Taxes on payment from angel/venture capital investment?

[tjd22]

Hello, I have a pretty complicated tax question that I wasn't able to find an answer to by searching the internet, so I hope you can help. So I made an investment in a startup business earlier this year, and the founder plans to repay it (with interest) in December, along with equity in the business. I'll use illustrative numbers for this example (though they are not too far off from the actual numbers).

-I make an investment of $100,000 in April, 2020.

-I receive repayment of $110,000 in December, 2020, and also retain 10% equity in this firm. Firm is still solvent at the end of the year, and I would still have my equity in the business. 

What would my tax situation look like? Would I have to claim the $110,000 as income, or just the $10,000? What rate would that be taxed at - my normal tax rate based on my income, or a lower rate? And would the 1-year capital gains tax provision kick in at any point (if so, I may defer my repayment for several months in order to get it at the lower tax rate)? 

Any help would be greatly appreciated!

-Tom

[tagteam · Accepted solution]

Quite frankly (and no offense intended), it is rather difficult to imagine an angel investor, who invests $100,000 in a startup, who does not have legal, financial, and/or tax counsel. Your question should be directed at one, or more, of those professionals.

Regardless, in an effort to shed some light, the answer to your question re income taxes is dependent upon the nature of the deal. 

The threshold question, it appears, is whether you invested $100,000 in exchange for a 10% share or a different share (e.g., 50%, 75%, 100%?).

Further, the way the deal was structured may dictate how the "repayment" is treated for income tax purposes.

In short, the $110,000 "repayment" could have a number of components, namely, a return of capital component, an interest component, a capital gain component, and even a dividend component if the entity is a C corporation.

[Anonymous]

the other thing is that all this should have been spelled out in a written document that you should have gotten.

[tjd22]

Thank you and the below poster for your responses. I appreciate the advice to get the appropriate counsel, but currently I do not have these individuals to rely on; I can look into that. The exact equity threshold is 13% if that matters (the 10% was illustrative) - basically it's for the equity and "repayment" of gross revenue (specifies thresholds) until $X repayment (I'd rather not specify the exact terms of the deal in a public forum post). The legal document does not mention any tax provisions. The company is an LLC if that matters. Any additional help would be appreciated, thanks!

[tagteam]

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@tjd22 wrote:

...basically it's for the equity and "repayment" of gross revenue (specifies thresholds) until $X repayment (I'd rather not specify the exact terms of the deal in a public forum post). 

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Yes, and therein lies the problem; the exact terms of the deal need to be disclosed before any specific answer (or advice) can be provided. 

Since this is an LLC, however, you should most likely be receiving a K-1 (1065) (or other tax reporting statement) for the tax year which should clarify the exact nature of the income and/or gain.

[tjd22]

Thank you, below are the terms of the deal. That's pretty much what I noted in my reply, but any other help would be appreciated. 

FOR VALUE RECEIVED of an $[X] from [investor] for a [Z]% equity stake in [company]
redeemable at sale to another company, IPO, or repurchase by [company]. Repayment from [campaign] with
[specific terms] of gross revenue, [specific terms] of gross revenue, and [specific terms] of gross revenue until full repayment of $[Y, which is higher than the above $X].

[tagteam]

The information you provided is obviously more than was provided previously but is still insufficient; there are a plethora of issues that need to be resolved (and more queries).

For example, is your equity stake being taken out by the repayment? If that were the case, for example, then a portion of the repayment would be a return of capital.

I can only presume that you are a passive investor (i.e., not materially participating in operations). 

[Carl]

In more simplistic terms another way I see the $100,000 is not as an investment, as much as a loan. It could also be argued that in addition to the $10K loan interest received in cash in December, the additional non-cash compensation of having an interest in the company could also be a form of "interest" so-to-speak.

As you can tell, I know just enough about this to be down right dangerous. Bottom line is, you should seek the services of a professional in your local jurisdiction that you can hold legally accountable and financially culpable for the advice, guidance and information they provide you. You can't get that on the Internet, or in a public user-to-user forum such as this one.

[tjd22]

Thank you Tagteam and Carl for your replies. I am retaining the equity % after repayment; that is not impacted by repayment at all. And yes, I am a passive investor.

The $100,000 is an investment - there is no guarantee that I will be paid back (i.e. if the product does not launch), and I can't take them to court over non-payment if that does not happen. And I agree about seeking the advice of a professional (I would do that before filing any taxes), just wanted to get some input from the many kind people here, which I very much appreciate, so I can know which strategic decisions to make before then. 

[tagteam]

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@Carl wrote:

In more simplistic terms another way I see the $100,000 is not as an investment, as much as a loan. 

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If an equity share in the company is what was received for the $100,000, then there is no loan and, apparently, @tjd22 will be repaid from a (hypothetical) revenue stream.

Regardless, since there is no guarantee of repayment (nor evidence that the $100,000 was received in exchange for a promise to repay with interest of some sort), the $100,000 probably cannot be characterized as a loan.

In any event, @tjd22 does need professional guidance with respect to the tax implications of this transaction.