It’s common knowledge that most startups fail before they find a strategic acquirer or IPO. Therefore, venture capital is an inherently high-risk industry. However, especially if you’re invested in a smart firm, it can potentially be the highest-returning asset class in your portfolio.
You could invest in emerging markets and might see an annual 4.7% return over a decade, as we’ve seen in the past. Or you could invest in hedge funds and potentially nab a 7.5% annual return. Further still, you could invest in global real estate and realize a 15.2% return annually. The venture capital industry, in contrast, provided annual returns of 33.3% to investors over a decade. On an after-tax basis, the potential returns become even more compelling: In data taken from 2008 to 2018, investors in venture capital enjoyed a return on their investment of more than 50%.
The reason for this is the tax-favorable rules related to Qualified Small Business Stock (QSBS), under Section 1202 of the Internal Revenue Code, which can benefit investors in many VC-backed startups. Under Section 1202, gains from the sale of stock in QSBS-eligible companies can qualify for a 100% federal tax exclusion up to the greater of $10,000,000 or 10 times the investor’s tax basis in the stock. And if a QSBS-eligible investment is made by a venture capital fund, the individual investors in the VC fund might be able to take advantage of the full Section 1202 gain exclusion on their individual returns.
“Venture capital is one of a very select few investment classes that has the potential to qualify for Section 1202 gain exclusion, due to the strict criteria required to qualify for Section 1202,” says Chris Sieber, Founder of Sieber CPA. Even better, many states follow the federal rules for Section 1202 and allow an exclusion at the state tax level also.
Real Estate vs. Venture Capital
Many investors consider real estate investments to diversify their portfolio and take advantage of the tax deferral provisions of Section 1031. Although Sections 1031 and 1202 can each provide investors tax benefits, Section 1031 only allows real estate investors to defer, but not permanently exclude, gains from real estate exchanges. Section 1031, which applies to real estate transactions, and Section 1202 “are fundamentally different concepts,” Sieber explains.
To qualify for 1031 treatment, investors need to find a suitable replacement property within 45 days, and close on the property within 180 days. “At some point when the real estate investor is looking to fully dispose of his or her real estate assets, they will pay tax on the deferred gain,” Sieber says. “The gain on Section 1031 exchanges can be permanently excluded under the current Internal Revenue Code by holding the exchanged real estate asset until you pass away, at which time your beneficiary would receive a step-up in basis to the fair market value of the asset when you pass.”
Section 1202, covering QSBS, is perhaps considered less frequently, but has its own set of benefits. “It allows holders of Qualified Small Business Stock to permanently exclude gains of up to the greater of $10,000,000 or 10 times their basis from taxation, assuming they meet all the criteria,” he says. “QSBS offers an exclusion opportunity rather than a deferral opportunity.”
On the flip side, real estate can be a great income-generating investment with distributions from rental incomes monthly, quarterly or annually. In contrast, venture capital is highly illiquid, meaning your money is tied up — for a minimum of five years, and more often up to 10 years — with distributions coming from the sale of portfolio companies. This can make eventual income from investments lumpy and unpredictable.
So, while an investor might net a higher after-tax Internal Rate of Return (IRR), and a higher after-tax net multiple on their investments in venture capital, they should plan on not seeing any money for at least five or 10 years — and be prepared to potentially lose all of it, due to the high-risk nature of the asset class.
Sieber says he’d never advise someone consider an asset class strictly for tax reasons. “Investors should always consider their investment goals, risk tolerance, and the likelihood the investment will generate returns when analyzing an investment” he explains.
Venture Capital and Estate Planning
Tax planning goes hand in hand with estate planning, and it’s important to understand how alternative investments impact both. Catherine Lee Clarke, an Investment Officer with Hirtle Callaghan says, “illiquid investments like venture capital can play a special role in estate planning, too. Families can achieve a discounted valuation for estate and gift tax purposes due to the lack of marketability and control resulting from the structure of the underlying investments. For example, a pool of illiquid investments with a net asset value of $1 million might receive a 30% valuation discount for the lack of marketability and control. That means that the investors could transfer those assets to a trust or descendant and only have it count against $700,000 of their lifetime exemption. At the current 40% federal rate for gift and estate taxes, that $300,000 valuation discount saves the investor $120,000 in taxes. Once the gift is made, the future growth in the investments is outside the original investor’s estate. Investors considering this strategy should engage their estate planning attorney to hire a valuation expert to manage the process with their investment advisor. They should also ensure that the trust or individual receiving the asset has enough liquid cash to make capital calls.”
While returns in any type of investment could be uncertain, dealing with taxes every year is a certainty. If you’re considering an investment in an alternative asset like venture capital, there’s no better time to do so than tax season when tax burdens and estate planning are both top of mind.