Tax implications for angel investors in the U.S.

^{This writing is for educational purposes only. This is not meant to be any legal, tax, or financial advice. All decisions regarding the tax implications for angel investors should be made in consultation with your independent tax advisor or CPA.}

If you are testing the waters of angel investing in the U.S., understanding the tax treatment of angel investments is especially important. While you are enjoying the ups and downs of sharing the company-building journey with entrepreneurs, it is crucial to keep accurate tax records and be aware of all the tax rules and regulations the IRS has made for angel investors.

My experience with angel investing and its tax implications comes with Hero House Angels, a global group of 70+ angel investors who back the founding and growth of early-stage deep tech and science-driven companies in the U.S.. I have been asked a lot about the angel investors’ tax benefits, whether they are tax deductible investments, etc. Though I always advise anyone to consult with their tax advisers, below is an overview of the tax implications of angel investments for a beginner.

Before getting into details, let’s set the stage first with some basics. There are 2 types of income: ordinary income (wages, salaries, bonuses, interest income, etc) and capital gains (income gained from the sale of something you own for a price more than it cost you). Similarly, there are 2 types of taxes: ordinary income tax (10-37% as of 2022 depending on the tax brackets you fall into) and capital gains tax (0%, 15%, 20%, and very rarely above 20% depending on the threshold of your income).

As an angel investor, you buy preferred equity (gives advantages over the common stock owners which is a subject of separate discussion) in the company and wait for a few years (could be even 10+) until someone buys your equity, which in the startup’s life is the exit event - M&A or IPO. That’s how you make money. From a tax perspective, that sounds like a regular capital gains tax. So what’s unique or different about the tax treatment of angel investments?

Thankfully, there are certain tax incentives for angel investors which vary based on the company’s structuring. The gold standard for startups is to register a C-corporation (or C-corp) in Delaware for various reasons (you can read more here). If the company you are planning to invest in is formed as a Limited Liability Company (LLC) or Limited Partnership (LP), that’s a red flag. What we see more often is angel investors investing in a C-corp through a syndicate where SPVs are set up for each investment as LLCs or LPs. So let’s dive into both scenarios.

1. IF YOU INVEST DIRECTLY IN A C-CORP:

Tax treatment of angel investments has been made particularly attractive if the company is formed as a C corporation.

Section 1202: Partial exclusion for gain from certain small business stock

In simple terms, Section 1202 says that capital gains from angel investments are exempt from capital gains taxes if the stock is qualified as QSBS (qualified small business stock) under certain circumstances:

1. The stock has been originally issued by the company, not another stock owner.
2. The company cannot have more than $50M in assets at the moment of investment.
3. The company is using at least 80% of its assets in the active conduct of a business.

(So far so good as most if not all startups pass these criteria).

4. The stock must be held for at least 5 years before selling.
5. The greater of the first 10x return or $10M is eligible for Section 1202: anything above this threshold will be treated as a standard capital gain.

Section 1045: Rollover of gain from QSBS 1 to QSBS 2

If you are a pre-seed or seed investor in the company, chances are you will need to wait 5+ years until the company has an exit. However, the company can also have an early exit event which for you would mean that Section 1202 will not apply. Here comes Section 1045! It allows rolling the proceeds (not the gain!) over to another company (again, it must qualify as a QSBS) and deferring tax payments for the capital gain from the initial investment. If you do the rollover of proceeds (meaning reinvest the proceeds in another company) and the total period of holding the stocks of both companies is more than 5 years, Section 1202 will come back into effect. With all its beauty, there are still things to keep in mind:

1. You have to hold the QSBS 1 stock for at least 6 months.
2. You need to do the rollover within 60 days from the date of the QSBS 1 stock sale.

The first one is easy to comply with as very rarely companies will have an exit in such a short time unless you decide to sell your stock. The 2nd point is something to plan for in advance. Being part of angel groups is one good strategy to secure constant deal flow. Hero House Angels can be one to consider.

Section 1244: Not all capital loss is a capital loss 

Let’s now see what happens if the company doesn’t perform well. Like in all other investments, you can offset a capital loss against capital gain from a better-performed investment you had. The icing on the cake for the tax treatment of angel investment comes in the form of Section 1244 which basically says that capital loss on the first $1M invested in the company can be treated as an ordinary income loss. As we saw in the beginning, the tax rates on ordinary income are higher than those on capital gains so you are better off reducing your ordinary income. This is particularly attractive given that you can only have $3000 in net capital loss and need to roll over the rest to the following years. Section 1244 says you don’t even need capital gains - you only need ordinary income, which for most people is a bigger pool than capital gains.

To illustrate this, let’s go over this quick example. Let’s say you earned $100,000 as an ordinary income and made 2 investments of $10,000 each in 2 companies. One of them shuts down, the other gives a 5x return.

Scenario 1: If Section 1244 doesn’t apply:

Ordinary income tax = $100,000 * 24% = $24,000

Net capital gain = $10,000 * 5 - $10,000 = $40,000

Tax on net capital gain = $40,000 * 15% = $6,000

Total tax due = $6,000 + $24,000 = $30,000

Scenario 2: If Section 1244 applies:

You can consider your $10,000 capital loss as ordinary income loss. See below:

Ordinary income tax = ($100,000 - $10,000) * 24% = $21,600

Capital gain tax = ($10,000 * 5) * 15% = $7,500

Total tax due = $21,600 + $7,500 = $29,100

The more you earn as an ordinary income, the higher the ordinary income tax rate is, meaning the difference in these 2 scenarios becomes more advantageous.

Section 1244 is applicable for only the first $1M that went into the company. Though most angel investors join in the very early days of the company and $1M is a pretty good threshold, it is still important to be aware of.

2. IF YOU JOIN A SYNDICATE/SPV:

Special purpose vehicles or SPVs have become increasingly common among angel groups and angel investments in general. The concept is as follows: a group of angel investors pull the money into a vehicle with a special purpose (in our context, investment in a company; could also be securitization of loans, risk isolation of standalone projects, etc.). The formed entity becomes an investor for the target company and thus appears in the company’s cap table. There is often a syndicate lead who takes care of the SPV setup and management.

The underlying legal entity of an SPV is mostly an LLC or LP. LLC is a “passthrough entity” which means all the gains and losses that LLC generates pass to its members (shareholders). As an LLC member, you will receive a K-1 document which will show your share of income in the partnership. You will need to file your K-1 document on your Form 1040 U.S. Individual Income Tax Return before April 15.

Even if the LLC/LP has had no income or loss during the year (which is often the case when investing in startups) you will get your [blank] K-1 showing no income or loss for the year and file with your Form 1040. Income/loss and thus a taxable event for you occurs at the exit event or when the company shuts down. Theoretically, the company can share a dividend or distribution so you may have some capital gain then but that rarely happens with startups. Please note that in cases when the LLC/LP buys convertible notes issued by the company, another taxable event may happen before the debt-to-equity conversion on your share of the interest which will be taxed as ordinary income. That is not going to happen in SAFE investments.

When investing through a syndicate, unless it is structured as a C corp (and as you saw that’s rarely the case for angel syndicates) you will still enjoy the benefits of Section 1202 and Section 1045 we talked about as long as the portfolio company qualifies as QSBS. This allowance makes angel syndicates a particularly attractive way to make investments.

RECORD KEEPING

As part of your angel investing routine, accurate record-keeping should not be disregarded. While you will need all the information and documents only once when you file your returns, it is nice and trouble-free to keep accurate records along the way. Below are a few items as a summary to keep in mind:

• Make sure you have your K-1s for each company you’ve invested in before the filing season. This is relevant for investors who joined an SPV. If you invested directly into the C-corp, you don’t need a K-1 as C-corps are not pass-through entities, rather they hold the gains and losses to themselves.
• If you had positive exits for the year, check which of your investments qualify for Section 1202 and Section 1045 of the Tax Code and if you have reached the timeline and amount cap for each.
• If you had a loss in your portfolio investments, check if you can treat it as ordinary income loss via Section 1244.
• If you invested via a Convertible Note instrument, account for the tax treatment of any interest from the conversion of that note.
• Track the Tax Code updates for the current year.
• Always consider consulting with a certified tax counsel before filing your annual taxes.

SUMMING UP

Above we discussed different nuances of tax implications for angel investors in the U.S.. Non-US investors even if investing in U.S. assets will need to look at the tax regimes in their countries. Generally speaking, non-US investors will still receive their K-1s, and may be subject to U.S. withholding tax requirements. There are certain exceptions though and it is absolutely necessary to consult with professional tax advisors.

In general, angel investing is a good way to support the entrepreneurial scene development in your region and beyond while also securing good returns for you. In general, angel investing is a good way to support the entrepreneurs in your region and beyond while also securing good returns for you and enjoying the extra tax benefits.

To re-highlight, you still need to consult with a professional tax advisor to understand the impact and implications of your investment in your individual tax situation. However, I hope this article helped you get a better understanding of the tax implications for angel investors.

If you have other questions about tax on angel investments or other related topics or are interested in getting some investment deal flow, you can contact me via LinkedIn.

Credits:

Profuse thanks to people who have reviewed this article, namely Kenji Funahashi, Partner at Wilson Sonsini; Jack Topdjian, Healthcare Venture Partner at SmartGateVC and Founder of Healthcare Equity Angels; and Ashot Arzumanyan, Partner at SmartGateVC.

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