Angel Investments: Capital Losses

Not all startups end with a successful exit. As a matter of fact, we know the vast majority of startups exit with a thud rather than a bang. While no one really likes to see an investment lose money there is a provision in the tax code to take a little sting out for investors of unsuccessful enterprises.

IRC Section 1244 is a provision in the tax code allowing stockholders of Qualified Small Businesses to treat part of your loss as an ordinary loss rather than a capital loss! How much? For married filing joint filers, you can claim up to $100,000 and for single filers you can claim up to $50,000!

Capital Gains versus Ordinary Income

Let’s put this in context. Under most instances when you have a loss as a stockholder you are able to claim it as a capital loss. If you own it for less than a year, it is a short-term loss and if you own it for more than a year it is a long-term capital loss.

For simplicity and brevity, I’m assuming everyone understands the rates and the way short-term and long-term positions affect each other.

Regardless, if your capital losses exceed your capital gains, you can use up to $3,000 as a capital loss to offset ordinary income and then carry forward the remainder, if there is any, to the following year. The loss carryforward can then be used to offset capital gains in that year.

So losses, as we’ve known them for some time, allow for up to $3,000 to offset ordinary income. But IRC Section 1244 allows married filing joint filers to claim up to $100,000 to be used to offset ordinary income (individual and head of household can claim up to $50,000).

That’s up to a $97,000 difference for those math challenged readers!

As you can see from Table 1 below, the top ordinary income tax bracket is 39.6% and the top capital gains tax bracket is 20%. In essence, being able to deduct up to $100,000 of losses as ordinary income (offsetting income taxed as high as 39.6%) is much more impactful than being able to offset capital gains (offsetting income taxed as high as 20%). I’ve excluded the new tax on unearned income for simplicity purposes.

Table 1: Taxable Income Tax Brackets    
Source: https://www.irs.gov/pub/irs-drop/rp-15-53.pdf
Tax RateSingleMarried Filing JointHead of HouseholdCapital Gains Rate
10%$0 - $9,275$0 – 18,550$0 - $13,2500%
15%$9,276 - $37,650$18,551 - $75,300$13,251 - $50,4000%
25%$37,651 - $91,150$75,301 - $151,900$50,401 - $130,15015%
28%$91,151 - $190,150$151,901 – $231,450$130,151 - $210,80015%
33%$190,151 - $413,350$231,451 - $413,350$210,801 - $413,35015%
35%$413,351 - $415,050$413,351 – $466,950$413,351 - $441,00015%
39.60%$415,051 +$466,951 +$441,000 +20%

 

Requirements

There are obviously necessary requirements for this special treatment.

1) At the time of issuance, the company was a small business corporation. The definition of a small business corporation means its aggregate capital can’t exceed $1,000,000 upon issuance of the stock. In the taxable year when aggregate capital exceeds $1,000,000 the company must designate which shares qualify;

2) Cash or other property was used to acquire the shares in the company and the stock must have been issued after July 18, 1984; and

3) For the most recent 5 years prior to the loss, the company must have generated at least 50% of its income from sources other than passive investment income (income excluding royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities).

Similarly, to Section 1202 and the capital gains exclusion, you must own actual stock – not a convertible note for this to qualify. Fortunately, preferred stock qualifies for Section 1244 treatment as long as it was issued after January 18, 1984.

Planning around Section 1244

Section 1244 limits who can claim the ordinary income loss to individuals, couples, and, in some instances, partnerships.

In order for an individual member of a partnership to make this claim, you need to have been a member of the partnership when the stock was acquired and stayed a member for the entire time the stock was owned.
As an added benefit, 1244 losses are treated as a trade or business loss for computing an individuals’ net operating loss (NOL). As a result, losses attributable to Section 1244 are allowed for NOL purposes without being limited to nonbusiness income. What does this mean?

Let’s assume I invest $100,000 into a C Corp making widgets in 2010. Five years later, in 2015, the business collapses and I lose all my money in it. At the same time, I quit my job in late 2014 and only had $25,000 of income for all of 2015. Since my stock is treated as a NOL, I can use $25,000 of the loss in 2015 AND carry-forward the remaining $75,000 of loss to the following year (technically you can carry it back for two years or carry it forward for up to 20 years). Pretty cool.

However, if I had invested $200,000 into the Widgets C Corp in 2010 while watching the business fail in 2015 and I had $500,000 of other income, I would only be able to use $100,000 of the loss to offset other income. The remaining $100,000 ($200,000 – $100,000) would be treated as a long-term capital loss and used to offset capital gains in the future. Any carry-forward for next year would simply be treated as capital loss.
With that being said, if I tried to sell my stock in the company for $50,000 in 2015, I’d be better off from a tax perspective to try to sell it over two years to maximize my tax benefit. Notwithstanding, selling failing, illiquid small business stock over two years may not be possible and the stock could be worth much less by waiting until the new tax year.

How to report?

Work with your accountant to properly report Section 1244 losses on Form 4797.

Summary

Obviously this can be pretty beneficial for investors in small businesses (e.g., angel investors). There are very few ways to reduce your adjusted gross income (AGI) these days but 1244 losses are one to maximize. The difference can be pretty compelling a $50,000 capital loss at a 20% capital gains tax rate would reduce taxes by $10,000 while a $50,000 ordinary income loss at a 39.6% income tax rate would reduce taxes by as much as $19,800.
Much like with Section 1202 gains (click here for my article on this), it’s important to work with your team to identify which investments qualify. Nonetheless, when investments unfortunately go bad, it’s important to maximize the tax impact of the loss. In this instance, IRC Section 1244 is likely your best bet.
For more information on losses described in IRC Section 1244, please click here.

*William Bissett is an Investment Advisor Representative with Secrest Blakey & Associates, a Registered Investment Adviser. Opinions expressed here do not necessarily reflect those of Secrest Blakey & Associates. The topics discussed and opinions given are not intended to address the specific needs of any reader.

**Secrest Blakey & Associates does not offer legal or tax advice, readers are encouraged to discuss their financial needs with the appropriate professional regarding your individual circumstance.

***Investments described herein may be speculative and may involve a substantial risk of loss. Interests may be offered only to persons who qualify as accredited investors under the Securities Act, and a Qualified Purchaser as defined in Section 2(a)(51)(A) under the Company Act or an eligible employee of the management company. There generally is no public market for the Interests. Prospective investors should particularly note that many factors affect performance, including changes in market conditions and interest rates, and other economic, political or financial developments. Past performance is not, and should not be construed as, indicative of future results.