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Hypothetical situation: I invested $250,00 in 2015 in a startup, and the business failed. Can I deduct the entire loss?
Angel investors are often willing to risk losing money to fuel new startups and support job growth. The government protects angel investments with a unique tax benefit.
The trick is to know how to recoup some of your losses to reduce your tax bill. It is critical knowledge because it keeps angels in the investment game to fuel new startups and the economy.
Understanding the Investment Structure: What’s Your Tax Situation?
Understanding the nature of your investment will help inform you about what tax benefits may be available to you through current income tax rules.
Is the company a C Corp (which pays its taxes) or a pass-through entity such as a Limited Liability Company?
Are you buying stock or getting stock options? (LLC)?
Deducting 100% of your investment losses as Ordinary Losses
The Internal Revenue Code (IRC) Section 1244 is the key to helping you recoup your investment losses.
One of the most important things to know when investing in startups is taking an ordinary income deduction on losses instead of capital. There are some requirements, but it’s worth looking into because IRC Section 1244 gives investors this ability and sets them apart from other types, like traders.
There are caveats such as needing to be part of the company’s first $1 million of capital and a few other requirements.
The benefits of qualifying for a 1244 deduction can’t be understated. Usually, investors take a capital loss with a maximum $3,000 deduction per year if they do not have any additional capital gains. Depending on a $200,000 loss on investment for someone in the highest tax bracket, the investor would pay $84,000 less in a year when they qualified for 1244 treatment compared to not qualifying. That is real money.
You should know if you have 1244 stock upfront and not when the loss happens. It is much easier to get the documentation early rather than when things have unraveled.
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