Two seldom discussed rules in the Internal Revenue Code afford early investors some tax benefits they may not be aware of. One deals with gains on an exit transaction, and the other deals with losses should your investment not materialize successfully.
Losses: 1244 Stock
Section 1244 of the Internal Revenue Code allows certain investors that have purchased stock in qualified small businesses the ability to take a portion of their loss as an ordinary loss versus a capital loss. This is beneficial to most taxpayers due to the fact that ordinary losses can offset ordinary income, such as W-2 earnings, self employment income and other income such as interest and dividends. Ordinary income is generally taxed at higher rates for most higher earning individuals, so the ability to take an ordinary loss is tremendously beneficial.
If your investment qualifies, up to $50,000 or $100,000 (if married filing jointly) of a loss can be treated as an ordinary loss. To qualify, your investment must be in 1) a “small business;” 2) stock issued for cash or other property (not services!); and 3) the company derived more than 50% of its revenue in the last 5 years from an active trade and not items such as interest, dividends or royalties. A small business is one that has not raised more than $1,000,000 for its stock at the time of investment and is a domestic Corporation. If a Corporation raises $2 million in a raise, the Corporation can designate the first million dollars as 1244 stock. It is important the Company earmark this stock at the time of investment.
Gains: 1202 Stock
Section 1202 of the Internal Revenue Code deals with a gain on a stock sale. If your investment qualifies for 1202 treatment, up to 100% of the gain could be excluded up to the greater of $10,000,000 or 10 times your investment. To qualify, this stock must 1) be a domestic C Corporation from inception; 2) the gross assets of the Company must be under $50 million at the time the investment is made; and 3) the stock can be issued for cash, property, or services. The Corporation must again be an active business versus an investment business or one similar to a service business such as a law firm. You must hold the stock for at least five years.
The percentage of your gain excluded depends on when you acquired the qualifying stock. If you became an investor between February 17, 2009 and September 27, 2010, your exclusion percentage is 75% of the gain. If you became an investor after September 27, 2010, the exclusion is 100%. After this date, the exclusion percentage is currently back down to 50%. The alternative minimum tax (AMT) will apply to stock acquired in 2014 and beyond on those sales as well as the new net investment income tax (3.8%) on gains above the exclusion amount. For AMT purposes 7% of the excluded gain must be included as a tax preference item if your exclusion is not 100%. So, for example, if you are subject to a 50% exclusion, 53.5% of the gain must be included as taxable income for AMT purposes, which effectively taxes you at an AMT rate of either 14% or 15%, depending on your tax bracket.
These rules are quite complicated and their application to your situation may or may not work depending on your particular investment and when you acquired and sold your shares. You should contact your tax advisor for further discussions if you believe you could potentially qualify.
This article was updated January 29, 2018.
Jeffrey D. Solomon is the Managing Partner of Katz, Nannis + Solomon, PC. The firm is now ranked one of the Top 25 CPA firms in Massachusetts and its emerging business group has grown to be a true leader in Massachusetts. Jeff can be reached at firstname.lastname@example.org.