Taxes and start-ups. Do entrepreneurs or investors in early-stage companies even care about taxes? Well, right now taxes are on the minds of many investors because of the recent increase in tax rates. However, while taxes went up significantly for most investments, taxes for start-up investments just dropped like a rock… all the way down to zero! In an MBA class that I teach, we call this Tax Nirvana.
Although no investor is going to decide to bankroll a start-up just because of tax benefits, taxes do matter to them. And, if you are an entrepreneur searching for capital, you want to give potential investors every reason in the world to say yes. What could be a better excuse than avoiding taxes?
Starting this past January 1st, taxes on investment income were bumped up significantly for most investments. As one example, let’s say that a few years ago you had invested Apple’s stock (AAPL) and are sitting on some healthy gains. Now you are getting a little antsy about Apple’s prospects. If you sold Apple’s stock last fall, your tax rate on the capital gains would have been no higher than 15%. However, after January 1st the tax rate for some investors has increased to 20%, plus the gains are now subject to a 3.8% Medicare surcharge. This makes the new tax rate 23.8% -- a whopping 59% increase.
But, start-up taxes went in the opposite direction. As part of the recent ‘American Taxpayer Relief Act of 2012’, capital gains on most early stage investments are effectively ZERO because the investment gains are excluded from income. Frankly, it feels like a bit of a joke that the government used the word ‘Relief’ in the title of a tax bill that raised taxes. That said, start-up investors did receive real relief.
From a tax perspective, how much better is a start-up investment relative to other typical investments?
This special tax provision is called ‘Qualified Small Business Stock’, and it has been around for many years in various forms. The two important criteria for start-ups are that they (i) must be a C corporation, and (ii) must have less than $50 million in assets when the investment is made.
It gets even better…. in addition to avoiding federal income tax, investors also do not pay any state income tax. How? Due to the manner in which this tax provision works, the investment gains on start-ups are completely excluded in calculating federal income, and therefore none of the gains are passed through to the state tax return.
Start-up Tax Nirvana does have a few restrictions and limitations. An investor can only exclude up to $10 million in gains or a 10X return, whichever is greater. Then again, no one is going to complain at a $10 million gain or 10X return. In addition, the stock must be held for at least five years by the investor.
As a start-up entrepreneur, is there anything that you must do to get your company to qualify? No. As long as you are a C corp tax-payer, just complete your regular annual tax return and be sure to list the amount of company assets. The tax return already asks for this information.
These favorable tax rules have only been extended through Jan 1st, 2014, but any investments this year will permanently qualify.
Enjoy start-up Tax Nirvana while it lasts.
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