Why tax season is a great time to consider a venture capital investment
It is common knowledge that most startups fail before they find a strategic acquirer or an IPO. Therefore, venture capital is an inherently high risk industry. However, especially if you are invested in a smart business, it can potentially be the most profitable asset class in your portfolio.
You could invest in emerging markets and earn 4.7% annual return over a decade, as we’ve seen in the past. Or you can invest in hedge funds and potentially earn a 7.5% annual return. What’s more, you can invest in global real estate and earn an annual return of 15.2%. The venture capital industry, on the other hand, has provided investors with 33.3% annual returns over a decade. On an after-tax basis, the potential returns become even more compelling: According to data from 2008 to 2018, venture capitalists enjoyed a return on investment of over 50%.
The reason is the tax advantageous rules related to Qualified Small Business Equities (QSBS), under Section 1202 of the Internal Revenue Code, which may benefit investors in many venture capital-backed startups. Under Section 1202, gains from the sale of shares in QSBS-eligible companies may qualify for 100% federal tax exclusion up to a maximum of $ 10,000,000 or 10 times the tax base of the QSBS. investor in action. And if a QSBS-eligible investment is made by a venture capital fund, individual investors in the venture capital fund might be able to take advantage of the full exclusion of section 1202 gains on their individual returns.
“Venture capital is one of the few investment categories that have the potential to qualify for the exclusion of gains under Section 1202, due to the strict criteria required to qualify for Section 1202,” declared Chris Sieber, Founder of Sieber CPA. Better yet, many states follow federal Section 1202 rules and also allow a state tax exclusion.
Real estate vs venture capital
Many investors consider real estate investments to diversify their portfolios and take advantage of the tax deferral provisions of Section 1031. While Sections 1031 and 1202 can each provide tax benefits to investors, Section 1031 only allows investors real estate to postpone, but not to exclude definitively, gains from real estate exchanges. Section 1031, which applies to real estate transactions, and Section 1202 “are fundamentally different concepts,” says Sieber.
To qualify for the 1031 treatment, investors must find a suitable replacement property within 45 days and close the property within 180 days. “At some point when the real estate investor seeks to fully dispose of his real estate assets, he will pay tax on the deferred gain,” says Sieber. “The Section 1031 trade gain may be permanently excluded under the current Internal Revenue Code by retaining the traded real estate asset until your death, at which time your beneficiary would receive an increase in the market value of the asset. when you pass.
Section 1202, which covers QSBS, is perhaps less often considered, but it has its own advantages. “It allows holders of qualified small business stocks to permanently exclude earnings of up to $ 10,000,000 or 10 times their tax base, assuming they meet all the criteria,” says he. “QSBS offers an opportunity for exclusion rather than an opportunity for postponement.”
On the flip side, real estate can be a great income generating investment with monthly, quarterly or annual rental income distributions. In contrast, venture capital is highly illiquid, which means your money is tied up – for a minimum of five years, and more often up to 10 years – with distributions from the sale of portfolio companies. This can make the eventual income from investments flat and unpredictable.
So even though an investor may get a higher after-tax internal rate of return (IRR) and a higher after-tax net multiple on their venture capital investments, they should plan to not see any money for at least five. or 10 years. – and be prepared to lose all of it, due to the high risk nature of the asset class.
Sieber says he would never advise anyone to consider an asset class just for tax reasons. “Investors should always consider their investment objectives, risk tolerance and the likelihood that the investment will generate returns when analyzing an investment,” he explains.
Venture capital and estate planning
Tax planning goes hand in hand with estate planning and it is important to understand the impact of alternative investments on both. Catherine Lee Clarke, Investment Officer with Hirtle callaghan says, “Illiquid investments like venture capital can also play a special role in estate planning. Families can get an updated assessment for inheritance and gift tax purposes due to the lack of negotiability and control resulting from the underlying investment structure. For example, a pool of illiquid investments with a net asset value of $ 1 million could benefit from a 30% reduction in valuation due to lack of negotiability and control. This means that investors could transfer those assets to a trust or descendant and only count for $ 700,000 of their lifetime exemption. At the current federal rate of 40% for gift tax and inheritance tax, this write-down of $ 300,000 saves the investor $ 120,000 in taxes. Once the donation is made, the future growth of investments takes place outside the heritage of the original investor. Investors considering this strategy should hire their estate planning attorney to hire a valuation expert to manage the process with their investment advisor. They must also ensure that the trust or individual receiving the asset has sufficient liquidity to make capital calls. “
While the returns on any type of investment can be uncertain, it is certain that the treatment of taxes each year is a certainty. If you’re considering investing in an alternative asset like venture capital, there’s no better time to do so than tax season, when the tax burden and estate planning are both at the forefront.