More than you want to know about the tax impacts of angel investing.
A Forbes article from late last year claimed the tax advantages from angel investments were not exciting compared with those from real estate investing.
Earlier this year, a member of our angel group asked why we don’t ever mention the tax benefits of angel investing in our marketing and on our blog.
Clearly, despite our best efforts, angel groups do not explain well how taxes affect early stage investing. This article tries to change that: everything you could want to know about the tax implications of angel investing.
First up, quick but important disclaimers.
· This is not tax advice. We’re not qualified to give it, and cannot and do not!
· I deliberately simplify often, because the complexities and variations in life (and in the tax code) don’t really change the key lessons.
· You should, obviously, consult your own professional advisors and do your own research before making any tax-related decisions. This article is just for information only.
Second, this gets complicated and arcane. We’ve tried to make it simple and digestible, but where we’ve failed please tell us and we’ll try to make things clearer.
Lastly, before we get too far into the details, a quick “tax 101.”
· There are basically two ways to make money: “ordinary income” (things like wages and interest income) and “capital gains” (where you sell something for more than it cost you).
· There are two equivalent types of taxes: ordinary income taxes and capital gains taxes.
· There are also two basic kinds of companies: a “C-Corporation” (C-Corp) and a “Limited Liability Company” (LLC). Each kind of company can generate each kind of money and associated tax.
· Hopefully you knew that already, but if not a detour through the basics of company structuring and taxes would help before digging in on angel investing tax issues. Either way, I hope this is understandable even if taxes aren’t your specialty.
One last thing: I find numbers helpful, so I’ll put some examples in italics. Skip over them if you prefer concepts to numbers!
Capital gains
A basic angel investment might be:
· Find a C-Corp
· Buy equity (preferred equity) in it
· Wait until someone buys your equity.
From a tax perspective, that is a simple story:
· buy shares; later someone buys them from you; you pay capital gains taxes on your gain.
· With numbers: purchase 1 share for $1; sell it for $10; pay capital gain taxes on the $9 of gain ($10 minus $1).
That’s a nice outcome, of course; it’s even better when you consider the taxes you actually pay.
If you earn ordinary income, you pay ordinary income tax rates — which ranged from 10% to 37% in 2019. If you earn capital gains, you pay capital gains rates — which ranged from 0% to 20% in 2019. See the difference there? For the non-numerical, 0% is less than 10%, and 20% is less than 37%!
With numbers, let’s say you’re in the top bracket: $9 of ordinary income leaves you with (1–37%) * $9 = $5.67; $9 of capital gain leaves you with (1–20%) * $9 = $7.20. Enjoy that extra $1.53.
So, angel investing can create capital gains, which are generally better than other forms of income. That’s a win for angel investing.
However, it’s true of many other investments too. So why do we say that angel investing can create particularly attractive types of capital gains?
Section 1202 capital gain exclusion
We say angel investing can create especially attractive types of capital gains because of Section 1202 of the tax code. (Primary source here for those that like to read the tax code.)
Section 1202 basically says that capital gains from angel investments are exempt from capital gains taxes.
On our basic scenario above, delete the words “you pay capital gains taxes on your gain.”
(And change the post-tax proceeds from $7.20 back to $9. Enjoy that extra (extra) $1.80.)
Obviously not everyone is a fan of other people paying fewer taxes. But assuming you’re the one facing the tax bill, you probably consider this a good thing.
There are, of course, limitations on Section 1202. The gain has to come from a C-Corp’s “originally issued stock” (that means that the company must be selling shares, not you buying them from an existing owner). The stock must be a “qualified small business stock” (which is shortened to “QSBS” a lot), which means the company must use at least 80% of its assets in the active conduct of a business, cannot have more than $50M in assets when you invest, and must be in an eligible industry (so not, generally, service businesses or similar things).
If you’ve read anything about angel investing, you’ll see that these limitations very rarely apply: early-stage companies do not have $50 million of assets!
So to recap: an investor could make $9 of interest income and end up with $5.67; and angel investor could make $9 of capital gain and end up with the full $9 after the 1202 exclusion.
But there are two real limitations on Section 1202. First, it only applies to the first 10x return or $10M (whatever is greater). So if you have a >20x winner, only your first 10x of gain is exempt and you pay (capital gains) on the gains above that. This is a nice problem to have.
A more frequent problem, though, is that Section 1202 only applies if you held the stock for five years or more. What if you learned the lessons of “early exits” in angel investing and your gain was faster than five years? Read on…
Section 1045 rollovers
You made a $5,000 investment (in a QSBS C-Corp) through VentureSouth in 2018 and we sent you back a $45,000 check for the capital gain in 2020. What tax do you owe?
If you’ve followed the last example, you should have enough information to say “I hoped it would get the Section 1202 exclusion, but because the hold period was less than five years I pay capital gains tax on the gain.”
And with numbers, assuming again you’re in the top bracket and simplifying a little, you pay {$45,000 minus $5,000} * 20% = $8,000.
You could be right, but, like a (very niche) Choose Your Own Adventure book, you should go to Section 1045 of the tax code now.
Section 1045 (primary source here again) basically says that instead of paying gains you can “roll the proceeds over” into new QSBS and therefore defer paying taxes on them. If the total hold period exceeds five years, the Section 1202 exemption applies to all the gains.
To unpack that a little:
· Let’s say I take my $45,000 of proceeds and use it to make another basic angel investment in a QSBS-eligible C-Corp equity.
· As a result, I don’t yet have to pay the capital gain I would owe.
· If I keep holding this new investment for another three years (two years plus three years = five years in total), then I exit again I never pay the capital gains — neither those I owed from the first invest nor any from the second investment.
Pretty good. Back to keeping all my proceeds.
Again, there are naturally some limitations: you have to “roll over” the proceeds (not just the gain); you have only 60 days to find and execute the investments (if only there was somewhere you could go to find a steady supply of eligible investments…); and if you held the first stock for less than six months you can’t do this at all.
But still, for most successful angel deals, 1202 or 1045 should apply, so I think we’re justified in saying that Section 1202 is the Dabo of the tax code.
(By the way, I didn’t make the scenario above up. VentureSouth members faced exactly this calculation when we sent their K-1s for the handsome gain they made on a sale in 2018 of a company invested in during 2016. Lots of members did the Section 1045 roll over into new VentureSouth investments.)
Write offs
So far we have covered when investments go well. How about when things go wrong?
In general, if you lose money on an investment, you can offset that “capital loss” against a capital gain you have from something else.
For example, you make two $5,000 investments through VentureSouth, double your money on one, lose everything on the other. Your gain is $5,000 on the winner ($10,000-$5,000), and loss of $5,000 on the loser. You pay taxes on the net gain — so no capital gains are due.
That’s good news (relatively speaking), but again true of any investments that generate capital gains and losses, not just angel investments in early stage companies. Does angel investing have any extra benefits here? Of course it does…
Section 1244
The “silver lining” from the last section, of being able to write off the capital loss against other capital gains, was a dull, scuffed silver. This next one, called Section 1244, is a burnished, luminous, refulgent gleaming silver!
Section 1244 of the tax code (primary source here as usual) says that a capital loss on a small business stock can be treated as an ordinary income loss if the loss was on the first $1M invested in the company.
What does that mean? Recall right back to the beginning of this article: two types of income — ordinary income and capital gains; two corresponding tax rates — ordinary income rates and capital gains rates, with ordinary income rates being higher.
Section 1244 says you can consider the capital losses to be ordinary losses. Why does that matter? Because the tax rates on ordinary income are higher, and so it’s better for you to reduce your ordinary income rather than your capital gains, if you can.
In numerical form, consider this scenario: you earn $5,000 in ordinary income from your work, and make two $5,000 investments, where one returns 3x and one is a total loss.
· Scenario 1: consider the loss a capital loss.
o Ordinary income: $5,000
o Tax you owe on that (assuming a 37% ordinary tax rate) = $1,950
o Net capital gain is $5,000 ($10,000 net gain on the first investment, minus $5,000 capital loss on the second)
o Tax you own on that (assuming a 20% capital gain rate) = $1,000
o Total “income” = $20,000; total taxes paid $2,950
· Scenario 2: consider the loss an ordinary loss.
o Ordinary income: $5,000 less ordinary loss from investment #2 of $5,000) = $0 income
o Tax you owe on that (assuming a 39% ordinary tax rate) = $0
o Net capital gain is $10,000 (net gain on the first investment
o Tax you own on that (assuming a 20% capital gain rate) = $2,000
o Total “income” = $20,000; total taxes paid $2,000
You don’t have to use a spreadsheet to see that scenario #2 is better. Enjoy that $950 in your pocket.
Section 1244 continued
Section 1244 gets even more luminous.
In usual capital loss situations, you really need capital gains to offset the losses against, because you can only take up to $3,000 in net capital loss in a given year. (You roll forward the rest to future years).
But under 1244, you don’t need capital gains to offset things against — you need ordinary income. Generally people have more of that, from work, interest income, and more liquid investments.
But here’s the extra benefit: you don’t even need that! You can take up to $50,000 in net ordinary loss in a given year (for a single filer; $100k if you are married-filing-jointly).
No-one likes to lose money on angel deals — but if you do Section 1244 makes your life a little better than if you had lost the same money on something else.
Limits on 1244
Yes, there are some limits on Section 1244 losses. The $50k / $100k is one. Another is that it only applies to the first $1M that went into a company.
This is almost always true of “family and friends” money; it’s often true of the angel rounds; it’s generally not true of later stage, venture capital rounds. Angels > VC here.
It can be complicated on angel rounds too. How do you figure out who can take this benefit if, say, the $500k angel round represents the $750,000-$1,250,000 dollars into a company? Good record keeping, thorough understanding of the company’s cap table, being the lead investor and first funders in a round — all helps to make sure you get the benefit in these situations.
LLC passthroughs
You hopefully noticed that the really great benefits of Section 1202 and 1045 were focused on C-Corps. They don’t apply if you invest in an LLC. Do LLCs have some alternative benefits? Yes, they do: pass-through losses.
As quick background:
· An LLC is a “passthrough entity,” which means that the company doesn’t file tax returns, the individual “members” (the shareholders) do instead. If the company makes or loses money, the profit or loss is something the members have to deal with, not the company.
· Startup companies generally lose money. Initially this is deliberate; later on, perhaps less deliberate but making money is hard.
So when you invest in an LLC, there’s a good chance you will be passed a loss to deal with in your tax affairs. That is (counterintuitively perhaps) good news: investors can use those losses to reduce the ordinary income they have to pay (ordinary income) taxes on. (And remember back that reducing ordinary income is better because of the higher ordinary income tax rate.) They can also do it today, rather than this loss being stuck inside a C-Corp forever.
(Notice the similarity to passing on of depreciation costs in real estate investing…)
Some people invest in LLC just for this benefit.
Angel taxes wrap up
So to recap:
· Angel investments aim to generate cap gains (which is better than ordinary income)
· Frequently, those gains are totally exempt from capital gains under Section 1202 (which is better than pretty much every other asset).
· If they’re not exempt, maybe they can be rolled-over under Section 1045 and eventually become exempt.
· If things go badly, the capital loss might become an ordinary income loss under Section 1244 (which is good).
· Don’t forget to include LLC passthrough losses sometimes.
After all that, you net to an asset class where taxes have a much smaller impact on pre-tax investment returns than in many other assets.
Hopefully at this point you’re now confused enough to (a) consult a professional tax advisor and (b) add a few early stage investments to your portfolio!
