We do not provide tax advice. This article is for informational purposes only and must not be construed as tax advice. Please consult your tax advisor before making any investments or creating a tax plan.
Even though it happens every year, tax time can really sneak up on you. Here are our top ten tips for angel investors at tax time. If you have filed for a tax extension this year (deadline is October 15), this article may be helpful for you.
1. Plan ahead
Just like the old saying “Don’t wait for it to rain before you buy an umbrella”, it is better to be proactive, make a plan, and prepare yourself for tax time rather than just sitting back and hoping for the best.
It is not very helpful to discover that you could have saved a portion of taxes due if you had taken some action on your investments the prior year.
Tax costs can be a drag on the performance of an investment portfolio, so it is important to get this right. Tax planning is a vital part of any investment strategy and it is critical for angel investors to develop a tax plan.
2. Talk to an expert
Do you know the detailed ins-and-outs of the Tax Code? If not, then you may want to consider speaking to an accountant or a specialist tax advisor, particularly one with experience in early-stage investing. Not all advisors in the financial sector are familiar with the intricacies of angel investing, so there is a chance they might miss some of the tax advantages available in this area.
The cost of engaging a tax specialist could potentially be offset by your tax savings.
3. Qualified Small Business Stock (QSBS)
While startup equity can qualify for long-term capital gains, certain rules under Qualified Small Business Stock (QSBS) allow investors to go a step further and can qualify for an even more preferential U.S. tax treatment e.g. potentially up to 100% tax-free gains subject to certain conditions.
Watch a replay of our recent webinar on this topic – QSBS Tax Exemption Education Webinar
4. Take a portfolio view
The structure, balance, weighting, and asset allocation of an investment portfolio are key considerations for investors. It is important to take this portfolio view too into your tax planning.
The old-school approach for many investors and financial advisors has traditionally been to structure an investment portfolio on a 70 / 30 basis. This strategy allocates 70% of an investor’s funds to equities or equity focused investments, and 30% to bonds, or fixed-income investments.
The general theory of this approach is that the higher return (but higher risk) equities bucket provides growth opportunities for the portfolio, while the lower risk (but lower return) fixed income bucket provides safety for the portfolio to reduce risk and preserve investor capital.
The opportunities available today for investors and financial advisors to diversify their portfolios out of straight stocks and bonds have never been greater. A radical new approach is now accessible and available to investors to reinvent the old-fashioned portfolio structure.
A more modern strategy is 60 / 30 / 10. This new approach to portfolio structure means allocating 60% to equities, 30% to bonds, and 10% to Alternative Investments. The percentages may vary by portfolio, but the key idea is that Alternatives should be an integral part of every portfolio, in some percentage, for those investors with a higher risk tolerance. The reason for doing this is to access the high-growth potential of quality Alternatives.
With this type of structure, it is critical that your tax strategy takes this portfolio view into account.
5. Tax-smart account selection
Deciding how to set up your investment accounts is important. The main account types can be split into the following broad categories:
- Taxable personal accounts such as a personal bank account or a brokerage account.
- Taxable entity accounts such as a corporation, company, trust, partnership, or Special Purpose Vehicle.
- Tax-advantaged accounts such as an Individual Retirement Account (IRA), a 401(k) retirement savings plan, or a Roth IRA (a special IRA that is taxed differently to traditional IRAs).
The appropriate selection of the type of investment account to use depends on a range of factors that will depend on the individual’s circumstances such as age, income level, tax bracket, portfolio size, investing experience, portfolio structure, investment timeline, liquidity requirements, estate planning, charitable donations, characteristic of specific investments, and more.
Balance and timing are important here – different investments may be better suited to different account types, and the investor’s circumstances may change over time, so it is essential to be flexible and adaptable.
6. Know your tax deductions and tax credits
Knowing what you can and cannot claim as a tax-deductible expense or a tax credit are fundamental to mitigating your tax burden. You may have incurred expenses that could legitimately offset your tax, but if you do not tell the IRS about them, then the tax man would not volunteer that money for you. It is up to you to know your expenses and claim them.
There are many deductions and credits potentially available to taxpayers, including things like work-related expenses, home office costs, charitable donations, medical expenses, student loan interest, property taxes, mortgage interest, self-employment costs, residential energy credits, and more. Which is why you should consult with a tax professional.
Getting familiar with what is potentially available reduces your chances of missing out.
7. Investment timelines and capital gains
How long you hold an asset before selling has important tax implications. Short-term capital gains are taxed at regular income tax rates if the asset is held for less than a year. Depending on the investor’s income level and filing status, long-term capital gains are taxed at either 0%, 15%, or 20% for assets that have been held for longer than one year.
Understanding the rules around capital gains tax is an important consideration when contemplating the timing of an asset sale. Also, evaluating your likely income level in the current year vs. potential future years could also have an impact on how much tax you will need to pay on a given gain.
8. Savings plans for Education or Health
Education and health can be two major costs for many people.
Using a 529 Savings Plan for education expenses for your child can reap significant tax benefits including potential for tax-deferred growth and tax-free withdrawals for qualifying educational expenses.
A Health Savings Accounts (HSA) may allow you to save tax effectively for health expenses that you may incur in the future when in retirement.
9. Tax efficient funds
Continuing the discussion from above regarding portfolio planning and strategy, there are opportunities to include tax efficient funds or bonds when selecting your investment assets.
Some investments such as index funds, including mutual funds and Exchange Traded Funds (ETFs) may have built-in tax efficiencies. Also, ETFs can provide another potential tax advantage because of the unique way they are structured , known as the in-kind creation-and redemption mechanism, which may avoid certain capital gain triggers.
Interest payments on some municipal bonds are exempt from some taxes, which has the potential to lower your income tax obligations.
In summary, portfolio selection including funds with inherent tax advantages can help mitigate your tax liability.
10. Tax loss harvesting
Tax loss harvesting might sound a bit complicated, but the principle is relatively simple – it involves selling poor-performing assets that may generate a capital loss, to offset the capital gain from high-performing assets.
Investors are taxed on net capital gains, which is the total amount gained less any capital losses. But the losses must be realized for this to work, meaning the asset must be sold – this does not work if the asset has gone down in value, but you still own it. Note that if you legitimately believe the asset still has upside potential and may rise in value in the future, it is important to evaluate whether that value increase may be more than the tax saving associated with selling at a loss.
Consider also that if the capital loss outweighs the capital gain in a single year, it is possible to carry forward that tax loss to offset gains in future years.
Remember that these tips are for general information only and are not investment or tax advice. All investors must source their own information and get their own advice suitable for their own personal circumstances.
If you are interested in building your portfolio by adding investments in startups, you can find more information here on how to start angel investing.