Angel investors are usually high-net-worth individuals who invest in early-stage, typically high-risk, businesses, thereby helping support the entrepreneurial ecosystem.
The U.S. government supports this risky activity by making available certain tax advantages. These tax advantages may allow for the exclusion or rollover of a capital gain transaction, or provide ordinary tax treatment of a loss, rather than less favorable capital loss treatment. These provisions are quite technical in nature and you should seek your own tax counsel to determine if any of the items presented apply to your situation. But here’s an overview.
Exclusion of Gains.
IRS section 1202 allows taxpayers, other than corporations, 50 percent to 100 percent exclusion of gain from the sale or exchange of a defined qualified small business stock (QSB) held for more than five years. The gain eligible for exclusion in any tax year is equal to the greater of ten times the taxpayer’s basis in the stock sold during the tax year or $10 million. Any gains in excess of this limitation amount are taxed at normal capital gain rates. The gain exclusion percentage is based on the date the stock was purchased.
A section 1202 QSB is stock issued by a domestic C corporation (with certain limitations) after August 10, 1993, and:
• The stock is acquired by a taxpayer in an original issue for money or other property or as compensation for services provided to the corporation;
• The C corporation’s cash and other gross assets at time of taxpayer acquisition are $50 million or less; and
• At least 80 percent of the value of the corporation’s assets are used in a qualified trade or business, which is any business other than a business that:
o Provides personal or professional services;
o Operates a farm;
o Operates a hotel, motel, restaurant or similar business;
o Conducts banking, insurance, leasing, financing, investing or a similar business; or
o Produces or extracts products subject to percentage depletion.
No Alternative Minimum Tax is imposed on any eligible excluded gain.
Rollover of Gains.
IRS Section 1045 allows taxpayers, other than corporations, to elect to defer gain recognition from a stock sale by the rollover of such gain from a QSB sale transaction to another qualified replacement QSB stock. This section may be useful when realizing a gain on QSB stock held for less than five years. The requirements are:
• The taxpayer must have held the stock for more than six months and
• The replacement QSB stock must be purchased within a 60 day period from the date the original QSB stock was sold.
If the election is made, capital gain is recognized only to the extent the amount realized from the sale exceeds the cost of the replacement QSB stock. The election does not apply to gain treated as ordinary income.]
Ordinary Loss Treatment.
Typically when a taxpayer sells stock at a loss or it becomes worthless, it is considered a capital loss. However, IRS section 1244 allows ordinary loss treatment for up to $50,000 per year ($100,000 for joint returns) of qualified stock dispositions or worthlessness.
The requirements are different than for a QSB in sections 1202 and 1045. To meet the definition of section 1244 stock, which can apply to common or preferred stock of a domestic corporation, it must be stock issued after November 6, 1978, and:
• The shareholder taking the loss must be the original owner when the stock was issued for money or property (other than stock or securities). Stock acquired through gift, inheritance or purchase from someone other than the issuing corporation does not qualify.
• The corporation
o At the time the stock was issued, the aggregate amount of cash or property received by the corporation as a contribution to capital or paid in capital did not exceed $1 million.
o During the five years prior to the loss date of the sale of shareholder stock, more than 50% of gross receipts must have been from sources other than interest, dividends, rents, royalties, annuities and sales of stock and securities.
While the above provisions are quite technical, and impose record-keeping requirements beyond what investors and corporations may normally maintain, the favorable tax treatment may significantly enhance overall returns and reduce the impact of losses.
Kevin Learned is co-founder and director of Boise State’s Venture College, past president of the Boise Angel Alliance, and a member of Loon Creek Capital Group, which helps local communities create angel funds to support their entrepreneurs. Peggy Runcorn has more than 20 years of public accounting experience. She’s a member of the American Institute of Certified Public Accountants and Idaho Society of Certified Public Accountants. She is a partner in the Boise office of Eide Bailly.