What Isn’t QSBS?

A primer on the excluded categories of business under Section 1202.

Section 1202, the revenue code statute that governs Qualified Small Business Stock (QSBS) doesn’t tell you what types of businesses do qualify for gain exclusion, it tells you what doesn’t qualify. Section 1202 operates through an exclusion framework. Instead of defining which trades or businesses are allowed, it sets out specific categories of business activities that are excluded from QSBS eligibility. If your business falls into one of these excluded areas, your stock will not qualify for the gain exclusion—even if the company is otherwise a “small”, domestic C corporation.

To be eligible for QSBS treatment, a corporation must also meet the “active business requirement” during substantially all of the investor’s holding period. That term, though not precisely defined in tax law, is generally understood to mean between 80% to 95% of the holding period. In addition to staying out of excluded categories, the corporation must also use at least 80% of its assets (by value) in the active conduct of a qualified trade or business.

Understanding which activities fall outside the definition of a “qualified trade or business” is crucial, and Section 1202(e)(3) provides a clear list. Below are the excluded business categories, along with a description of the activities typically included in each.

Health

This exclusion applies to businesses providing medical services such as physicians, dentists, nurses, veterinarians, and other licensed professionals. Activities that involve direct patient care, billing to Medicare or Medicaid, or services performed by licensed healthcare providers are considered excluded health services. However, ancillary services (such as medical device manufacturing or lab testing and most all “bio-tech” businesses) that don’t involve patient care may still qualify, depending on the structure.

Law

Businesses that provide legal services, such as law firms or legal consultants, are excluded. This includes activities that involve advising clients on legal rights, drafting legal documents, or representing clients in court.

Engineering and Architecture

These exclusions apply to businesses that provide design, technical, or structural services. Engineering firms that offer consulting, technical design, and implementation advice, or architecture firms that create building plans and manage construction design projects, fall under this category.

Accounting and Actuarial Science

These professional services include bookkeeping, tax preparation, auditing, and financial analysis usually conducted by certified accountants or actuaries. Firms in these fields rely primarily on specialized training and certifications and bill clients by “case” or hours worked.

Performing Arts

Businesses where income is generated by artistic performance—such as musicians, dancers, actors, and entertainers—are excluded. This includes both solo performers and production companies centered on talent performance. In other words, you likely can’t exclude gains from the sale of your three-man puppet show.

Consulting

This broadly defined category covers businesses that are primarily in the business of giving expert advice to clients. Importantly, providing some level of consultation or customer interaction does not make a business a “consulting” firm. The exclusion applies when the company earns income by selling advice rather than by delivering a product or service. However, some deliverables, even if packaged nicely and for the client specifically, are still considered consultuing activities. We make this note to help entrepreneur understand that crafting a personalized deck for a client doesn’t count as an eligible trade/business activity for these purposes. Ancillary advice that accompanies software or equipment sales, for example, generally won’t trigger the exclusion.

Athletics

This includes businesses where the primary activity is participating in or organizing athletic competitions. Personal training, coaching, and professional sports participation generally fall under this umbrella.

Financial and Brokerage Services

Firms that derive revenue from investing, advising on investments, managing portfolios, or brokering transactions are excluded. This category includes financial advisors, investment bankers, insurance brokers, and others who operate in markets for securities, commodities, or other financial products.

Reputation or Skill-Based Businesses

This catch-all exclusion targets businesses where the primary asset is the reputation or individual skill of one or more employees. Celebrity-driven brands, influencer businesses, or enterprises built entirely on the fame or expertise of a single person may fall into this category. However, companies that rely on systems, processes, or collective know-how—as opposed to personal reputation—may still qualify.

Banking, Insurance, Financing, Leasing, and Investing

These are considered passive or financial businesses, and include any company whose primary activity involves managing money or lending it. Traditional banks, leasing companies, insurers, and investment funds fall squarely into this group.

Farming

Excluded farming activities include the growing, harvesting, or raising of crops and livestock. Even tree farming and similar agricultural ventures are disqualified under Section 1202. Even the trading of raw commodity farm products like grain could be excluded because “commodities” are excluded if they are un-modified in the function of the business.

Natural Resources

This includes any business engaged in the extraction or production of resources like oil, gas, and minerals that qualify for special depletion deductions under Section 613 or 613A.

Hospitality (Hotels, Motels, Restaurants)

Businesses that operate lodging or food service facilities—such as hotels, motels, restaurants, and similar establishments—are excluded. Even adjacent businesses like bars or cafés may fall into this category depending on their structure and operations.


In addition to these excluded business activities, certain asset-related thresholds can disqualify a corporation from maintaining QSBS status. If more than 10% of a company’s assets consist of non-operating real estate or investments in other companies’ stock or securities (unless majority-owned), it could lose its eligibility. Similarly, companies that hold excess cash or investment assets (more than 20% of company value)—outside of what’s considered working capital or earmarked for R&D—could also fall out of compliance.

Finally, while businesses that are still in the early start-up phase or heavily engaged in research and development may appear inactive, Section 1202 does carve out exceptions for certain pre-revenue activities if they are expected to lead to a qualified trade or business.

The bottom line: Section 1202 doesn’t offer a bright-line list of “good” businesses - it tells you what kinds of business activities are explicitly excluded. If your company is not engaged in one of those excluded areas and meets the structural requirements (C corp status, asset thresholds, and holding period), then it likely qualifies for one of the most generous tax incentives available to founders and investors.

Previous
Previous

March Brings Continued Funding Momentum for NY Startups

Next
Next

QSBS Spotlight: Mercury Raises $300M, Making More Liquidity Available