In the United States, funding that startups raise is not generally taxable. This includes startups that raise equity (like venture capital, angel or seed funding) or debt or venture debt - the corporation raising the capital should not pay taxes on the funding raised.
This is not the same as sales of equity by founders and business owners - this will very likely trigger capital gains taxes owed by the person selling the equity. So, if a founder sells shares (either directly to a VC or to the company to the VC) there is likely to be a taxable event. Founders selling shares should consult with their personal tax advisors; in fact, it’s best to consult with them several years in advance as there are some advanced tax strategies that should be considered to safely minimize how much money is owed to the government. In general, money coming out of a C-Corp to owners/founders, regardless of its source, will likely trigger some taxes.
NOTE: our firm, Kruze Consulting, does not provide personal tax advice, we only serve VC-backed Delaware C-corporations.
From the startup’s perspective, the investment is booked onto the balance sheet
Equity sales by the startup to investors should be booked as Equity on the Balance Sheet - read our guide on accounting for equity investments here. Convertible Notes should be booked as Short Term or Long Term Debt on the Balance Sheet. SAFEs are booked as equity as well.
From an investor’s perspective, venture capital investment taxation gets more interesting
Tax Implications of VC Investments
Capital Gains and Losses
From the VC’s perspective, VC investments are primarily subject to capital gains tax. When a VC invests in a startup and later exits at a higher valuation (through an IPO, acquisition, or another liquidity event), the profit is considered a capital gain, taxable at capital gains rates. The rate that the IRS will assess depends on the holding period: generally, investments held for more than a year qualify for long-term capital gains tax, which is lower than short-term rates.
Offset of Capital Gains with Capital Losses
When a VC-backed company fails, the invested capital can be claimed as a capital loss. This is why many VCs will push founders of failed startups for paperwork certifying that the company has failed. These losses can offset capital gains from other investments, reducing the overall tax liability. For instance, if a VC firm gains $5 million from one startup but incurs a $2 million loss in another, the taxable gain is only $3 million.
Qualified Small Business Stock (QSBS) exclusion
One of the most significant tax advantages for VC investors is the QSBS exclusion. Investing in Qualified Small Business Stock offers the opportunity to exclude a substantial portion of capital gains from federal taxes, subject to certain conditions. We have an entire article on QSBS.
State level exemptions
To foster a supportive environment for early-stage companies, several states have implemented incentives aimed at encouraging angel investments. These incentives are designed to attract more investors into the startup ecosystem, recognizing the crucial role they play in driving innovation and economic growth.
Naturally, California, the state leading in angel investments, surprisingly does not offer this credit.
The specifics of angel tax credits, including eligibility criteria, credit rates, and maximum credit limits, differ across states. Generally, states provide a credit rate between 20-30% of the invested amount. The upper limit for these credits usually falls between $50,000 to $250,000 annually. Again, these are focused on encouraging investors to deploy early-stage capital into specific regions/states. Check with your personal CPA to learn more; we are not experts on personal taxation.
Other questions on startup capital; these are focused on Delaware C-Corporations, which is the most common corporate structure that VCs like to invest in:
Do Startups Need to Produce K-1’s for Their Investors?
A startup that is a Delaware C-Corp that has raised venture funding from professional venture funds in the US does not need to produce K-1’s for their investors. We do see that sometimes angel or individual investors who participate in a venture round led by professional VCs ask our startup founders if they are going to get a K-1, and we have to reassure them that the answer is no. However, it’s always best to consult a qualified tax professional, because other types of entities like partnerships or LLCs will likely have to produce K-1s.
What Tax Documents do VCs Produce for Their Investors?
Venture funds produce tax forms for their investors, such as Schedule K-1. Schedule K-1 is a tax form that venture funds use to report the investor’s share of income, deductions, credits, and other items. It provides detailed information about the investor’s share of the fund’s income and expenses, which is then reported on the investor’s individual tax return. This form is typically issued to investors by the venture fund each year, usually by March 15th. Of course, we’ve found that most VCs are much slower to produce these documents. It is important for investors to include the information from Schedule K-1 when filing their personal tax returns to ensure accurate reporting of their investment income.
Is Startup Capital Taxable?
Startup capital itself is not typically considered taxable income; this assumes the capital goes onto the company’s balance sheet and is used to fund the company’s operations and growth. It’s viewed as an investment into the business rather than revenue. However, how this capital is used can have tax implications. For instance, if the capital is used to purchase taxable goods or services, then those transactions may be subject to tax. Or if the capital is used to pay the founders, this transaction would be subject to capital gains taxes.
Do Startups Pay Taxes on Investments?
Startups generally do not pay taxes on the money they receive from investments. These funds are considered capital contributions used to grow the business, not as taxable income. But startups must be mindful of other tax obligations that arise as they operate and grow. Additionally, if startups make investments into other companies - as in the startup has a corporate venture capital function that buys equity in other companies - those investment activities may have tax implications. Consult with an accountant.
Is Seed Funding Taxable?
Seed funding, similar to other forms of investment capital, should not be taxable when received. It is an investment in your company and does not count as income. However, the way these funds are utilized can lead to taxable events depending on the business activities involved.
Venture Capital Tax: What Should Startups Know?
While receiving venture capital is not a taxable event to the startup, the influx of funds can lead to other tax considerations. It’s important for startups to understand that subsequent financial activities, such as paying employees or purchasing equipment, may have tax implications.
Tax on Startup Investment: What Are the Basics?
The investment funds a startup receives and puts on the balance sheet should not be subject to income tax under normal circumstances. However, the use of these funds in business operations can lead to tax liabilities. It’s crucial for startups to understand and plan for potential taxes related to their business expenses. Note that cash flowing out of a C-Corp and into a founder’s pocket should be taxable.
