Zero Capital Gains Tax for Angel Investments, Available Today, How Important?

Just nine years ago during the NH primary, in our roles with the Portsmouth Chamber of Commerce and the eCoast Technology Roundtable, we had the pleasure of hosting presidential candidates discussing economic issues.  At one event, candidate Joe Lieberman turned to me saying “I’d like to have a zero capital gains rate on new investments in start-ups.  What would you think about that, George?”

Lest you forget, we were a few years into a recession at that time. “I’d really like to have some capital gains again,” I replied. “We can worry about how we tax them after that.”

Well frabjous day, today the rate is zero!  Among the tax extenders included in the American Tax Relief Act  (ATRA) passed by Congress on January 1st was a 100 percent exemption for gains made in Qualified Small Business Stock (QSBS).  Of course, the Jabberwock lurks in the details, see them below.

For perspective, we recently asked a number of well-informed angels about the importance of this tax incentive.

“The 100% exemption for gains made in QSBS has been (and remains) a primary pillar of the ACA and its Public Policy Committee,” says ACA President David Verrill.  “It was a main point that I made to Congress when invited last summer to testify about the Capital Gains rate before a rare joint hearing of the Senate Finance and House Ways and Means Committees.  ACA was an ever-present and loud voice in favor of the continued exemption during the recent "tax extenders" debate, and between ACA Executive Director Marianne Hudson, myself, and a dozen other members of the ACA Board we have been meeting with members of Congress to educate them about the benefits of this and other incentives (e.g. Federal Angel Tax Credit) to angel investors.”

 

“If there was a 25% federal tax credit up front, I'd sure invest more - about 25% more as a matter of fact!” continues Verrill, who invests with the Hub Angels. “On QSBS, if we have a company stock that could "delay" their exit by some reasonably short period of time, without meaningfully impacting the price, to hit the 5-year hurdle, why wouldn't we do that?  Now if the holding period was, say, 2 years instead of 5, then I think lots more people would be aware of and use the tax credit more.  ACA is suggesting a couple tweaks to so-called 1202, but the wheels in Washington move slowly - in case you hadn't noticed.”

Strongly supporting the tax incentive was Bill Swiggart of the Beacon Angels. “I've been a start-up lawyer since joining the Massachusetts Bar in 1982, when I incorporated Blue Lion Software in Massachusetts. It made computer games, and its premier game was sold to Spinnaker, an early game maker and vendor, a few years later.

“According to the records at the TaxPolicy Center,   the federal capital gains taxes, cut under Reagan from 40% to 28% 1979, and then to 20% in 1981, increased back to 28%-29% during 1987-1997. Speaking from my experience as a start-up attorney, I can tell you that this latter period corresponded quite closely with a period during which my clients experienced a much greater level of difficulty in raising funding for new ventures.

“More recently, cutting rates to 16% in 2003 did open the floodgates for the growth up new start-ups, and also that of organized angel groups. I formed my own group, Beacon Angels, in 2006, with 26 or so new members at our first meeting in Boston in a reflection of that trend. Therefore, it is my take that the start-up and angel communities in the United States really dodged a bullet when the ATRA only increased capital gains rates generally to 20% instead of the much higher level pushed by Obama.”

More reserved in his enthusiasm was Jeffrey Sohl, Director of the Center for Venture Research at UNH. “They certainly can’t hurt but the real question is will these tax incentives actually stimulate investment or would the investments have been made anyway (sort of like the failed housing stimulus which all it really did was just to shift demand by a few months).  If you ask anyone if they want a tax break the answer is almost always yes, but the real issue is if the particular monetary policy will accomplish what it is intended to.  So my opinion – this may help with those investments “on the margin” but if an angel sees a good deal she will likely invest whether or not there is a capital gains incentive.  The key here is that this policy really does not change the risk/reward evaluation since in order the get the benefit the investment must realize a capital gain (and after at least a 5 year holding period) and we all know how difficult that can be.”

Some other opinions.

Joe DiMartino,  Managing Director of the  Angel Investor Forum: “The Connecticut State incentive, a 25% credit, does have an impact, but a minor one. It isn’t a huge influencer.”

Paul Silva, River Valley Investors: “The psychological effect is important.  It’s not a deal maker or breaker.”

Jean Hammond, Golden Seeds: “It helps new angels to ante up that first check.”

Sandra Stone, Maine Angels: “Maine had a 60% seed capital tax credit for companies accepted into the program, which increased interest and caused people to invest larger amounts than they might otherwise have put at risk.  The credit capped out at $30M in Jan 2013, and our numbers are way off now. By the end of March last year, we’d invested $790K, and this year only $75K ($50K was the last of the tax credit!).”

Notice that although we started out discussing federal taxes, the conversation quickly segued into state issues. Probably a good shift, since that exposes us to more programs, more results, and more opportunities.

Any list of states where angel investors are most active would include California, New York and Massachusetts near the top. Any list of states with the highest rates of taxation would include California and New York, with Taxachusetts striving mightily to reclaim its historical place. So what might we conclude?

Angel investors are drawn to locations where opportunities are high rather than where taxes are low. Why? Who knows for sure? Maybe because they already live there.

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Zero Capital Gains Tax for Qualified Angel Investments  as provided by the Angel Capital Association Public Policy Advisory Council.

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Among the “tax extenders” included in the American Tax Relief Act passed by Congress on January 1st to avoid the “fiscal cliff” was a 100 percent exemption for gains made in Qualified Small Business Stock. Effectively this means that you pay no taxes on gains from your investments that meet several criteria and the Alternative Minimum Tax does not apply for investments made in 2013 and in 2012 (so it is retroactive).

We want to make sure angels and small businesses are aware of this tax advantage, which is designed to increase investment in the innovative startups that create jobs in America. If you are interested in this program, PLEASE TALK TO YOUR ACCOUNTANT to ensure you have all the information you need to structure your investments to meet all requirements.

Criteria and Limitations for Qualified Small Business Stock:

• Investments must be made by a non-corporate investor (for example, individuals or funds structured as LLCs).
• Investments must be made between January 1, 2012 and December 31, 2013 to qualify for no taxes on the gains.
• The company in which the angels invest must be a C corporation and must be a qualifying type of business (many businesses except financial institutions, farms, professional service firms, hotels, and restaurants)
• The company in which you invest must not exceed $50 million in aggregate gross assets at any time before the investment or immediately afterward. An important issue in this size is that 80% of the assets must be used in the "active conduct" of the business at all times.
• The stock must be purchased by the investor as an original issuance from the corporation, directly or through an underwriter. So, notes and warrants do not count. We're hearing that if you have an outstanding note that converts to stock before December 31st, then the stock would count for this program. (BUT TALK TO YOUR ACCOUNTANT.)
• The stock must be held for more than five years (subject to exemptions for qualifying tax-free rollovers)
• There are limitations on redeeming shares of the company's stock before and after the qualified stock is issued.
• The gains eligible for the zero taxes by any single taxpayer max out at $10 million or ten times the adjusted tax basis of stock issued by the stock
• The gains are also not subject to the Alternative Minimum Tax.

ACA recommends a full review of the legislation with your tax counsel to understand this provision and others that may or may not affect individual angels.

ACA will work this year to extend this 100% exemption in the future, or make it permanent. This seems possible, as there is bi-partisan support for it in Congress, particularly in the Startup Act 3.0.  We are also interested improving the 1202 regulations so that some of the criteria and limitations listed here go away.  You can see a full list of our recommended fixes here.

The description above of the current tax law is drawn from the recently established Angel Insights Blog, which features  commentary on startup investment trends, the latest on public policy affecting entrepreneurial investment, and other topics top of mind to active accredited investors.

 

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