management and operational functions beyond what tenant farmers did, including crop selection, equipment decisions, and land management.⁴

Borrowing Employees From Affiliates

Corporate groups routinely share staff across subsidiaries. Under the separate affiliated group (SAG) rule, all members of a corporation’s SAG are treated as a single entity for purposes of the active business test. A subsidiary can rely on employees of its parent or sibling companies, because those affiliates are close enough in the ownership chain to be distinguished from arm’s-length contractors.⁵ The catch: the corporation relying on affiliate personnel must still be the principal owner of the goodwill and significant assets of the trade or business for federal income tax purposes. You can borrow the people. You must own the business.

Activities That Do Not Qualify

Several categories of activity fall outside the standard no matter how much money they generate. The regulations draw a clear line between operating a business and sitting on valuable property:

Holding stock, securities, or land for appreciation is not active conduct. A corporation that owns nothing but a stock portfolio has no trade or business to speak of.¹
Leasing real or personal property under a net lease, where the tenant handles taxes, insurance, and maintenance, is treated as a passive investment. The owner is just collecting a check.
Holding undeveloped land with no significant development activity, or owning dormant mineral rights without exploitation activities, fails the test regardless of asset value.

The Five-Year History Under Section 355

For a tax-free spin-off, each trade or business relied upon must have been actively conducted throughout the entire five-year period ending on the distribution date.⁶ This prevents a corporation from standing up a shell operation six months before a spin-off and calling it an active business. Sixty continuous months of real activity.

The business model does not have to stay frozen. A retail store that adds an e-commerce channel, or a manufacturer that introduces new product lines, generally keeps its history because these are natural evolutions of the same enterprise. The regulations draw the line where a change is fundamental enough to constitute a different business altogether.³ A clothing retailer that pivots into commercial real estate development cannot carry its retail history forward.

Acquisitions Treated as Expansion

If a corporation that has been running a business for five years acquires another business in the same line of work, the acquisition is ordinarily treated as an expansion. The combined operation inherits the full five-year history.³ A regional restaurant chain that buys three more restaurants in the same market gets this treatment. A restaurant chain that buys a software company does not.

Interruptions in Operations

A temporary drop in activity does not automatically break the chain. The IRS recognizes that exceptional circumstances outside a company’s control can cause legitimate interruptions. Drought, fire, financial distress, and the bankruptcy of a major customer have all been treated as situations where temporary income loss does not disqualify a business, provided the company took reasonable steps to resume operations and kept employees managing its assets during the downturn.⁷

“Exceptional” does a lot of work. A company that has never generated revenue during its development phase does not get the benefit of this exception. The IRS draws a sharp line between a going concern that hits an unexpected wall and a startup that has not started earning money yet. A history of actual income before the interruption is what makes the exceptional circumstances argument viable.

Asset Composition Under Section 1202

Section 1202 goes further than asking whether the business is active. It examines what the corporation owns. During substantially all of the shareholder’s holding period, at least 80% of the corporation’s assets by value must be used in the active conduct of one or more qualified trades or businesses.⁸ This is where companies with large cash balances or investment portfolios run into trouble.

The corporation also must qualify as a “qualified small business,” meaning its aggregate gross assets must never have exceeded $75 million. The limit applies both before and immediately after the stock issuance. Beginning in taxable years after 2026, the $75 million figure will be adjusted annually for inflation.⁹

Working Capital and the Two-Year Rule

Cash in the corporate bank account does not automatically count as an active asset, but the statute carves out two exceptions. Cash held as reasonably required working capital counts toward the 80% threshold. So do investment assets the corporation reasonably expects to spend within two years on research and experimentation or on increased working capital needs.

The flexibility has a hard cap. Once a corporation has existed for at least two years, no more than 50% of its assets can qualify as active solely through the working capital exception. This keeps mature companies from stockpiling cash and claiming it all as working capital. Early-stage companies get more room, but the window closes fast.

The 10% Bright Lines

Two rules can disqualify a corporation independently of the 80% calculation. If more than 10% of the corporation’s asset value, net of liabilities, consists of stock or securities in non-subsidiary companies, the corporation fails for that period. If more than 10% of total asset value consists of real property not used in the active conduct of a qualified trade or business, the test also fails.

The real estate rule is aggressive. Owning, dealing in, or renting real property is explicitly excluded from being treated as active conduct for these purposes. A tech company that buys a building and uses it as its headquarters is fine because the real estate serves the active business. A tech company that also owns rental properties on the side could trip the 10% limit and lose QSBS eligibility entirely.

Holding Company Look-Through

A parent corporation can satisfy the asset requirements if it holds stock in controlled subsidiaries that are themselves running active businesses. The subsidiary’s active assets are effectively attributed to the parent. This only works when the subsidiaries actually meet the active conduct standard on their own. Stacking holding companies that each hold nothing but stock in other holding companies does not create active conduct out of thin air.

Industries Barred From QSBS Treatment

Even a corporation that clears every operational and asset-composition hurdle cannot qualify under Section 1202 if it operates in certain excluded industries. The statute bars the following from being a “qualified trade or business”:⁹

Professional services in health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage
Banking, insurance, financing, leasing, investing, or similar activities
Farming, including raising or harvesting trees
Businesses eligible for percentage depletion deductions on natural resources
Hotels, motels, restaurants, and similar operations
Any business where the principal asset is the reputation or skill of one or more employees

The last category is the broadest and most litigated. It targets personal-service businesses where the value walks out the door with the founder, but its edges are fuzzy, and companies in marketing, entertainment, and influencer-driven brands sometimes fall on the wrong side. These exclusions do not apply to the Section 355 active business test, which has no industry blacklist. A law firm organized as a C corporation could pass the Section 355 test. It would never qualify for QSBS treatment.

Recently Acquired Businesses Under Section 355

Section 355 prevents a corporation from buying an active business and immediately spinning it off tax-free. If a trade or business was acquired within the five-year window through a transaction where any gain or loss was recognized, that business cannot be used to satisfy the active conduct requirement. The same rule applies to acquiring control of a subsidiary that runs the business.⁶

Without this rule, a company with excess cash could buy a going concern, distribute it to shareholders, and convert what should have been a taxable dividend into a tax-free spin-off. The statute blocks that by requiring any acquisition within the five-year period to occur through a tax-free transaction, such as a statutory merger or stock-for-stock exchange, where no gain or loss was recognized.

Compliance means tracing the ownership chain of every business relied upon back through the full five years before the planned distribution. If any link in that chain involves a cash purchase or other taxable exchange, the entire distribution loses its tax-free character. This is the kind of issue that surfaces during due diligence and kills deals when it shows up late.

Consequences of Failing the Test

Failure looks different depending on which Code section is involved. Neither outcome is pleasant.

For a Section 355 distribution, failure means the stock distribution becomes a taxable event for both the distributing corporation and its shareholders. Shareholders receive what amounts to a dividend to the extent of the distributing corporation’s earnings and profits, taxed at rates up to 23.8% for qualified dividends, or at ordinary income rates up to 37% if the holding period requirements are not met. The distributing corporation may also recognize gain. There is no step-up in the inside basis of the controlled corporation’s assets, so the tax hit can compound later when those assets are sold.

For Section 1202, failure means losing the gain exclusion entirely. Instead of excluding up to 100% of the gain on qualified small business stock, the full gain becomes taxable as capital gain. For a founder who held stock for years expecting the exclusion, the difference can run into millions. Contemporaneous records of asset composition, employee headcount, and business activities are the only reliable way to prove compliance if the IRS questions eligibility years later.

1
eCFR. 26 CFR 1.355-3 – Active Conduct of a Trade or Business
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Internal Revenue Service. Revenue Ruling 2001-29
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GovInfo. 26 CFR 1.355-3 – Active Conduct of a Trade or Business
4
Drake Journal of Agricultural Law. Crop Share Arrangements and the Family Farm Corporation Planning Needed for Tax-Free Separation of Business
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Federal Register. Guidance Regarding the Active Trade or Business Requirement Under Section 355(b)
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Office of the Law Revision Counsel. 26 USC 355 – Distribution of Stock and Securities of a Controlled Corporation
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Internal Revenue Service. Active Trade or Business Requirement Under Treasury Regulation 1.367(a)-3(c)(3)(i)(A) (AM 2022-004)
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Office of the Law Revision Counsel. 26 USC 1202 – Partial Exclusion for Gain From Certain Small Business Stock
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Office of the Law Revision Counsel. 26 US Code 1202 – Partial Exclusion for Gain From Certain Small Business Stock