Equity crowdfunding is definitely an exciting part of the investment world. You have the chance to participate in early-stage companies that may ultimately become the next Amazon (NASDAQ:AMZN) or Microsoft (NASDAQ:MSFT).
But of course, there are some downsides. After all, there are tax issues to consider – and they can get complicated.
So then what are some of the basics? What should you know? Well, before answering these questions, let’s first get a backgrounder on equity crowdfunding.
The origins of this go back to the landmark JOBS Act (Jumpstart Our Business Startups), which was passed in 2012. In it, there were exemptions for filings with the Securities and Exchange Commission for early stage investments in startups. The goal was to help provide more funding sources but also open up opportunities for investors who are not wealthy.
Equity crowdfunding involves posting a profile of the company on a website and investors can then register to invest (the minimum could be as low as $100). Some of the top players in the market include Crowdfunder, AngelList, SeedInvest, MicroVentures and WeFunder (for more information on these, you can read my post on InvestorPlace.com).
There are different approaches to equity crowdfunding. One is where you get common stock – which represents ownership – in the company. Then there are SAFEs (Simple Agreement for Future Equity) instruments, which do not initially allocated shares. Instead, you will receive the equity when there is a trigger event like a venture funding, acquisition or IPO.
So, let’s see how taxes work for each approach:
Common Stock
When you acquire common stock in an equity crowdfunding funding, it’s essentially the same as if you went to an online broker and purchased stock of a company like Facebook (NASDAQ:FB) or Netflix (NASDAQ:NFLX). That is, you do not owe any taxes until you sell the shares for a profit.
Example: Suppose you buy 100 shares of Facebook for $20,000. This is the cost basis. Then let’s say that a few years later, you sell them for $35,000. The realized gain would be the amount from the sale ($35,000) minus the cost basis ($20,000) or $20,000.
You will pay the capital gains tax rate on this profit. And this depends on your holding period. If it is less than a year, then the rate is for what it would be for ordinary income (like your wages). Otherwise you will have preferential treatment. Note that the maximum tax rate – for when you hold stock for over a year – is 20%. Given that equity crowdfunding investments are longer term, you will likely have the preferential tax rate.
So, what if you sell the investment at a loss or the company goes bust? In this situation, you can write off a maximum of $3,000 from your ordinary income per year and you can carry forward any of the remaining losses to future years. You can also offset the loss against any capital gains.
SAFE Investments
By far, this is the most complex for taxes on equity crowdfunding investments. A SAFE is a hybrid security, sharing features of both common stock and debt. For example, it may have interest payments and investor protections. But there is also the potential to get stock in the startup.
In fact, the IRS has yet to provide any guidance on how to tax a SAFE. The main reason is that it is still a relatively new security.
Yet it seems that tax practitioners consider a SAFE to be similar to a futures contract. After all, the company is making a promise to deliver something at a later date. Thus, the purchase of the SAFE would not be taxable nor would the issuance of the shares. But the holding period would start at this time, which is a disadvantage compared to common stock. Essentially, there would not be taxes until there is a sale.
However, SAFEs can have different terms – and this may impact the tax considerations. In other words, if you do invest in a such instrument, it’s best to get advice from a tax professional, who has experience with these types of securities.
Tom Taulli (@ttaulli) is an advisor and author of various books and online courses about technology, including Artificial Intelligence Basics, The Robotic Process Automation Handbook and Learn Python Super Fast. He is also the founder of WebIPO, which was one of the first platforms for public offerings during the 1990s. As of this writing, he did not hold a position in any of the aforementioned securities.
