News & Insights

As we celebrate South Carolina angel investing tax credit transfer season (among other things), we found this report on the SC Dept of Revenue’s website here (under Publications / Reports / Additional Reports) about who applied for the credit in 2021. We thought you might enjoy reviewing it with us. The maximum $5M of credits were awarded in 2021. (We noted that here, when the award letters revealed a 30% credit, indicating $5.78M of valid credit applications.) These data tell us (I think for the first time) where those awardees came from, and raises a few interesting questions. South Carolina Most credits were awarded to people in South Carolina – $3.37M, or 67% of the total awards. Not a great surprise: South Carolinians are naturally the most likely to be making angel investments in South Carolina companies. Maybe surprising, though, is Greenville County’s total dominance here. Over half (58%) of the credits to South Carolina locations, or 39% of all the awards, were in Greenville. Charleston was a distant second at 14% overall, and Columbia (Richland and Lexington counties combined) only just over 2%. Does that reflect a more vibrant tech community in Greenville? More knowledgeable angel investors? Another possible explanation is more “wholesale” applicants in Greenville, which we have thought in the past used up large amounts of credits – but the average award in Greenville ($43k) is lower than in Charleston ($70k), so that does not seem to be it. Whatever the reason for Greenville’s lead, it is not a small difference! Not South Carolina Equally interesting (at least to us) is the location of non-SC investors. First, it’s surprising how few credits went to direct neighbors – just 4% from North Carolina and essentially nothing (0.3%) from Georgia. Apparently, it remains difficult to attract investors up or down I-85! Second, Virginia posts an impressive showing, and especially the coast – almost 12% of the total awards, and over 1/3 of all out-of-state investors. Could that be because there’s an excellent angel group there (and a VentureSouth group)? Or because Virginia has an angel tax credit of its own so people are more familiar? Third, New England (MA, CT, NH, NY) has more awards at 8% than the southeast (excluding SC, so NC, GA, FL, TN). Areas with well-established early stage investing ecosystems create investors that become more willing to invest anywhere – if you give them compelling investment opportunities and structures. Or perhaps simply everyone from New England is moving to South Carolina… And lastly, notably absent are credits to any west coast locations. California usually dominates angel investing and venture capital statistics, but not in this report! Are west coast investors simply not willing to look this far afield for early stage investments? Maybe this data illuminates academic studies like this one on the importance and use of angel tax credits. Whatever the reason, it’s their loss! Just one more thing One last interesting note is how many applications were denied. Of the 138 applications sent in, only 123 were approved – meaning more than 10% of applications people thought would get a credit ultimately did not. Given the challenges on paperwork timing, this is a lower rejection rate than I would have guessed – but still disappointing if you’re part of the 10%. Make sure the company is properly qualified before you invest. And if you are applying for a credit on investments made in 2022, make sure your applications are submitted before the end of the year! More guide here. Happy Thanksgiving and Happy Investing.

An overlooked attraction of angel investing, compared to most other asset classes, are the fun tax rules around gains and losses on early stage investing. Sounds odd, but it’s true. As we discussed in our guide to angel taxes, the gains from angel investing are often tax free – thanks to the Dabo of the tax code. Following a lucrative 2021 for VentureSouth members, we have spent much of the last few weeks explaining to investors the tax consequences of their exits. We thought it might be useful to share a case study on a recent exit, as it covers the range of tax implications described in the guide. VentureSouth members made five investments in a company, as follows:priced preferred equity seed round in 2015a small purchase of common stock from a departing cofounder in 2017a convertible note in 2017; this note converted into the next round of equity in August 2018priced preferred equity Series A-1 round in 2018, and a further priced preferred equity Series A-2 round in 2029…and exited when a purchaser acquired our shares in 2021. Sounds complicated, but this is a typical journey for an early-stage investor. Each of these rounds is an interesting angel investing tax scenario, so let’s take them one by one. 1) Priced equity held more than 5 years We’ll start with the best. This first round was an investment in Qualified Small Business Stock (“QSBS”), as a a C-Corp running a real business with less than $50M in assets. This is the “base case,” a typical angel investment in a southeastern deal. As QSBS stock held for over five years, gains on this stock are exempt from capital gains taxes. (There are, of course, some limitations, like a max gain of 10x or $10M. There are also more…creative… methods (“stacking”, “packing”, and of course “peanut buttering” discussed here), which do not really apply to angel investors but make for interesting reading.) So the gains on this investment were tax free for our members. Not only was this the best pre-tax return (earliest money in, at the lowest price, so the largest gain); the returns are entirely tax free. What more could you ask for? 2) A purchase of founder’s common stock The next round was a similarly strong pre-tax return, but had a less favorable tax impact. QSBS only applies to newly-issued shares in a company. If you buy existing shares – as in this case where common stock shares held by a founder were purchased in a “secondary transaction,” or more generally, like when you buy shares in a public company – QSBS does not apply. QSBS is designed to encourage new investment. While active and liquid secondary markets make investing more appealing – it’s more palatable to buy stock (and found companies) if you can sell that stock one day – QSBS is focused on rewarding new funding of startup companies, and so is limited to newly-issued shares. Even without the benefits of QSBS, though, this is still fairly appealing as a long-term capital gain taxed at capital gain tax rates. 3) Later priced equity rounds held for less than five years Let’s disrupt the timeline by next tackling #4, the two recent priced equity rounds. Both these investments were QSBS: still a C-Corp with less than $50M in assets, still operating, selling newly-issued shares. So you might think QSBS / Section 1202 / Dabo applies. Unfortunately (from a tax perspective), this was, fortunately (from an IRR perspective), a quick win, with capital deployed and returned within five years. That means the stock was not held long enough to get the Section 1202 exemption. The good news, though, is that these proceeds are eligible for “rollover” under Section 1045 of the tax code. If the proceeds are redeployed into new QSBS within 60 days, no capital gains tax is due on the gains. Investors then face the decision: do we bank the proceeds (and pay long-term capital gains tax on the gain); or do we “roll the dice again” by reinvesting the proceeds into one or more (sensibly: more) QSBS companies? Letting tax treatment determine your investing has the tail wagging the dog, but recognizing the net, post-tax returns is a critical part of investing successfully. 4) The convertible note round The most complicated round of all is the convertible note round in the middle. If you’re familiar with VentureSouth’s soapbox, you know we are generally not fans of convertible notes. One reasons is taxes. The original investment in the convertible note was not into stock of a C-Corp, so QSBS doesn’t apply. The QSBS “clock” only starts when the note converts – which in this case was several months later, which is typical. There are other complications too. How much of the “gain” here was from the accrued interest on the convertible note (taxable as interest?)? How much came at the conversion event? How much should each be taxed? This is a bit beyond the scope of this post, but let’s just say the tax treatment might be murkier on notes than on priced equity. As one hypothetical, notice that if the exit had been in January 2022, a priced round in December 2016 would have been capital gains tax free under Section 1202, but a convertible note at the same time (but that converted in June 2017) would not. (It would have been Section 1045 rolloverable based on the date of conversion, which is good, but it ties up capital for more than six years total to get the treatment you might have received after five. Not so ideal. And no guarantee that the rolled-over money would not be written off!) Not a bad outcome, of course, but one tangible example of where equity would’ve been better (post taxes) and simpler than a note. To sum up: One company, five rounds, four different tax treatments. Fun stuff we hope you agree! We think VentureSouth members benefit from having access to early stage, QSBS-eligible deals; from a steady supply of Section 1045 rollover-eligible companies so eligible proceeds can be reinvested within 60 days; and a full-time team who love explaining the tax implications of investing before and after the investment. Perhaps you will join us for the next one! PS – Section 1045 in action! As an interesting aside, some of our members invested into this company using proceeds from a successful exit of another VentureSouth portfolio company. The prior exit was from a QSBS company held less than five years, and so the proceeds from that exit were eligible for rollover under Section 1045. The successful investors took those proceeds, redeployed them into Company A, and made a further multiple of gain on them. First company was held for two years; second held for three; added together they passed the five years required for QSBS to apply – so all the gains became capital gains tax free. This is Section 1045 working exactly as advertised!  Double win.

June has been busy at VentureSouth so blogging has been light, but we hate to leave gaps between posts about taxes so here’s a second to follow the renewal of the South Carolina angel investor tax credit earlier this month.As you hopefully know, several tax deadlines were extended – notably tax day moving from April 15th to July 15th – in response to the pandemic. But you may not know that the Section 1045 rollover window was lengthened too.What does that mean and why does it matter?First, back in our posts about angel investment tax issues, especially this one about Section 1045, we explained how you can defer (and eventually eliminate) capital gains from successful angel investment if you “rollover” proceeds into other investments. You have 60 days from the exit to make a rollover, so finding a suitable deal at the right time can be hard. (Unless you’re a member of an angel group with reliable deal flow, of course.)The COVID rule change extended the rollover period. If your investment reached a successful exit in February or March, the roll-over deadline should have been in April or May. After the extension, the deadline for rollovers was pushed out to July 15 (or later if the 60-day window would be later anyway).So if you were an investor in any recent angel deal exit and just realized you could avoid capital gains by doing a Section 1045 rollover:Go discuss with your tax advisor now!Find an interesting deal to roll proceeds into. Give us a call: we have plenty of open rounds under review. The tax savings will surely more than cover your VentureSouth membership!Takeaway:Taxpayers have until July 15, 2020 to complete the Section 1045 rollover if the 60-day deadline was on or after April 1 and before July 15.Don’t have any relevant deals? Give us a call, we know some people.

So to recap:Angel investments aim to generate cap gains (which is better than ordinary income)Frequently, those gains are totally exempt from capital gains under Section 1202 (which is better than pretty much every other asset you can invest in ).If they’re not exempt, maybe they can be rolled-over under Section 1045 and eventually become exempt.If things go badly, the capital gain loss might become an ordinary loss under Section 1244 (which is a silver lining!).Don’t forget to factor in state angel tax credits in some cases, LLC passthrough losses in others.After all that, you “net down” to an asset class where taxes have a much lower smaller impact on pre-tax investment returns than in many other assets.Hopefully after these posts you’re now confused enough to (a) consult a professional tax advisor and (b) add a few early stage investments to your portfolio!Any questions?

You hopefully noticed that the really great benefits of Section 1202 and Section 1045 were focused on C-Corps. They don’t apply if you invest in an LLC. Do LLCs have some alternative benefits? Yes, they do: pass-through losses.As quick background:An LLC is a “passthrough entity,” which means that the LLC itself files tax returns but doesn’t pay any taxes; the individual “members” (the shareholders) do instead. If the company makes or loses money, the profit or loss leads to taxes the members have to deal with, not the company.Startup companies generally lose money. Initially this is deliberate; later on, perhaps less deliberate but making money is hard.So when you invest in an LLC, there’s a good chance you will be “passed” a loss to deal with in your tax affairs. That is (counter-intuitively perhaps) good news: investors can use those losses to reduce the ordinary income they have to pay (ordinary income) taxes on. (And remember that reducing ordinary income is better, because of the higher ordinary income tax rate.) They can also do it today, rather than this loss being stuck inside a C-Corp forever.(Notice the similarity to passing on of depreciation costs in real estate investing…)Some people invest in LLC just for this benefit.

Yes, there are some limits on Section 1244 losses. The $50k / $100k is one. Another is that it only applies to the first $1M that went into a company.This is almost always true of “family and friends” money; it’s often true of the angel rounds; it’s generally not true of later stage, venture capital rounds. Angels > Venture Capital here.It can be complicated on angel rounds too. How do you figure out who can take this benefit if, say, the $500k angel round represents the $750,000-$1,250,000 dollars into a company?  Good record keeping, thorough understanding of the company’s cap table, being the lead investor and first funders in a round – all helps to make sure you get the benefit in these situations.

Section 1244 gets even shinier.In usual capital loss situations, you really need capital gains to offset the losses against, because you can only take up to $3,000 in net capital loss in a given year. (You roll forward the rest to future years).But under Section 1244, you don’t need capital gains to offset things against – you need ordinary income. Generally people have more of that, from work, interest income, and more liquid investments.But here’s the extra benefit: you don’t even need that! You can take up to $50,000 in net ordinary loss in a given year (for a single filer; $100k if you are married-filing-jointly).No-one likes to lose money on angel deals – but if you do Section 1244 makes your life a little better than if you had lost the same money on something else.

The “silver lining” from the last post of being able to write off the capital loss against other capital gains was a dull, scuffed silver. Today’s silver lining, called Section 1244, is a burnished, luminous, refulgent gleaming silver.Section 1244 of the tax code (primary source here as usual) says that a capital loss on a small business stock can be treated as an ordinary income loss if the loss was on the first $1M invested in the company.What does that mean? Recall back to the first post in this series: two types of income – ordinary income and capital gains; two corresponding tax rates – ordinary income rates and capital gains rates, with ordinary income rates being higher.Section 1244 says you can consider the capital losses to be ordinary losses. Why does that matter? Because the tax rates on ordinary income are higher, and so it’s better for you to reduce your ordinary income rather than your capital gains, if you can.In numerical form, consider this scenario: you earn $5,000 in ordinary income from your work, and make two $5,000 investments, where one returns 3x and one is a total loss.Scenario 1: consider the loss a capital loss.Ordinary income: $5,000Tax you owe on that (assuming a 37% ordinary tax rate) = $1,950Net capital gain is $5,000 ($10,000 net gain on the first investment, minus $5,000 capital loss on the second)Tax you own on that (assuming a 20% capital gain rate) = $1,000Total “income” = $20,000; total taxes paid $2,950Scenario 2: consider the loss an ordinary loss.Ordinary income: $5,000 less ordinary loss from investment #2 of $5,000) = $0 incomeTax you owe on that (assuming a 39% ordinary tax rate) = $0Net capital gain is $10,000 (net gain on the first investmentTax you own on that (assuming a 20% capital gain rate) = $2,000Total “income” = $20,000; total taxes paid $2,000You don’t have to use a spreadsheet to see that scenario #2 is better. Enjoy that extra $950 in your pocket.

The angel taxes posts in this series so far have covered when angel investing goes well. What about when things go wrong?In general, if you lose money on an investment, you can offset that “capital loss” against a capital gain you have from something else.For example, you make two $5,000 investments through VentureSouth, double your money on one, lose everything on the other. Your gain is $5,000 on the winner ($10,000-$5,000), and your loss of $5,000 on the loser. You pay taxes on the net gain – so no capital gains are due because the net result was getting your money back.That’s good news (relatively speaking), but again true of any investments that generate capital gains and losses, not just angel investments in early stage companies. Does angel investing have any extra benefits here? Of course it does: come back tomorrow to learn more…

You made a $5,000 investment (in a QSBS C-Corp) through VentureSouth in 2016 and we sent you back $45,000 for the capital gain in 2018. What tax do you owe?If you’ve followed the last posts, you should have enough information to say “I hoped it would get the Section 1202 exclusion, but because the hold period was less than five years I pay capital gains tax on the gain.”And with numbers, assuming again you’re in the top bracket and simplifying a little, you pay {$45,000 minus $5,000} * 20% = $8,000.You could be right, but, like a (very niche) Choose Your Own Adventure book, you should go to Section 1045 of the tax code now.Section 1045 (primary source here again) basically says that instead of paying gains you can “roll the proceeds over” into new QSBS and therefore defer paying taxes on them. If the total hold period exceeds five years, the Section 1202 exemption applies to all the gains.To unpack that a little:Let’s say I take my $45,000 of proceeds and use it to make another basic angel investment in a QSBS-eligible C-Corp equity.As a result, I don’t yet have to pay the capital gain I would owe.If I keep holding this new investment for another three years (two years plus three years = five years in total), then I exit again I never pay the capital gains – neither those I owed from the first invest nor any from the second investment.Pretty good. Back to keeping all my proceeds.Again, there are naturally some limitations: you have to “roll over” the proceeds (not just the gain); you have only 60 days to find and execute the investments (if only there was somewhere you could go to find a steady supply of eligible investments…); and if you held the first stock for less than six months you can’t do this at all.But still, for most successful angel deals, 1202 or 1045 should apply, so I think we’re justified in saying that Section 1202 is the Dabo of the tax code.(By the way, I didn’t make the scenario above up. VentureSouth members faced exactly this calculation when we sent their K-1s in 2019 for the handsome gain they made on a sale in 2018 of a company that was invested in during 2016. Lots of members did the Section 1045 roll overs into new VentureSouth investments.)