The 2017 Tax Reform created dramatic changes in the landscape for investors. Capital gain deferral? Check. Reduction in tax rates? Check. Exemption for capital gains tax? Check. Read further for a high-level overview of five top tax issues for investors to consider, with a mix of new rules alongside some “oldies but goodies”.
Qualified Opportunity Fund (QOF)
QOFs (which I have discussed previously in this article) are all the buzz in the tax world because of the amazing tax benefits. But the emphasis here is on potential tax benefits – there are a lot of hurdles to jump through. The main two benefits are: (i) defer and reduce your capital gains tax for capital gains in the current year and (ii) eliminate future capital gains tax on your QOF investment.
To get the tax benefit from a QOF, you must have capital gain. When you invest your capital gain in a QOF, you both defer and, if you invest for long enough, reduce the capital gains tax. In addition, if you invest long enough, you can entirely eliminate the capital gains tax on your investment in a QOF.
QOFs are tailor-made for experienced real estate developers that develop long-term real estate projects. They can also work for investors with persistence and a creative tax advisor. The biggest two hurdles are: (i) the investment has to take place in a “qualified opportunity zone,” which is a particular census tract specially designated in each state for economic development, and (ii) the investment amount is limited to the amount of an investor’s capital gain.
There are numerous other requirements and rules beyond the scope of this summary. While they work best for real estate, the potential tax benefits for operating companies can be even bigger. The problem is that it’s very difficult to apply the QOF rules (and work through many open questions) to operating companies. This is an evolving space so stay tuned!
Blockchain Start-up Investments
Investing in blockchain companies is a complex area but there are a few key concepts.
First, “SAFT” (or simple agreement for future tokens) agreements generally provide beneficial tax treatment for both investors and the start-up. Specifically, investors get the capital gain treatment they expect. In many cases, the start-up can defer the tax imposed on their token sale until they deliver the tokens.
Second, more recently investors have been investing in contracts that entitle them to either equity or tokens at some future time. Unfortunately, these investments are considerably more complex both for blockchain companies and their investors. Beware of the tax implications if the investors elect to receive tokens when the tokens have a high value. There, both the investor and the blockchain company could wind up with phantom income.
Small Business Stock
Small business stock qualifies for tax benefits both on gain and loss, but there are strict rules to qualify.
- Loss. A loss on small business stock is an ordinary loss up to $50,000 ($100,000 for joint returns), allowing investors to avoid the normal $3,000 limit on deducting capital losses. The main hurdle here is that, at the time of investment, the corporation can’t have more than $1,000,000 in capital.
- One way to accommodate this restriction is for investors to contribute assets with low basis and high built-in gain. There, only the basis counts towards the $1 million limit.
- Gain. The small business stock gain exclusion (or Section 1202 exclusion) has more powerful potential tax benefits than the small business stock loss. Those who qualify can exclude capital gain up to the greater of $10 million or 10 times their investment amount. There are three main requirements for the small business stock exclusion.
- First, the holder must have a five-year holding period.
- Second, as of the time of the investment, the corporation can’t have more than $50 million of gross assets.
- Third, the corporation can’t be engaged in one of several restricted industries ranging from health to law to engineering and financial services.
The small business stock gain exclusion is frequently over-looked as a tax benefit. While the five-year holding period is a long time, the benefits are powerful and all founders should remember this.
20% Pass-through Deduction
The 20% pass-through deduction (discussed in this article) is a new tax benefit passed with the 2017 tax reform. The passthrough tax deduction provides a tax benefit for small businesses organized as partnerships and S-Corporations to put them on par with the reduction in the tax rate for C-Corporations. It is devilishly complicated but in broad strokes, there are two main restrictions.
First, there is a quantitative limitation for taxpayers with more than $157,500 ($315,000 for joint returns). At that income level, the tax deduction is tied to the W-2 wages paid by the business.
Second, above the income limit described above, the deduction is limited to certain types of businesses. This industry limitation is based on the industry limit for the small business stock gain exclusion. (Although, if things weren’t complex enough already, the pass-through tax deduction is available for a wider group of businesses than the small business stock gain exclusion.)
Abandoning Partnership Loss
This is a much less well-known tax benefit, but it can be a way for business owners to claim an ordinary loss, similar to the small business loss deduction. If a business taxed as a partnership (such as a multi-member LLC) has become worthless, the owner may claim an ordinary loss by abandoning his or her interest in the business. The Fifth Circuit even confirmed this result in a notable 2015 case. But the devil’s in the details.
Among other requirements, the partnership must have no outstanding debt that is allocated to the partner, the partner must reasonably believe the partnership interest is worthless, and the partner must take an affirmative step to abandon his or her interest.
I summarize these five key investor tax benefits in the table below. If you think you might qualify for one of these benefits, you should consult your tax adviser who can help craft a solution for you based on your particular situation.
|20% Pass-Through Tax Deduction (199A)||Qualified Opportunity Fund||Small Business Stock Gain Exclusion (1202)||Small Business Stock Loss||Partnership Interest Abandonment||SAFT|
|Income Deferral||No||Capital gain tax deferred until 2026||No||No||No||Deferred until token issuance|
|Deduction / exclusion||Up to 20% Deduction||Complete Exclusion||Complete Exclusion||Ordinary Loss||Ordinary Loss||No|
|Specific to entity type||independent contractor / passthrough entity||No||C-Corp||C-Corp||Partnerships and multi-member LLCs||No|
|Specific for industry / type of business||not available for prohibited businesses||Unclear how it applies outside of real estate||not available for prohibited businesses||Limitation on amount of passive income.||Any active business||Blockchain company issuing tokens|
|Limit on Amount of Tax Benefit||Limitation based on W-2 Wages above $157,500 ($315,000 for joint returns)||No||Limited to $50 million of gross assets||Up to $1 million of capital||No||No|