Angel investing is when a single investor or an investor group invests in a startup company in the early stages. The angel investor(s) will provide the capital needed to start the company in exchange for ownership shares. Those investors who partake in angel investing can claim significant tax advantages through various angel investor tax credits.
However, this can be challenging, as the IRS tax codes regulating angel investment tax credits are complex, continuously changing and being updated. Funds used for angel investments aren’t directly tax-deductible as, say, charitable contributions are. Instead, you have to complete some complex forms and make some calculations.
The obvious benefit of angel investing is that you become a part owner of a company that’ll, hopefully, become profitable and return an increased value for a future sale, along with regular dividends. In addition, some tax write-offs and tax credits are also beneficial to an angel investor.
In the simplest terms, an angel investment tax credit allows the investor to deduct a percentage of the costs of the investment from their taxes above and beyond the normal deprecation allowances. Another benefit is that the typical return on investment angel investors can expect to get rises into the 30% range, depending on the amount invested and the nature of the project.
Even though it feels like a charitable donation when engaging in angel investing for tax calculation, it’s quite different. An angel investment sector is necessary for the existence of the startup market. The benefits for the startup are apparent, and there’s no loan to pay back, as the angel investor receives shares of the company instead. Granted, that cuts into the future profits, but without funding, there’s no company and, therefore, no profits.
Conversely, investors want to get involved in venture capital or angel investing because if you get in on the ground floor of a company that ultimately turns out to be very profitable, either via an initial public offering or by being acquired for a large sum of money, you can garner huge profits. While startups fail more often than not, the hope is that the gains will significantly outweigh the losses.
The question now becomes figuring out how taxes figure into the equation. Let’s look at this from the top down. Generally, people make money in two ways: regular income from wages and interest or capital gains. Capital gains are money earned from your investments, either from selling at a higher value than you paid or by dividends paid out periodically. Each type of income is taxable, the first through income taxes and the second through capital gains tax. Angel investing falls into the latter category.
For example, you invest in a startup, and it eventually gets sold. Your shares may be worth significantly more than when you purchased them, and you’ll pay capital gains tax on the difference. If your investment loses money, then your loss amount is tax deductible. Typically, you can use your capital losses to offset your capital gains on your tax return. Let’s take a look at how particular tax codes can be used for angel investors.
If you’re an angel investor, one part of the IRS tax code you’ll want to look into is section 1202, which benefits angel investors. Seek out someone fully experienced with tax planning for angel investors who fully understands the tax implications of section 1202. In certain circumstances, section 1202 tax provisions can significantly reduce your tax liability. Up to 100% of all capital gains can be exempted from federal income tax. Per one such provision for total exemption, if you hold on to your shares for at least five years, your gains after the sale are 100% tax deductible.
Not all stocks qualify for exclusion under section 1202. The stocks must be for small businesses or startup companies’ stock to qualify under section 1202. There’s also a limitation on the amount of income exempt under section 1202, which is 10 times the initial investment or $10 million, whichever is less.
Another thing to be aware of is that some industries are excluded from the exemptions in section 1202. Angel investors investing in service, restaurant industries, real estate, finance, mining, farming, extraction, and hospitality can’t use section 1202. In addition, angel investors who invest in a company that makes investments can’t use the provisions from section 1202.
Section 1202 is the central part of the tax code that most benefits angel investors, but it isn’t the only section with benefits. Section 1045 states that if you take all your capital gains from a qualifying angel investment and put it into another qualifying angel investment within 60 days, all the reinvested capital gains would be exempt from income tax. Another benefit of section 1045 is that the new investment carries forward the holding period from the previous investment as it relates to section 1202.
For section 1202 to apply, you must hold on to your investment for five years. You can sell and reinvest as many times as you want following these guidelines, and once the total reaches five years, you can sell and not have to reinvest and use section 1202 to exempt those capital gains from tax liability. Be wary here; however, 60 days is a very short amount of time. Ensure you’re not rushing into a bad investment to take advantage of section 1045. That’s a surefire way to lose a significant amount of money.
The Pasquesi Sheppard Family Office Services staff is ready to help you with a wide variety of services. Our expert staff includes consultants and accountants uniquely qualified to give tax advice, including advice regarding angel investing. You can reach us 24 hours a day, seven days a week via our secure online form or call 847-234-5000. Our team would be happy to answer your questions or set you up for a consultation to discuss how we can serve as a valuable financial partner.