Posted On: 10/13/2021

Posted By: Carlo Peralta

It’s a risk to put money into any sort of investment product out there, no matter how good the deal may be. The United States offers startup investors specific tax breaks to encourage them to put their money at risk in early-stage enterprises.

Startup investments can qualify for tax-favorable treatment in the United States when it comes to long-term capital gains. Occasionally, these tax breaks may be very large in size.

Every startup investor should be aware of the following three parts of the Internal Revenue Code (IRC):

• Section 1202: Allows capital gains from select small business stock to be excluded from federal tax.
• Section 1045: Allows rollover of gain from one qualified small. Business stock to another qualified small business stock.
• Section 1244 (losses): allows losses from the sale of shares of small, domestic corporations to be deducted as ordinary losses instead of as capital losses.

Sec. 1202 – up to a hundred percent exemption on QSBS gains (up to $10 million or ten times the cost basis).

Internal Revenue Code Section 1202 provides the first startup tax credit (IRC). For qualifying stocks held for more than five years, this exemption allows up to 100 percent tax-free profits on gains of up to $10 million (or 10X the cost basis).

Qualified Small Business Stock (QSBS) stipulates that an investment must satisfy the following conditions to be eligible:

1. No hotel, agricultural or mining firm, restaurant, financial institution, or architectural, legal, or engineering business is a domestic C corporation (not LLC).
2. Preferred or Common shares are used as a medium of exchange (not Convertible Note or SAFE).
3. As the original purchaser, you got your shares straight from the firm issuing them: (i.e., not acquired on a secondary market).
4. Neither before nor after the offering did the company have gross assets over $50 million.
5. At least 80% of the company’s assets must be used to actively conduct one or more eligible companies to meet specific operational business standards.
6. After the 27th of September, 2010, the QSBS was purchased (less than 100 percent tax exemptions may still apply to QSBS acquired before this date).

Even when contrasted to long-term capital gains, Section 1202 could provide investors with substantial rewards.

How do you feel about cashing out on an under-five-year QSBS investment?

Section 1045 – QSBS Tax-Deferred Rollover

Your earnings may be eligible to be rolled over into another QSBS investment, and the taxes on those gains delayed if invested within 60 days after you sold your QSBS investment if you kept it for more than six months but less than five years.

You may be allowed to use the Section 1202 tax-free exemption when selling the new QSBS if you keep the new QSBS investment for a total of five years (including the previous QSBS’ holding period).

A 1045 rollover after two years owning the QSBS of Startup A, followed by an investment in Startup B’s QSBS, may allow you to qualify for Section 1202’s five-year holding term after only three years of holding Startup B’s stock.

To make use of the 1045-EZ tax deduction on their federal income tax return for the year of the transaction, the taxpayer must make a special election.

It doesn’t matter if the new QSBS meets the 5-year holding period or not. The tax deferral on gains made under 1045 at the time of conversion will still be available.

Both investments must be made into QSBS, which means that both companies must be C corporations, not LLCs.

But what about losses from startup investments?

Section 1244 – Small Business Corporation (SBC) Losses

Losing money on an investment is a third way for startup investors to lessen their tax burden. Section 1244 permits a $50,000 tax deduction for an individual or $100,000 for a married couple from your taxable income as ordinary income.

Because you can deduct up to $50,000 a year in ordinary losses instead of the $3,000 maximum on capital losses, this can result in more significant tax savings than the $3,000 limit on losses from public market stock.

Several conditions must be followed to qualify as an SBC loss, such as:

A-C- or S-Corporation in the United States holds the shares of stock.

There were no services or securities exchanged for the stock (as opposed to Section 1202). Therefore the stock was solely bought in return for cash or property.

Securities were bought straight from the company (i.e., not via a secondary sale)

In the beginning, the issuer raised $1 million in stock.

50% of gross receipts are from an active business (e.g., not from royalties, rentals, dividends, interest, etc.) during the five years before the loss.

Regardless of whether the gross receipts criteria are passed or not, stock in a holding company is not an investment.

Assume an organization raises $1 million or more in a single round or subsequent rounds, and the total raised exceeds $1 million. Typically, the first $1 million of a company’s equity must be designated as Section 1244 stock. Without the 1244 deduction, the funds raised in that round will likely be split equally among all investors.

To avoid spending a lot of time in the future, keep meticulous records now (and ask your CPA to help). Keep track of your fundraising history and the amount of capital raised for each company so that you may assess if your stock qualifies as 1244 stock in the future with greater ease.

Are Convertible Notes and SAFEs taxed the same way as other types of convertible securities?

To be eligible for any Section 1202, 1045, or 1244 tax write-offs, you must own common or preferred stock in the company.

Convertible securities such as Convertible Notes or Simple Agreement for Future Equity (SAFEs) are not eligible for these tax write-offs until they are converted to equity. If you sell them before the conversion, you’ll still be able to claim long-term capital gains on them.

The five-year holding term commences on the conversion date if the convertible security is converted into QSBS-compliant common or preferred stock.

Consult your tax advisor or accountant about all of the potential tax implications of owning convertible securities. Aside from long-term capital gains and conversions, startup investors holding convertible securities should also be aware of the following tax implications.

The terms of a convertible note can vary greatly, and even if you don’t receive any cash from it, you may have taxable income. Suppose your note stipulates that you must pay interest on a semi-annual or annual basis. In that case, you may obtain a 1099 tax form and be liable for the taxation of this interest. In most cases, early-stage enterprises do not pay out interest to investors directly; instead, the interest accrues as an added value that will be converted into shares if and when a conversion occurs. When the loan is converted to equity, you may owe taxes on the interest that has accrued.

SAFEs, on the other hand, fall into a far more nebulous tax category and have terms that fluctuate even more than convertible notes. Section 1202 does not recognize SAFEs as equity ownership because they were traditionally pre-money. When Y Combinator revised its SAFE template in 2018, they included section 5(g), which stipulates that post-money SAFEs should be considered as common stock under IRC Section 1202, to the template.

To date, as early as 2020, none of the new YC terms (including the post-money determination) have been incorporated into any of the crowdfunding SAFEs that we have studied.

Angel investor tax credits at the state level

In addition, investors should know that several states offer tax incentives for qualifying angel investments. It’s always worth examining, even if the minimum requirements are more significant (e.g., $25,000 in some states) or if there are restrictions on where your firm can operate or where you can live.

So, what if I’m a non-resident American investor?

Lastly, non-US citizens who make investments in US companies may still be obligated to submit a US federal and/or state tax return (if they do so under an LLC) and abide by all regulations in their own jurisdiction.

International investors cannot invest in all Reg CF crowdfunding offerings. Check the requirements of each deal before investing and be aware of any tax consequences.

Capital Q Ventures and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.