While sometimes it may feel like you’re giving money to charity as an angel investor, that’s not how it works for tax purposes. Money you invest as an angel investor is not tax deductible like a charitable gift. It’s more complicated.
Angel investing is the heart and soul of the startup/venture capital ecosystem. The reason people do it is that when you invest in a good company early at a very low valuation, you can make lots of money if the company goes to an IPO or gets acquired for a big valuation. But not every company is a success. And angel investors end up losing money on some companies. The gains on successful companies will hopefully more than balance out losses on others, and the process continues.
Applying taxes to angel investing
So how do taxes figure into that process? Let’s start with some high-level background. People make money in two ways: ordinary income, from wages or interest; and capital gains, where you sell something for more than you paid for it. Both of those sources of money are taxable, at different rates, through income taxes and capital gains taxes.
Angel investing falls into the second category. If you invest in a startup, and it gets sold, and your share is worth a lot more money than you paid, you’ll pay capital gains taxes on that amount. What happens when you lose money, though? Well, in those instances your loss is tax deductible. You’re generally allowed to use those capital losses to offset any capital gains.
To look at a simple example: An angel investor puts $1 million in two different startups. Startup A fails, is shut down, and the $1 million is lost. Startup B is successful, and the angel investor receives $2 million from the company’s sale. The investor owes no capital gains – the $1 million loss on the unsuccessful startup offsets the $1 million capital gain on the successful startup. Or to look at it another way, the angel investor started with $2 million and ended with the same amount. No capital gains taxes are due.
What’s the advantage of angel investments?
But that’s not really why people make angel investments. Angel investors hope for large gains, but capital gains generate taxes. If Startup B is sold and the investor receives $10 million, the investor now owes capital gains tax on $8 million [$10 million - ($1 million initial investment + $1 million capital loss on Startup A)].
The most common tax benefit for angel investors - QSBS
There is also a tax benefit for investors who buy qualified small business stock (QSBS) which can help investors shield up to $10 million in capital gains in some circumstances. You can read more about QSBS here. The basic summary is that if the startup - and you, the investor - meet some very specific qualifications you may be able to avoid some serious capital gains at the federal level.
Typically angel investors invest in several different startups hoping that one or two will be successful. The ones that aren’t successful create capital losses that are tax deductible, and those can be used to offset gains on the companies that are thriving. Your accountant may need you to provide proof that a company shut down and didn’t make it.
Kruze is an expert at startup corporate taxation. If you have more questions about angel investing or how it impacts your taxes, let us know, we’d love to refer you out to a CPA who is an expert (but note that it’s NOT us, we stay focused on corporate taxes.) If you want to learn more about taxes and early-stage startups, visit our startup tax return page.