Did you know there are tax advantages Congress put in place to spur entrepreneurship and investing in early-stage companies? In today's episode of The Angel Next Door Podcast, host Marcia Dawood sits down with Jeff Solomon, a seasoned CPA with over 35 years of experience, to unearth some of the most critical tax strategies that can significantly impact founders and angel investors alike. As they dive into the complexities of U.S. tax codes, they uncover and simplify valuable insights that can help maximize returns and minimize financial pitfalls for those investing in small, high-growth businesses. Jeff Solomon, a partner at Katz, Nannis and Solomon in Boston, specializes in working with tech-based and life science companies, including numerous angel and VC-backed startups. His firm, which boasts a team of 75 professionals, provides a comprehensive suite of accounting, auditing, and tax services aimed at helping fast-growth companies navigate the financial landscape. With decades of experience in advising entrepreneurs and investors, Jeff brings a wealth of knowledge and a unique perspective on leveraging tax codes to benefit early-stage investments. This episode is a treasure trove for anyone involved in angel investing or looking to understand the financial intricacies of high-growth startups. Marcia and Jeff discuss essential topics like Qualified Small Business Stock (QSBs), the critical 1202 tax exemption that can make $10 million in gains tax-free, and the nuances of the R&D tax credit. They also explore lesser-known strategies like the 1244 code for handling investment losses and the 1045 rollover to maintain tax advantages. Whether you're an experienced investor or just getting started, these actionable insights are pivotal in shaping successful investment portfolios. Don't miss out on this must-listen episode that demystifies complex tax strategies and offers practical tips for optimizing your investments.
Did you know there are tax advantages Congress put in place to spur entrepreneurship and investing in early-stage companies? In today's episode of The Angel Next Door Podcast, host Marcia Dawood sits down with Jeff Solomon, a seasoned CPA with over 35 years of experience, to unearth some of the most critical tax strategies that can significantly impact founders and angel investors alike. As they dive into the complexities of U.S. tax codes, they uncover and simplify valuable insights that can help maximize returns and minimize financial pitfalls for those investing in small, high-growth businesses.
Jeff Solomon, a partner at Katz, Nannis and Solomon in Boston, specializes in working with tech-based and life science companies, including numerous angel and VC-backed startups. His firm, which boasts a team of 75 professionals, provides a comprehensive suite of accounting, auditing, and tax services aimed at helping fast-growth companies navigate the financial landscape. With decades of experience in advising entrepreneurs and investors, Jeff brings a wealth of knowledge and a unique perspective on leveraging tax codes to benefit early-stage investments.
This episode is a treasure trove for anyone involved in angel investing or looking to understand the financial intricacies of high-growth startups. Marcia and Jeff discuss essential topics like Qualified Small Business Stock (QSBs), the critical 1202 tax exemption that can make $10 million in gains tax-free, and the nuances of the R&D tax credit. They also explore lesser-known strategies like the 1244 code for handling investment losses and the 1045 rollover to maintain tax advantages. Whether you're an experienced investor or just getting started, these actionable insights are pivotal in shaping successful investment portfolios. Don't miss out on this must-listen episode that demystifies complex tax strategies and offers practical tips for optimizing your investments.
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Marcia Dawood
Well, hi, Jeff. Welcome to the show.
Jeff Solomon
Thanks, Marcia. Thanks for having me.
Marcia Dawood
Yeah, well, I'm excited to talk to you today about all things taxes. And I know everybody's always like, taxes, do we really want to talk about that? But there are so many things that angels really don't know about our tax system, and especially things about qsbs qualified small business stock. So we're going to talk all about that. But Jeff, why don't we start out, tell our listeners a little bit about your background and about your firm.
Jeff Solomon
Sure. So, my name is Jeff Solomon. I've been a CPA for probably 35 years or so. Started in big national firm and realized pretty quickly when I was in their privately owned emerging business group over there that I loved working with entrepreneurs and angel investors and working with startups, and I realized that wasn't the platform for me. I loved accounting, but I knew it had to be a little sexier than just accounting and taxes. So, basically, long story short, we founded this firm years ago, and today, probably 90, 95% of our clients are tech based companies, life science companies, and lots of angel backed, vc backed companies. We don't do nonprofits here at Katz, Nanis and Solomon. We're located in Boston, by the way.
Jeff Solomon
We're about 75 people, and we really work with entrepreneurs, fast growth companies that want to IPo, but don't need a big four yet, usually come to us. But as part of that, we're working with their investors all the times, the angels, all the time. And we work with dozens and dozens of angel groups and special syndicated groups, special purpose entity funds, and things like that to help them with their taxes. We have a whole tax group here at Katz, Nanis and Solomon. So we do the taxes. We have an audit group that audits companies and stuff like that. So that's who we are, what I've been doing the last 35, 40 years.
Marcia Dawood
I love that because we have a lot of companies that are growing, and they're not quite at that stage yet where they need, like, a big four accounting firm. So good to know that you're out there and available. So, let's talk a little bit about USP's. What is it? Explain to our listeners a little bit about its origin and then how they can take advantage of it, possibly.
Jeff Solomon
Yeah. So qualified small business stock. It's a code, section 1202 in the IR's code. And it's this really cool thing that I've been talking about for probably ten or 15 years. And every year I do presentations to angel groups, and there's always a few people in the crowd that still don't know about it. If you're an angel group, you got to know about this and a few other tricks we're going to talk about in a little while, because as an active investor, you need to know about this because it could have huge implications down the road. Think about a situation where you sell your company and you have a hundred million dollar gain. Wouldn't it be great that if there was something out there that I didn't have to pay tax on, the $400 million? Well, there is something.
Jeff Solomon
It's 1202 stock. If you actually are a shareholder of and you own this type of stock in a company that qualifies, there's a potential that $10 million of that $100 million is entirely tax free. And by the way, it's not just federal. Most states in the US now recognize QSBs 1202 stock because most of them follow federal. So now there's the state tax, that's tax free as well. Okay. And I'm going to give a couple examples in a little while where you can multiply the 10 million for a family and make it 30, 40, 50. I had a shareholder that had a $60 million exit last year.
Jeff Solomon
He had three daughters, and he was able to save 40 million of the 60 million was tax free.
Marcia Dawood
Wow.
Jeff Solomon
Million of the 60 million was entirely federal and state tax free. Can you believe that?
Marcia Dawood
Amazing.
Jeff Solomon
So it's really cool. It's something I get gassed up about every time I talk about it, and it's something that entrepreneurs. In fact, I had a call this morning with a startup, and one of the discussions we were having with the lawyer was entity type. And it's something that a startup founder needs to think about, because if there's a potential exit down the road, do I want to be an S corp? Do I want to be an LLC? Because one of the requirements of QSBs is that you have to be a C Corp and you have to have gotten your stock when it was a C Corp. So we have this discussion about what type of entity should a startup be? Because if you think there's a potential big exit down the road, then qsbs may be the way to go. But being a C Corp also has its baggage too, that you have to deal with in way against the pluses and the minuses of an s corp in a partnership.
Marcia Dawood
Right. So the way I've always thought about 1202 is from the angel standpoint, because that's my standpoint. Right. But this is all shareholders. Right.
Jeff Solomon
Anyone gets founders employees if you qualify. And we can talk about some of the qualifications in a second. But yes, it can't. Yeah. It has to be originally issued from a C Corp and it has to be to an individual or flow through entity, like a partnership that goes to an individual. So I have some funds that invest in C Corps.
Marcia Dawood
Right.
Jeff Solomon
I think we work, you and I work together on some probably, right. They invest a C corpental, you get a k one, or the other partners get a k one. And it says, we sold this C Corp company. And by the way, this $10,000 gain on your k one is QSBs 1202. Make sure that when you do your taxes, you tell your tax guy to make sure that's tax free because that's part of the first $10 million for you.
Marcia Dawood
Right. Okay. So it's all shareholders. It has to be a C Corp. What are some of the other qualifications?
Jeff Solomon
Right. So we'll talk about the most important ones. There are devils in the detail that we can dive into if we have time and you want to. But the biggest things to qualify for qualified small business stock is, as you already said, marcia, it has to be a C Corp. It has to be originally issued from the company. So if I held stock in startup company and you bought it from me and my shares were 1202, yours won't be because you bought it from me and you bought it secondarily. So it has to be issued directly from the company. Okay.
Jeff Solomon
The next hurdle that we sometimes fall into is the holding period. Right. Now, everyone knows capital gains is a one year holding period. Right. You hold it for one year in a day, you're great. You got that lower capital gains rate at 20% federally. Right. But for 1202, it's a longer period.
Jeff Solomon
Five years. You have to hold for five years. Can't be four years and nine months. Okay. I've been in that situation before with sellers that are selling company and they're just short. And there are ways to potentially fix that, which we can talk about also. There's lots of details, but there's a five year holding period. Okay?
Marcia Dawood
Right.
Jeff Solomon
So that's one. So that's probably number two. C Corp, original issue holding. Holding period, five years. The next thing is it needs to be a qualified trader business. Okay. And the IR's defines what a qualified trader business is. And most active technology companies or life science companies would qualify.
Jeff Solomon
What they disallow are like a financial service firm or CPA firm or a law firm. It can't be like, like a service company or something like that. It has to be an active trader business, not a service type of company. Okay? It can't be like a healthcare company or something like that. Or like I said, an accounting firm. Okay? So it needs to be a qualifying business. After that, probably the next test that we go through is at the time the holder of those shares got the stock. At the time they got their shares were the assets on the company's books under $50 million in value, million in value.
Jeff Solomon
So if you come into a later stage company and you get C Corp stock and you've held it for five years, but if they have already raised a bunch of money and there's a bunch of assets on the balance sheet and it's over $50 million, then after that point, none of those shares qualify. It's only the people that own stock in the first $50 million. The interesting thing there is, I always tell people that own stock options, and I know you get stock options sometimes, and a lot of angel people get stock options or restricted shares you want. Sure. You exercise early enough that when you exercise your options, the shares that you get are still under the $50 million total company value.
Marcia Dawood
Interesting. Okay. So I was able to use this particular 1202 exemption when I had, from the very first angel investment I made. I held the stock for eight years, and it was a three x return. And I was able to not pay capital gains on my gain, which was great. And it incentivized me to then go and invest in other startup companies, which I think is the actual reason why the whole thing exists. Right?
Jeff Solomon
That is right. That's right. That's what Congress was hoping. Right. They want people to invest in smaller types of businesses. And this is a huge, huge thing that, again, most people don't even know about. Right.
Marcia Dawood
Right.
Jeff Solomon
Now, Marshall, one of the things I mentioned a little bit earlier is the five year holding period. If you're at three and a half years of a holding period and you end up with a big exit and you're going, oh, I really don't want to pay capital gains tax on it, what else can I do? There is a way you can do a rollover, a 1045 rollover into another qualified small business stock. So if you sell your stock and if you take the proceeds, let's say you got $10 million from that sale, if you take the proceeds and take the $10 million and invest it in another QSBs company within the qualifying time, I think it's 30 days, maybe 60. I think it's 30, then the time keeps accruing. Okay. And it will continue to age, and you can get to that five year mark. So that when you sell that other company down the road, that $10 million that you put in, that 1st 10 million, even though you may not have met QSBs in that second company, the first 10 million will qualify for QSBs. So a lot of people don't really know about that, but there's a way to continue aging your shares, but you have to take the money and put it into another QSP's.
Jeff Solomon
Yes.
Marcia Dawood
We had this happen where there was a sale, it was like four years and six months, so we didn't quite make it. And we then found another qualifying company that we could then invest in. Okay, so the amount of money that goes into the new company, that just gets to take on the life of and the clock keeps running, basically.
Jeff Solomon
Correct? That's correct. Yep.
Marcia Dawood
Got it.
Jeff Solomon
Yeah.
Marcia Dawood
And so then tell me about 1244.
Jeff Solomon
So 1244. So that's on losses. Is that what you're talking about? On losses?
Marcia Dawood
Yes.
Jeff Solomon
Okay. So we're done talking about 1202, but every angel investor has a couple of those losses in there that they invested. The company goes belly up, and you're trying to figure out what to do with it. And again, this is something that a lot of angel investors do need to know about. This is a code section that says if you're an early investor in a company, you can take potentially some of your loss and treat it as an ordinary loss versus a capital loss. Now, let me stop there for a second. Capital gains and losses are taxed at a 20% rate. Usually.
Jeff Solomon
Okay, could be 15, could be zero, but usually 20% rate. Ordinary rates today go up to 37%. And you can't use excess capital losses, more than $3,000 a year, against all your other types of income. You can offset capital gains and losses against each other, but if you have excess losses, you can't use more than $3,000 against all your other income. So what this type of company allows you to do on a loss, when the company goes where you sell it or the company goes bust, is you can treat some of the loss as an ordinary loss versus a capital loss. Okay, so. Right, so that type of loss can be treated as an ordinary loss. 50,000 single, 100,000 joint as an ordinary loss.
Jeff Solomon
Any loss above that is still a capital loss. But the first, if you file jointly, 100,000, you can use against your other ordinary income. So your wages, your interest, your dividends, all that other type of income.
Marcia Dawood
But what is the qualification then? The same kind of thing. You had to hold the stock for five years and all that good stuff?
Jeff Solomon
No, there's actually a different holding period. You have to be part of the first million dollars in into that company. So if you came in in around a series a and they had already raised a bunch of angel money, a couple million dollars, your stock won't qualify for 1244. Okay. It can be an s corp, it can be a C Corp. So it can be common or preferred.
Marcia Dawood
Okay, interesting. But it can't be an LLC.
Jeff Solomon
Cannot be an LLC. It has to be a corporation. A small business corporation. That's correct.
Marcia Dawood
So if you're the first million and you and the company goes out of business, or you sell at a loss and you have a loss on your investment, normally that would be under a capital loss.
Jeff Solomon
That'd be a capital loss limited in the capital loss rules against your capital gains. But you can carve out $100,000 if you're filing jointly as an ordinary loss, and take that, move that to another part of your tax return.
Marcia Dawood
Nice. Okay.
Jeff Solomon
Okay.
Marcia Dawood
But there isn't necessarily a holding period.
Jeff Solomon
No.
Marcia Dawood
You just have to be the first.
Jeff Solomon
Million in available regardless of your holding period. That is correct.
Marcia Dawood
Interesting. Okay. These are great things for angels to know about. So we learned that 1202, there's the possibility of you having a gain if you've held the stock for more than five years and you do not have to pay capital gains at all as long as it qualifies. We've also heard that if you don't hit the five year mark, there is a possibility if you make another investment with that gain quickly, that you could potentially carry it over using 1045. And now we're learning that if you had a loss and you were the first million dollars in, there's a potential that you could use that loss against your ordinary income.
Jeff Solomon
Yeah, under twelve foot or four. That's exactly right.
Marcia Dawood
Excellent. All right.
Jeff Solomon
Yeah. So really cool stuff, right?
Marcia Dawood
Cool stuff every angel needs to know about. So let's talk for a minute, because there has been a lot of people talking about this, especially lately, about the R and D tax credit. Tell us what that is and how, what's going on with it right now.
Jeff Solomon
Yeah, it's still a little bit in flux, but I've been saying that for three years now. Okay. So for years and years, a lot of startup companies have availed themselves of taking R and D expenses and calculating R and D credit into dollar for dollar dollar credit against income, right? Which is great, but a lot of startups don't make income. So what Congress did a few years ago is they said you could take that R and D credit and use it against the company's payroll taxes, which was even better. So that was really cool, right? Now you could take that credit, and if I'm a lost company, I can now monetize it against the payroll taxes. I'm paying all these engineers to build my product. So that's cool. So life was going on and it was great.
Jeff Solomon
But about three years ago, Congress let the old law expire that said that companies had the ability to expense or capitalize R and D costs. And when they let that expire, it pushed you back to the old rules that said companies have to capitalize R and D costs. Okay, so the credit rules are still out there. Those same credit rules for R and D credits are still out there. That's a separate area. But now what the current rules are, in addition to being able to calculate a credit, now you need to take your R and D costs and you have to capitalize, okay? And you have to amortize them over five years for domestic R and D, and believe it or not, 15 years for foreign R and D. So let's just think about it for a second. So you're a startup company and you're building a product, and you have a bunch of payroll engineers, and you just spent a million and a half on engineering salaries, which is not uncommon for a young startup.
Jeff Solomon
Right. Most of that engineering time is R and D under how they define R and D. Developing a new product, there's risk. Nothing's out there like it. It's qualified R and D. Under the old rules, you could expense it, and I could also calculate a credit against it, and it was great. Well, I can still calculate a credit against it, but now under the new rules, this poor company has to take that million and a half dollars and not deduct it, and then amortize that over five years. In the first year, they get 10% of the million and a half dollars, so they can only write off $150,000 of their 1.5 million spend.
Jeff Solomon
So it's really taking a lot of companies into a tough situation where, believe it or not, some companies are having to pay tax because of the capitalization of its R and D costs. It's really crazy.
Marcia Dawood
Wow. So what have you been seeing lately? Like, are a lot of companies struggling now because of these changes?
Jeff Solomon
Yeah, yeah. We've had a bunch of companies say, this is going to put us out of business. We can't pay our taxes. Does Congress realize that they're doing this to us? So it's really a terrible thing. You sit there and you wonder what Congress is doing because it's actually penalizing people for doing research and developing for new products. It's actually penalizing these poor companies. There's talk about them trying to pass this bipartisan. Both parties have said they want to get rid of this and reverse what's happened over the last few years.
Jeff Solomon
But what's happening in Washington? Who knows if they're going to ever get it done?
Marcia Dawood
Right? Right. Well, even with 1202, we were working with Congressman Kostof's office to get that holding period, that five years on more of a sliding scale. So it would start around three years and then. But it's tied up.
Jeff Solomon
We haven't. That's right. That's right. That's right. That's right. Now, one additional thing that you and I have talked about is there's a way that you can take your $10 million going back to 1202 for a second. You can take your $10 million exemption, and if you gift some of your founders stock to somebody else, the qualification of startup 1202 stock tax along to that person. So if you have a child or three children, you can actually gift one 10th of your shares to each of the ten kids, and each of those kids will get $10 million tax free as well.
Jeff Solomon
So I've had situations where I've had founders sell their company, and because they set up trust for their kids and things like that, most of the 50 or $60 million was tax free. So you can do what they call stacking 1202, which is really cool as well.
Marcia Dawood
That's amazing. So my last question before I let you go, Jeff, what is the best way that as investors, we should be keeping track of all of this information? Because it seems like a lot. I know you said that sometimes we get, depending on the way we invest or through the vehicle we invest, we might get a k one. But what are some of your suggestions?
Jeff Solomon
Yeah, let's first talk about 1202. I get asked all the time by angels and angel groups, is there something proactively I have to do for the company to tell me whether it's 1202 qualified or not? And believe it or not, the answer is no. You don't actually need to get something in order to take or to treat the sale of a stock as QSP's. You just have to meet the definitions at the time you sell your stock. Right. We do have a bunch of angel groups in our portfolio that actually write. And, Marcia, I don't know whether any of your groups do actually write into their term sheet with the company that the stock they're getting, the angel group that's getting their stock qualifies for QSP's. Have you seen that at all in any of your docs?
Marcia Dawood
I haven't seen it directly, but I have definitely heard people talking about doing it.
Jeff Solomon
Yeah, that doesn't really do anything. We get asked all the time, will you vet or opine that our stock qualifies for qsbs? We're selling our company. Our shareholders want to know it. So we do a professional service to a lot of companies where we actually go through a bunch of different tests to make sure that they meet all the different qualifications. And again, as I said at the outset, there are a lot of devils in the details. There's things, changes in the cap table or redemptions. The company, by redeeming some of its shares, can taint shares over a period of time and things like that. So you need to look at it almost on an annual basis and make sure that your stock still qualifies.
Jeff Solomon
So sometimes you need to go out and do that. But other things that angel investors should do to keep track of, it's a great question. We have some angel investors that actually have developed their own Excel sheets to track cap calls and things like that. I know you work with a bunch of angels that have done that. There's actually out there that does that today where you can track all your investments. I will tell you, one of the biggest things I've seen, regrettably, is an angel investor dies, and it's all up here. He or she knows I've invested in these ten companies, how much I put in, and the poor spouse, let's say the wife has no idea about it, doesn't even know that Bob invested $100,000 in the startup, and it becomes a searching match that we've had to go through and do a lot of work to figure out what's out there. So trying to memorialize somewhere and letting your accountant know, here's all the investments I have actively.
Jeff Solomon
One of the things we do every year is we actually sit with our taxpayers that are angel investors and say, okay, you said you invested in these ten companies last year. What's the status of them? Right? Oh, this one's the walking dead. Can I write it off, Jeff? Well, maybe you can. Let's talk about it. Can I take that loss, just track what's going on with them. So it's important to do that. The other thing sometimes we do advise clients to do as their net worth goes up is to consider maybe some type of family partnership or llc, like a family limited partnership or family LLC, and start having the kids money outside of their estate. Start investing in some of these long term investments that could really appreciate, and start using some of the kids money, inheritance money, to start investing in startups is a good way to maybe capture growth outside of your estate, because that's always something that people today worry about income taxes, they worry tomorrow about estate taxes, but it's something we all have to worry about someday, potentially.
Marcia Dawood
Sure, that makes a lot of sense because the tail on some of these investments just can be very long. If you're a little bit older, you don't necessarily want to invest in something that could take ten plus years to see any liquidity.
Jeff Solomon
I'm curious. I talk to my angels all the time. In fact, I was talking to one of the managing directors of an angel group last week, and I said, what's the average length that you think you're going to invest in a startup? And he said, jeff, now we don't think we're going to get out of any investment sooner than five years, and it's probably going to be 710 years by the time we get out of it.
Marcia Dawood
Absolutely.
Jeff Solomon
Back when I started doing this, you're flipping them in three years, Marcia, it was great, but now it's just everything is just slowed down.
Marcia Dawood
Yeah. And the environment is a little challenging, let's say the least. There just hasn't been a lot of m and a activity in the last two years, which is making angels feel very poor and illiquid, so makes it a lot harder. Right.
Jeff Solomon
The other question I get asked all the time, Marsha, is, can I take some of my angel expenses and deduct them? Right. Right. I go to the ACA conference, can I deduct that I'm going out to see a company, can I deduct that? And that's you really need to talk to your CPA and find out his understanding of what you're doing. And it's going to come down to facts and circumstances. If you're an investor, an avid investor, and you could treat it as a qualifying trader business, then potentially you could expense some of those expenses. Usually, though, they fall in the category of portfolio expenses, and they're usually not deductible because they're kind of investment expenses. You're an investor, you're not really doing it as a trader business for profit. So we have those discussions with angels every now and then to see whether it makes sense to change the classification or not.
Jeff Solomon
But it's an aggressive approach if you want to start deducting all those expenses.
Marcia Dawood
Yeah, that's what I've always do that.
Jeff Solomon
Yeah, exactly. Right.
Marcia Dawood
Right. Well, Jeff, this has been fantastic. Thank you for sharing all your wisdom with our listeners. There's lots of good nuggets of information here that all angels need to know. So thanks for coming on the show today.
Jeff Solomon
Okay. Appreciate it. Thanks for having me.