August 5, 2016
Angel Investors – Are You Leaving Money on the Table?
Many of our clients have been fortunate enough to have invested in early stage companies who have ultimately done well. But as we all know, investments in start-ups can be very risky, even in times of economic growth. To encourage individuals to fund small businesses, the IRS provides a tax break when the stock purchased in certain companies doesn’t pan out.
The assets that will make you eligible for this break are called Section 1244 stocks (named after the corresponding section in the Internal Revenue Code). If you sell Section 1244 stock at a loss, or if it becomes worthless, you may be able to treat all or part of the loss as an ordinary loss rather than a capital loss on your tax return. Since capital gains are taxed at 20% and ordinary income is taxed at 39.6%, this can provide significant savings. In addition, the $3,000 limit on capital losses will not apply, so even if you have no capital gains, you will still be able to deduct your loss.
How do I know if my stock qualifies as 1244 stock? In order for stock to qualify as Section 1244 stock, the following criteria must be met:
- The stock must have been issued from a domestic (US) C corporation or S corporation.
- At the time the stock is issued, the corporation must have been a “small business corporation” (i.e., your investment must have been part of the first $1 million raised by the corporation).
- The corporation must derive more than 50% of its gross receipts from operating business income.
- The stock must have been issued only in return for money or property (as opposed to services).
The maximum amount that may be treated as a Section 1244 loss for any taxable year is $50,000 if filing as a single taxpayer or $100,000 if married filing jointly.
Here’s how it works:
Example – Angel Investor Adam earns $500,000 in wages and has no other capital gains or losses. He purchased Section 1244 stock for $50,000 a few years ago, and his investment was part of the first $1 million the company raised. The business did not work out and the stock is now worthless. If his $50,000 loss is treated as a capital loss, it will be limited to $3,000 for the year, making his taxable income $497,000 and his tax liability $140,000. However, since the stock qualifies under Section 1244, the $50,000 loss is treated as an ordinary loss and will offset his wage income. This decreases his income to $450,000, which in turn reduces his tax liability to $122,000. Angel Investor Adam saved $18,000 by reporting his Section 1244 stock loss.
We encourage our clients to take advantage of this excellent opportunity to reduce tax liability whenever possible. If you think you might have incurred a loss on Section 1244 stock, please feel free to contact us for more information.