Lesson #133: How to Avoid Paying Taxes on Startup Investments

For this lesson, I solicited the help of Ira Weiss, a Partner at Hyde Park Venture Partners in Chicago.  He first wrote on this topic for BuiltInChicago, but was gratious enough to let me share his learnings with all of my Red Rocket blog readers.

Taxes are currently on the minds of many investors because of the recent increase in tax rates. However, while taxes went up significantly for most investments, taxes for startup investments just dropped like a rock… all the way down to zero!   Although no investor is going to decide to bankroll a startup just because of tax benefits, taxes do matter to them. And, if you are an entrepreneur searching for capital, you want to give potential investors every reason in the world to say yes. What could be a better excuse than avoiding taxes?

Starting January 1, 2013, capital gains taxes were raised significantly for most investments, from 15% to 20% for some investors.  In addition, capital gains are now subject to a 3.8% Medicare surcharge. This makes the new tax rate closer to 23.8% -- a whopping 59% increase.  Not to mention, ordinary income taxes on any interest income received, grew from 39.6% to 43.4% for the highest income brackets.  This takes a big chunk of the upside out of traditional stock and bond investments.

But, startup taxes went in the opposite direction. As part of the recent American Taxpayer Relief Act of 2012, capital gains on most early stage investments are effectively ZERO because the investment gains are excluded from income.  This gave investors a real incentive to put more of their monies into startup companies, as a real shelter from paying taxes on the gains.

This special tax provision for startup investments is referred to as Qualified Small Business Stock, and it has been around for many years in various forms. The two important criteria for startups are: (i) they must be a C corporation, and (ii) they must have less than $50 million in assets when the investment is made.   In addition to avoiding federal income tax, investors also do not pay any state income tax on this type of investment.  Why?   Because given the way in which this tax provision works, the investment gains on startups are completely excluded in calculating federal income, and therefore none of the gains are passed through to the state tax return.

This startup "tax nirvana", as Ira likes to call it, does have a few restrictions and limitations. An investor can only exclude up to $10 million in gains or a up to 10x return, whichever is greater.  And, the stock must be held for at least five years by the investor.  As a startup entrepreneur, there is nothing you need to do to get your company to qualify. As long as you are a C-corp tax-payer, just complete your regular annual tax return, and be sure to list the amount of company assets on your tax return form.

These favorable tax rules have only been extended through Jan 1, 2014, but any startup investments made in 2013 will permanently qualify for the tax savings.  So, tell all your friends and angel investor targets that 2013 should be the year they start to move more of the investment capital into startups, to enjoy the tax savings while they still can.

Thanks again, Ira, for sharing your insights here.  To follow Ira on Twitter, you can follow him at @iraweiss.

For future posts, please follow me at:  www.twitter.com/georgedeeb.