Happy April Fools’ Day! Today is all about having fun with harmless pranks and jokes. Less fun?: Tax season. We’re officially in the home stretch, with just 17 days left until the deadline.
Whether you’ve already filed, you’re halfway done, or you’re leaving it to the last minute, there are a few key tax programs you should know about if you’ve invested in any startups.
Let’s go over the three most common ones.
1. The Rollover Perk (IRC § 1045)
Section 1045, the rollover rule, allows taxpayers who have invested in a qualified small business (QSB) to defer paying the capital gains tax–which can be as high as 37%--by “rolling over” those gains into new small business investments. So if you invest in a startup that eventually pays you $10,000 in returns, you can avoid paying the IRS up to $3,700 if you reinvest that $10k into a new QSB (or several). You do need to hold each investment for a minimum of six months–but considering most startups take at least a few years to reach an exit event, that shouldn’t be an issBe sure to check whether any of your portfolio companies fall under the QSB designation. Here’s a quick guide that outlines the requirements.
2. The Capital Gains Exemption (IRC § 1202)
Under Section 1202, anyone who invests in a QSB and holds that investment for five years or more is eligible for a complete exemption on any capital gains they make from that deal. For example, let’s say you invested $1,000 into a startup. Ten years later, that company is acquired in a hefty deal, and you’re paid out $10,000 in returns. Without Section 1202, you’d need to give the IRS up to $2,000 in capital gains tax–but thanks to this handy exemption, you can keep all $10k.
3. The Loss Write-off (IRC § 1244)
Section 1244 allows investors to write off any losses on small business investments at their income tax rate, rather than the capital gains rate. This one’s a little tricky, so here’s an example: Let’s say your annual income is $150k. Your tax bracket gives you a federal earned income tax of 24% – but the capital gains tax for your income is 15%. In the event that one of your small business investments fails or loses value, you can write off that loss at your income tax rate (24%), giving you a bigger write-off that can ease your financial burden on tax day. This particular rule applies to a broader range of small businesses, not just QSBs.
All three of these scenarios are possible for anyone who invests in startups regularly. Luckily, the U.S. government has these three programs in place to incentivize investing in small businesses and offset some of the financial risk involved.
If none of your portfolio companies have matured yet (e.g., had an exit event or dissolution), you won’t have to report anything at all about those investments on tax day, unless you’ve received some kind of distribution from them, like dividends or interest payments. So, even if a startup you’ve invested in posts a higher valuation later on unless you’ve cashed out of that investment, you won’t owe any taxes on those unrealized gains.
Keeping these rules in mind can help you make better decisions as you build your portfolio. For example, if you have an opportunity to cash out of an investment you’ve held for four and a half years, holding onto it until you cross that five-year mark can save you from paying thousands of dollars or more in taxes.
Meanwhile, the rollover rule is a great incentive that ties in perfectly with our recent discussion about investing in multiple deals, instead of just one or two. Not only does this strategy mitigate risk and increase your chances of a big “hit,” it can also be a tool to defer paying taxes on any gains you might make.
In short: this is an exciting time to be building out a diverse portfolio–and if you’re prepared with the right knowledge, you can greatly reduce or even eliminate your tax burden if and when you make a return.