Crowdfunding Tax Relief for Startup Investors

Did you know that 75% of venture-backed startups fail? The failure rate increases to around 90% for startups without venture capital to support operations. Without startup investors, there would be no innovation and higher failure rates, which is why the IRS has numerous provisions in place to provide much-needed tax relief for startup investors.

In this article, we’ll explore three key sections of the tax code and the type of relief they provide to startup investors.

Section 1202

Section 1202 provides tax-free gains on up to $10 million in gains or 10x the cost basis of qualifying stock held for at least five years. There are specific criteria that must be met to qualify, including:

  • The business is set up as a domestic C Corporation and is not a farm, hotel, mining company, restaurant, architecture firm, law firm, financial institution, or engineering firm.
  • The investment is comprised of common or preferred shares, not convertible notes.
  • You are the original purchaser of the stock.
  • The business’s gross assets never exceeded $50 million.
  • The company meets active business requirements, with at least 80% of assets used in operations.
  • The shares were acquired after September 27, 2010. Shares purchased before this date are subject to a lower exemption threshold.

Investors participating in startup activities can leverage this deduction to eliminate tax liabilities associated with appreciating business stock.

Section 1045

Section 1202 requires a five-year holding period to eliminate the tax liability. What happens if you hold a qualified stock for less than this period? This is where Section 1045 comes into play, allowing investors to rollover gains into another qualified investment. An election must be filed on your income tax return in the year of the conversion.

Let’s say you did a Section 1045 rollover after holding a qualifying company’s stock for two years. You then used the proceeds to invest in another qualifying stock. You only need to hold the second company’s stock for three years to meet the five-year holding period rule to take advantage of Section 1202.

Section 1244

The third exemption available to startup investors is found in Section 1244, which allows certain losses to net against ordinary income. Capital losses are limited to $3,000 per year, meaning it could take years to fully deduct a loss on an investment. Section 1244 bypasses the capital loss limitations and allows investors to write up to $50,000 (or $100,000 for joint filers) in losses against ordinary income. Here are the rules to qualify:

  • Stock is in a domestic C or S Corporation.
  • The stock was acquired by exchanging cash or property, not in return for services.
  • You are the original purchaser of the stock.
  • The stock was part of the first $1 million raised by the company.
  • At least 50% of a company’s gross receipts come from an active trade or business for the five years before the loss. Rents, royalties, and investment income are excluded.
  • The stock is not part of an investment or holding company.

To qualify for the Section 1244 deduction, accurate recordkeeping is required to identify which stock issuances are part of the first $1 million.

Summary

Each of these provisions states that convertible notes and simple agreements for future equity (SAFE) are not considered equity ownership in a company until they convert. However, these agreements will still qualify for long-term capital gain taxation, which can come at lower rates compared to your marginal tax bracket.

If you’re looking to take advantage of any of these sections of the tax code, it’s important to work with a qualified CPA. For more information or to determine your eligibility, reach out to Kislay Shah CPA PC at or 646-328-1326.