If you’re like most startup investors (including me), taxes are likely the last thing on your mind when screening companies. It might not be until you get that first Schedule K-1 in the mail on March 15 that you realize that you may have bitten off more than you can chew from a tax perspective.
By asking a few simple questions before making any investment, a startup investor can quickly assess how and if their tax situation may be impacted by each investment.
The five tax questions that every startup investor should answer before making any investment are:
- Entity type - am I investing in a Limited Liability Company (LLC) or a C Corporation?
- Security type - am I investing in a convertible security (e.g. Convertible Note, SAFE) or in equity ownership (e.g. Common or Preferred Shares)?
- Federal tax write-offs - if investing in a C Corporation, does my investment qualify as Qualified Small Business Stock (QSBS) under Section 1202 and 1045, or a Small Business Corporation (SBC) under Section 1244? See our separate article that dives into more detail on these three US tax write-offs.
- State taxes - if investing in an LLC, will I need to file taxes at the state level in either the LLC’s state or my own? Are other state tax credits available?
- Taxable or retirement account - am I investing using a taxable account or non-taxable (or tax-deferred) retirement account?
Question 1: What type of entity am I investing in? LLC versus C Corporation
The first tax question that a startup investor should ask is whether the security being offered is an investment in an LLC or a C Corporation.
This applies whether you are a traditional angel investor investing under Regulation D (Reg D) or a non-accredited crowdfunding investor investing under Regulation Crowdfunding (Reg CF) or Regulation A (Reg A+).
For equity crowdfunding campaigns, the type of entity is easy to assess from the Form C filing or from the funding portal’s campaign page.
The reason investors should know this in advance is that LLCs taxed as partnerships must issue Schedule K-1 forms to all partners (i.e. investors who own equity). This is because LLCs are pass-through entities, meaning that taxes are “passed through” to the partners and handled at the level of each individual’s tax return. This can create taxable gains or losses for investors each year and can be a burden when accounting for multiple Schedule K-1s come tax time.
Because of these pass-through taxes, some Venture Capital (VC) firms are prohibited from investing in LLCs because they have tax-exempt Limited Partners (LPs) that can’t receive active trade or business income due to their tax-exempt status.
Another important reason that investors may only want to invest in C Corporations is because Section 1202, 1045, and 1244 tax write-offs are only applicable to certain C Corporation investments.
Question 2: What type of financial security am I investing in? Convertibles vs. Equity
Next, asking whether the security being offered is a convertible, such as a Convertible Note or SAFE, or equity, such as Common or Preferred shares, can help an investor determine whether to expect certain tax provisions to apply.
For Convertible Notes and SAFEs, since those investments are not considered equity ownership until conversion, investors are not able to take advantage of certain exemptions, such as 1202 tax-free gains on QSBS (see Question 3).
However, for investors who are concerned about investing in LLCs and receiving Schedule K-1 forms, the benefit of investing through a convertible security is that you will not receive a Schedule K-1, since you aren't an owner of equity in the company.
Question 3: Do I qualify for federal tax write-offs for startup investors? Section 1202, 1045, and 1244
The third question that every startup investor must ask is whether the investment is Qualified Small Business Stock (QSBS) under Section 1202 (gains) or Section 1045 (rollovers), or is a Small Business Corporation (SBC) under Section 1244 (losses).
Most investors in public stocks understand that when you buy and sell a stock, you pay a lower tax rate called long-term capital gains if the stock is held for longer than one year. While long-term capital gains still apply to startup investments, investors may be able to claim other special tax write-offs, which can be even better than long-term capital gains.
Special tax write-offs for startup investors include:
- Section 1202 - up to 100% exemption on QSBS gains, up to $10M or 10X cost basis (holding period: more than five years)
- Section 1045 - tax deferral of QSBS gains for rollovers into another QSBS investment made within 60 days (holding period: 6 months to 5 years)
- Section 1244 - write off SBC losses against ordinary income
For more details on each of the above tax exemptions, check out our article about the thee ways that the U.S. provides tax relief to startup investors.
While these three tax write-offs for startup investors cover federal taxes, there may also be tax implications at the state level.
Question 4: Will I owe any state taxes? State tax credits and non-resident state taxes
Another reason that some angel investors refuse to invest in LLCs is because investing in a partnership may trigger non-resident tax liabilities at the state level.
Again because LLCs are pass-through entities and taxes are handled on the individual’s tax return, this may require an investor to file a state tax return in the state that the LLC is registered in.
Some LLCs, such as my investments through the crowdfunding real estate company Fundrise (use my Fundrise referral link to get 90 days of no fees), may do a composite state tax filing. This essentially is a state tax filing by the LLC on behalf of the partners so you won’t have to file your own with the state. This can lessen the burden on investors, especially since most crowdfunding investors are only investing $100-$500 per deal and will likely have trivial amounts (in the single dollar range) on their Schedule K-1.
Another thing that may save smaller investors from having to file a non-resident state tax return is that the annual amount most retail investors would expect to get from an early-stage LLC should be less than most states' threshold for filing requirements.
Some examples of 2019 non-resident state filing thresholds are:
As you can see, each state’s non-resident filing requirements vary. Do a Google search for “non-resident filing requirements for [state]” to see what the limit is for the state where the LLC is located.
State Tax Credits for Angel Investors
After considering whether an LLC investment may trigger you to owe taxes at the state level, you should investigate whether you may qualify for state tax credits. These state tax credits are typically subject to minimum amounts (e.g. $25,000) and restrictions based on the business' location, your state of residence, and certain types of qualifying businesses.
Perform a Google search for “state tax credits angel investing [state]” or contact a local angel investing group to see what (if any) state tax credits might be available.
Question 5: Should I invest using a taxable or a non-taxable account?
Lastly, startup investors should realize that there are opportunities to invest using retirement account dollars in order to get tax-deferred or tax-free growth.
Services such as AltoIRA and RocketDollar provide self-directed retirement accounts to allow investors to diversify into alternative assets like startups. This means investors can take advantage of the potential tax saving capabilities of retirement accounts.
This can be a great option for retail investors who might not have a lot of disposable income or taxable investments but who contribute significant amounts to their retirement accounts.
As with any investment, startup investing is risky, so remember to only allocate a small portion of your portfolio to startups (many angels recommend 5%) and diversify your investments among many startups (at least 20 to start, but ideally 50+).
The Importance of Keeping Detailed Tax Records
Above all, you should keep detailed records of your startup investments. These records may not be needed for many years, but your future self (and CPA) will thank you for keeping detailed notes about key dates, QSBS qualifying criteria, and other details when and if you need them in 5-10 years.
While using spreadsheets and downloading PDFs can work for the novice investor when starting out, tax records and other investing notes can quickly get out of hand as the number of startups in your portfolio increases.
To help track all your startup investments in one place in a beautiful and easy-to-use interface, check out our VentureWallet portfolio management app.
Disclaimer This article is for informational purposes only. Nothing should be construed as legal, tax, or investment advice. Always consult with your professional tax, legal, or investment advisor.