Is there ever an upside when a risky startup investment evaporates right before your eyes? Absolutely! The US government provides a tidy benefit to angel investors who take on the risk and economic impact of these investments. The trick is to know how to recoup some of your losses to reduce your tax bill. There are also tax strategies that help angel investors keep more of their earnings when they have winning exits. This is critical knowledge to have because it keeps us angels in the investment game so we can fuel new startups and the economy.
Although federal income tax laws are critical to understand, they are secondary to the savvy angels’ investment strategy. First and foremost is always to evaluate the potential of the business and team you are looking to invest in. Tax considerations are just one piece to consider. And of course, consult your tax advisor for suggestions based on your personal situation.
Recently I spoke to Glenn Martin, senior manager at the national public accounting and consulting firm McGladrey LLP, about the key tax issues angels should keep in mind when they invest. Martin will lead a December 3 free webinar on the topic of tax strategies for angels and entrepreneurs. Here are some of his top recommendations:
Understand what you're investing in: What type of investment instrument are you investing in? Is the company a C Corp (which pays its own taxes) or a pass-through entity such as a Limited Liability Company (LLC)? Are you buying stock or getting stock options? Understanding the nature of your investment will help inform you about what tax benefits may be available to you through current income tax rules.
Recoup some of your investment losses: Sincemore than half of angel investments lead to a loss, take time to learn how to protect your downside through Internal Revenue Code (IRC) “Section 1244” of the federal tax code. This is the most important tip for most angel investors because IRC Section 1244 gives investors the ability to take an ordinary income deduction on losses rather than the standard capital loss deductions. There are caveats such as needing to be part of the first $1 million of capital raised by the company and a few other requirements.
The benefits of qualifying for a 1244 deduction can’t be understated. Normally investors would take a capital loss with a maximum of $3,000 deduction per year, if that is the angel’s only capital transaction. Depending on the size of the investment, it could take many years to recoup the loss at that rate. But if you meet the 1244 requirements, you could monetize those losses much more quickly – up to $50,000 in a year for single filers or $100,000 for joint filers. In a scenario Martin presented to me on a $100,000 loss on investment for someone in the highest tax bracket, the investor would pay $42,000 less in a year when they qualified for 1244 treatment compared to not qualifying. That is real money.
The important message here is to know if you have 1244 stock up front and not when the loss happens. It is much easier to get the documentation early rather than when things have unraveled.
Reduce taxes in successful investments: Do you know about Qualified Small Business Stock (QSBS), also known as “IRC Section 1202”? This tax provision allows investors to minimize or eliminate taxes on successful exits in qualifying companies. Depending on the timing of your investment (more on that later), 1202 could result in a 50 to 100 percent reduction the gain on these companies. This makes it worth the time to gather documentation and complete some extra tax forms.
Qualified Small Business Stock was developed in 1993 to spur investment in startup businesses, rewarding the combination of investor risk and job creation involved. In general, investments must be made by individuals or partnerships in C Corporations with less than $50 million in assets. The stock must be purchased directly from the corporation, and held for at least five years. Many businesses are eligible, except for businesses in the service, finance, mining, extraction, restaurant, and hospitality industries, in addition to certain types of real estate businesses. The amount of gain that can be excluded is limited to the greater of 10 times the investment or $10 million – so this can be a huge windfall.
Understanding the amount of gains you can exclude and whether or not the Alternative Minimum Tax (AMT) applies is a little complicated because Congress has changed the gain exclusion amount several times in recent years:
- 50% exclusion for stock purchased between 1993 and February 17, 2009
- 75% exclusion if purchased between February 18, 2009 and September 27, 2010
- 100% exclusion if purchased between September 28, 2010 and December 31, 2013 (with no application of AMT)
- 50% exclusion if purchased in 2014
Think about that 100% exclusion. It means that anyone who purchased 1202 stock in 2011 and has a successful exit in 2016 (the required five year holding period) could end up paying NO taxes on the gain!
That full exclusion caught the interest of many angel investors when it was first enacted in 2010 and led to increased investment activity. Here’s hoping that Congress considers re-enacting the full exclusion again for the future. It is included as one of several “tax extenders” in the EXPIRE Act that might be voted on yet this year.
Even at the current 50% rate, the exclusion has value today for many angels because any gains will be excluded from the new 3.8 percent Medicare tax on individuals with adjusted gross income in excess of $200,000 ($250,000 for joint filers).
It is imperative, Martin says, that investors keep track of when they invest in a QSBS stock to know how to report the gains and how much - or how little - tax to pay on the gains.
For your investments that don’t have the full 100% exclusion, there is the “IRC 1045 rollover”. This allows investors to roll over proceeds from the sale of stock from one startup investment to a new QSBS investment to delay paying capital gains that may have accrued on the first investment. If your IRC 1202 investment exclusion is 50%, then this may be a way to invest in another QSBS qualifying company and owe no tax on the gains you invest in the new company.
All of these tax programs, and others not mentioned here, surely require a visit with an accountant who understands angel investment.
The bottom line on tax tips for angels? Know the tax laws in advance so that you can benefit from them before investing in a startup. Then make sure you get and maintain the right information when you make the investment to provide your tax accountant.
