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What happens if you invest in a company and the company fails? Can you deduct your loss? If you can deduct your loss, what sort of loss is it, capital or ordinary?
An ordinary loss is the best type of loss because it can be set off against ordinary income (your salary). Capital losses are only deductible against capital gains plus $3K of ordinary income per year. If you don’t have much in the way of capital gain, because of this $3K per year limitation, it might take you years to fully deduct your losses.
In general, investments in corporations result in capital losses only when the corporation’s stock is completely worthless. The “completely worthless” test can require that the company be completely dissolved and wound up*. Even if the corporation is nearly dead, it still may not be dead enough for you to take a loss. One way to take the loss on a nearly defunct company is to assign the shares for $1 to an unrelated third party. Some angel groups set up programs to facilitate these types of assignments.
While capital losses are problematic because they are only deductible against capital gains and then up to $3K of ordinary income per year, Section 1244 of the tax code converts some capital losses into ordinary losses. In order to take advantage of Section 1244, your stock must be Section 1244 stock, which is generally stock that represents the first $1M invested in a company. But Section 1244 is limited, to $50K for individual taxpayers and $100K for married couples filing jointly.
Don’t Invest Through A Non-Roth IRA
dangerSometimes angels will want to invest in a company through an IRA. This does not usually make sense. Why? Because an angel investment, if it is a good one, should result in a long-term capital gain or be tax-free under Section 1202 (if the investment was in qualified small business stock), but if you make this investment through a non-Roth IRA you will convert these gains to ordinary income (distributions through a traditional IRA are taxed as ordinary income).
If an investment is a loser, if you made the investment through an IRA you won’t be able to take the loss. This can be a terrible thing because your losses can shelter your gains. Remember also that if your investment was part of the first $1M invested in a company, the loss may be deductible as an ordinary loss as opposed to a capital loss. It would be a real shame to invest in such a way that you cheated yourself out of a valuable tax benefit which Congress enacted to encourage investments in small businesses.
Second, many IRA custodians will refuse to go along. They won’t want to let you invest your IRA in a private company whose offering materials do not include a private placement memorandum.