Investors should avoid these mistakes that could kill their tax-free gains 

A discussion about 1202 tax strategy with Scott Pinarchick, a partner at Mintz, which specializes in tax and private equity services.

Tom Lazay, Companyon Ventures

Throughout my fundraising discussions with angels, VCs, and family offices, I’ve been surprised by how many sophisticated investors are unaware of the tax-free opportunities provided by 1202, or they are confused about its specifics.  

To clear up this confusion, particularly surrounding investments in venture capital funds or with alternative investment vehicles, I sat down with Scott Pinarchick, a partner at Mintz, which specializes in tax and private equity services. He shared the following information:  

General tax background 

If an early-stage investment qualifies for 1202 treatment and successfully exits, its investors can avoid up to 100 percent of the capital gains tax on the greater of $10 million or 10x their cost basis. The general 1202 qualifying criteria for tech investments are: 

  • The stock was issued by a domestic C-corporation; 
  • On the date of stock issue and immediately after, the aggregate gross assets of the issuing corporation didn’t exceed $50 million; 
  • The issuing corporation doesn’t purchase any of the stock from the taxpayer during a four-year period beginning two years before the issue date; 
  • The stock is held for at least five years; 
  • The corporation uses its assets in an active qualified business. 

Venture fund investments 

While 1202 benefits extend to angels who directly invest, they also apply to VC fund investors (or LPs) on a per-LP and per-company profit distribution basis.  

Fund LPs who are US taxable individuals directly receive 1202 benefits from a QSBS investment so long as they’re LPs when the fund makes and exits that investment. 

LPs use different strategies to indirectly attain 1202 benefits to varying success. 

Lazay

One of these strategies — of pooling capital into a US S-Corporation, LLC, partnership, or common trust to make a fund investment — still gives 1202 benefits to LPs so long as the structure is a flow-through entity with gains hitting a US taxable individual.  

However, another strategy, called deal warehousing, negates 1202’s benefits for all parties involved. LPs warehouse a deal by investing prior to their fund’s first close through personal funds or Special Purpose Vehicles. Once the VC fund closes, these early investments are transferred into that new fund.  

Yet LPs seeking tax benefits should invest directly from a closed or fertile fund instead of warehouse.    

Convertible notes 

While many investors buy equity in an early-stage company, others use different instruments, such as convertible notes, which can eventually transfer into equity. Some convertible notes convert at a near-term financing rounding, but others take years if the startup delays that round or exits prematurely. 

The convertible note execution is not the start of the holding period for QSBS, however, since a convertible debt instrument isn’t considered equity. Rather, investors must convert the note into equity to start that five-year holding period. 

Given this nuance, if investors suspect that a convertible note’s lifetime could be long, they might consider negotiating a priced round with the entrepreneur instead of using a debt instrument.  

SAFEs 

Similarly, some startups execute a SAFE (Simple Agreements for Future Equity) as substitutes for equity rounds while they fundraise or complete an investor diligence process. While tax authorities generally don’t consider a SAFE debt, whether they qualify it for 1202 really depends on its precise terms.  

On one hand, a SAFE can be interpreted as a prepaid forward contract for investors to attain new stock when it’s issued. In this scenario, a SAFE isn’t considered equity and an investor isn’t treated as an owner until that stock issue. On the other hand, a SAFE can be interpreted as current equity even though it technically becomes a different class of equity. In this case, the five-year holding period begins at the SAFE’s issue.  

Given this gray area, investors should seek tax advice when classifying SAFE investments. 

Tom Lazay is a general partner at Companyon Ventures, an early-stage venture capital firm.