Editor’s note: Investor and entrepreneur David Gardner is the founder of Cofounders Capital in Cary and is a regular contributor to WRAL TechWire.
CARY – It is not lost on me that reading an article that discusses a section of the tax code is probably not on most people’s favorite-things-to-do list. However, if it helps put some serious money in your pocket as an investor or to garner more investment capital as an entrepreneur then it just might be the most interesting thing you have read lately.
I’m writing this from a hotel in Boone where I just listened to a conference presenter discussing the tax advantages of opportunity zones and how you can write off 10 percent of that gain on qualified investments in certain places. He did a great job as did the last half dozen or so presenters I’ve heard expounding this tax exemption. The audience seemed to really eat it up.
I could not help but wonder why no one ever talks about the 1202 exemption that allows small business investors to pay zero Federal and zero NC State taxes on 100 percent of their gains. One of my early investments exited this summer. I calculated the capital gains and set aside $700,00 for the tax man. Since I’m anticipating two or three more possible exits this year, I decided it would be a good time to do a little tax planning with my CPA. She reminded me of the 1202 tax exemption and deemed that my profits this year are completely free from both Federal and NC income tax. It was like making another $700,000 unexpectedly!
I’m surprised at the number of investors, accountants and wealth managers who don’t seem to know about or dismiss the 1202 exemption. This is probably because it slowly rolled in below the radar over many years. First enacted back in 1993, the amount of one’s investment that could be exempted has varied as has the maximum dollar savings that was allowed. As the amount of the exemption came and went and at times was insignificant, investors and some accountants began to think of it as not a big deal. In 2010 however, Congress, sensing that the incentive was not really doing a lot to inspire early stage investing, set the exemption permanently at 100 percent. Because investors are required to hold an investment for five years before they can take the exemption, no one could even qualify for the 100 percent exemption until 2015 at the earliest.
So…. this amazing tax incentive still resides mostly below the radar to investors. It is a simple exemption to understand, to qualify for and to claim on your return. Your investment must be in a C corporation with less than $5 million in revenues and you must wait at least five years to sell your stock. That’s mostly it. Some service industries are excluded such as hospitality and banking but since venture funds are setup as LLC’s with profits flowing directly through to its investors, your profits from investing in early stage venture funds can also qualify for the 100 percent exemption.
Other tax exemptions pale by comparison and it just keeps getting better. Statistically, across all investment asset classes, venture fund investing has consistently generated the best returns over the last twenty-five years and early stage venture funds have statistically outperformed larger later stage funds by almost 100 percent. Because early stage venture funds invest in early stage companies, these investments almost always qualify for the 1202 exemption as they are typically small at the time of the investment and held for five years or more by seed investors. It is hard to believe that the best long-term investment opportunity is also 100 percent tax free!
I am even more confused now as to why we still have a shortage of early stage investment capital in North Carolina.