January 30, 2021
Have you called your accountant, or purchased your tax software yet? As tax season creeps up on us, you may be interested to learn about a tax break unique to some venture capital investments. The Internal Revenue Code §1202 allows capital gains from select small business stock, like many early-stage startups, to be excluded from federal tax.
If the qualified small business stock was acquired after Sept. 27, 2010, and is held for more than five years, §1202 allows for 100% exclusion of up to $10,000,000 of capital gains from the sale of the stock.
First, a history lesson on IRS Code §1202. Enacted in 1993 as a means of incentivizing small business investments, this provision originally excluded 50% of capital gains recognized on Qualified Small Business Stock from an individual’s gross income—but it didn’t stop there. To stimulate the small business sector following the 2008 recession, the American Recovery and Reinvestment Act then increased the exclusion rate from 50% to 75% for Qualified Small Business Stocks purchased after Feb. 18, 2009. This exclusion was again bumped to 100% on capital gains from Qualified Small Business Stock purchased after Sept. 27, 2010.
This incentive isn’t a flash in the pan either. Congress passed The Protecting Americans from Tax Hikes (PATH) Act of 2015, which was then signed into law by President Obama the same year. This Act made some tax benefits permanent, including the Qualified Small Business Stock capital gains exclusion located in IRS Code §1202.
Not every small business is a qualified small business stock (or “QSBS”), which will have a few key features. According to the Internal Revenue Code, the stock must be “issued by a domestic C-corporation other than a hotel, restaurant, financial institution, real estate company, farm, mining company, or business relating to law, engineering, or architecture.” (For instance, companies in the consumer and tech sectors qualify, but financial services do not.)
When the stock is issued, the small business must also have $50 million or less in gross assets to qualify. One caveat: The investment must be held for five or more years to qualify for the exclusion. So, if we were to make an investment that was then acquired the following year— which is still a good result for the portfolio—the stock would not qualify.
As an investor in a VC fund, you would receive a distribution from that fund once a company has exited—an IPO, acquisition, etc.—and your K-1 statement would report the amount and nature of the gain you were allocated. If a portfolio company qualifies for §1202 capital gain exclusion, your K-1 would report the gain separate from any other gains during the year, and your tax advisor would report the capital gain exclusion on your personal tax return.
As a reminder, the K-1 shows the income or loss realized by the fund when it sells an investment. Any unrealized gains on investments held by the fund will not be shown on a K-1. Similar to a brokerage account, the best way to understand the value of the portfolio is by reviewing your portfolio statements, not your year-end tax reporting documents.
This tax benefit is unique to venture capital versus other investments such as real estate, blockchain or publicly-traded companies. Normally, you would pay a maximum federal tax rate of 23.8% on capital gain on the sale of stock—however, if the company qualifies for §1202 gain exclusion, you would pay zero federal tax on up to $10,000,000 of gain and get to pocket the whole sum.
The firm invests primarily in smaller companies who typically have less than $50MM in assets and whose stock is often eligible for §1202 treatment (subject to the five-year holding period requirement). That said, not every investment we make will qualify for the §1202 capital gains exclusion, and just because a company doesn’t qualify doesn’t mean it isn’t a stellar investment. Our portfolio company, Felix, does not qualify as a Canadian company—but it has already grown six times since our initial investment.
Overall, H Venture Partners’ goal is to build a portfolio that delivers a great return on an after-tax net basis, and we consider §1202 implications while evaluating any company for our portfolio.
Note: H Venture Partners does not offer tax advice. Please contact your tax professional for more information.