Section 1202 tax exclusion provides angel investors and entrepreneurs with a 100% tax break of up to $10 million.
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.
It goes to show that almost anyone with a bank account and $50 could become an Angel Investor… (paraphrasing Robert Herjavec at the Angels and Entrepreneurs Summit.)
If you are at all thinking about becoming 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 Angel Investors
We’ll use the Federal Reserve’s data and say that you, as an angel investor, could’ve made $1650 from backing startups.
For every dollar you could’ve made in the stock market…
And let’s be more realistic and say you as an angel investor put $500 into a start up.
You would’ve been sitting on over $165,000, in just over the first 10 years of the Fed’s study.
Completely tax free.
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.