Everybody loves a tax deduction, as we were reminded in the recent presidential campaign.
A provision of the I.R.S. tax code can help de-risk early-stage impact investments by providing a significant tax deduction for losses from investment in “qualified small businesses.” In some cases, the deduction is even more advantageous that the tax deduction for charitable donations. And of course, the investment may be a success, which is even better than a deduction.
The oft-overlooked provision, Sec. 1244 of the I.R.S. tax code allows for losses for investors in Qualified Small Business (QSB) stock to be deducted against ordinary income, as opposed to being treated as a capital loss. This deduction is considered ‘above the (Adjusted Gross Income – AGI) line,’ which makes it a better deduction than a similar contribution to a 501c3 non-profit, which is itemized, or ‘below the line.’
For impact investors that want to support new for-profit ventures tackling social or environmental problems, §1244 is a win-win strategy: If the startup succeeds at having their intended impact, and successfully builds a profitable business, the investor receives triple-bottom-line returns. If the venture tries and fails, at least the individual or family can deduct their losses against ordinary income, and that deduction is better than if they gave the investment to a non-profit approach to the same problem.
To qualify for a 1244 deduction, the company must be a US domiciled C-corporation. The company cannot derive over 50 percent of its revenue (actual or expected) from passive activities, such as rents, royalties, financial services, etc. or in which human capital is the primary product. The investment must be through an equity-like instrument, not a loan. And the investment must be part of the first $1 million received from outside investors.
Another provision of the tax law, Sec. 1202, allows some profits from qualified small businesses to be tax-free. Like 1244, companies must be US-based C-corporations and investments must be through equity-like instruments. To qualify for the tax treatment, at the time of investment, there must less than $50 million in net assets on the company’s balance sheet and at least 80 percent of the company’s assets are deployed towards ‘active’ activities (not rent, royalties, etc.).
With a little forethought, and good record-keeping at the time of investment, impact investors can lower their after-tax risk and raise their after-tax returns on the solutions to real-world problems. Under any win-loss circumstances, the application of §1244 and §1202 means investors would be better off than if they donated the same money to non-profits.