Time to Invest In Startups

So with the planned increases in personal tax rates (which hit small businesses that report via K-1, i.e. S-corporation and LLCs election S-Corporation status), combined with the collapse in small business credit, there is a concern about declining business investment.  Since large established businesses tend to lose jobs over time, job growth is dependent on  small business growth.  There is a proposal floating on capital hill to create a capital gains tax-free investment opportunity for small businesses.

The basic idea, to qualify, the company must be structured as a C-corporation (a taxable entity), and not in certain segments of the economy, but for those businesses, a qualified investor would be able to realize their capital gains tax free.  The qualifications: direct investment in the company (not buying via broker), an asset cap on the business, and the tax status of the entity, and the investment will be exempted from capital gains AND AMT taxes… the later is important because qualified angel investors often fall in the AMT window, which eliminates the preferential treatment of capital gains because the AMT tax recaptures it.

This presents an interesting opportunity.  The problem with the capital gains rate and start-ups is that most start-ups fail, so angel groups pool money and invest so they make money on the 1-in-10 successes.  The opportunity for entrepreneurs is developing a business concept that would rapidly deploy capital raised under this exemption, in a way to safely purchase assets that will appreciate and create most of the gains in the form of capital gains rather than profits that would be double taxed because of the corporate structure.

The stated goal is high tech and construction companies that tend to create high wage jobs, but those ventures are inherently risky and the requirement of an original investment would prevent pooling.  The pool of investors able to make 10 angel investments individually is pretty small, and most groups aggregate themselves through a pass-through entity like an LLC organized for taxes as a partnership, which conceivably would be prevented from taking advantage of this new status.

The question is, what “high tech” business, for tax purposes, could be “low tech” enough to be a safe investment, providing a market or greater return that would be tax free.  Highly speculative investments wouldn’t be relevant, and the long term gain needs to be through capital gains, not profits, or the tax advantages would be wiped out and you’d be better off using an LLC using a partnership return.  With capital gains rates scheduled to return to 20%, plus a 3% health care levy, and some in the administration talking about raising them higher, it’s time to focus on tax sheltered investment vehicles.  The low tax environment has discouraged tax shelters allowing people to focus on the underlying investment, but the coming years of tax increases brings back the importance of sheltering income for high net worth opportunities, and creates an opportunity for smart entrepreneurs.