Over the past few months I've been surprised to find that very few angel investors and entrepreneurs are aware of one of the most important developments for startups in a long time. If you are an angel investor or a founder make sure you read this article carefully as it could save you millions.

Recently Congress extended Section 1202 of the Internal Revenue Code, providing significant tax benefits to angel investors and entrepreneurs. The Section 1202 tax exclusion provides tax-free gains on 100% of gains related to startup investments, up to $10 million per investment. This provision enables entrepreneurs to exclude up to $10 million of gains as well. A version of this provision has been around for years but previously it was not a permanent exemption, the exemption was less than 100% during certain years and it was generally less straightforward.

The 1202 tax exclusion should make angel investing more attractive than ever before and also provides a major benefit to entrepreneurs. Just make sure you understand the details:

Section 1202 Basics

  • 100% tax break for gains made on investments in qualified small business stock (startups or small businesses).
  • Maximum exclusion equals the greater of $10 million or ten times the initial investment (technically the adjusted tax basis).
  • Alternative Minimum Tax does not apply.
  • Companies must be properly incorporated in adherence with Section 1202.
  • Founders, employees, angel investors, fund general partners and taxable limited partners are all eligible to the tax break.

Example of Impact on Entrepreneurs

A company is acquired for $50 million and the founder owns 20% of the company at exit. The founder would receive $10 million prior to taxes and would have $10 million of gains.

If the company took advantage of the 1202 tax exclusion, he/she could exclude the entire $10 million of gains from taxes.

Example of Impact on Angel Investors

Another company gets acquired for $500 million and an angel investor who invested $100,000 early on now owns 2.5% of the company at exit. The angel investor would receive $12.5 million at exit and would have a $12.4 million gain ($12.5 million of proceeds less original investment of $100,000).

As long as the company took advantage of the 1202 tax exclusion, the angel investor could exclude $10 million from taxes and would just get taxed on the remaining $2.4 million.

Section 1202 Requirements

  • The investment must be held for at least five years.
  • The company must be incorporated as a C Corporation.
  • The company must be incorporated in adherence with Section 1202.
  • The company must have no more than $50 million in assets before the investment or immediately afterward.
  • The business may not be in the service, finance, farming, mining, extraction, restaurant, hospitality, or real estate industries.
  • Corporations which make investments are not eligible.

This development should give more credence to the argument for C-Corporation vs. LLCs and likely overrides my prior argument for LLCs. If you are a founder, you might be able to take advantage of this exemption even if you weren't aware of it upon incorporation. Talk to your lawyer or accountant. If you are an angel investor, make sure any startup you are investing in is aware of the 1202 tax exemption and makes the proper elections to comply if they qualify.

Published on: Sep 13, 2016