Venture capital (VC) funds operate by seeking outsized returns through investing early in companies that change the world, shake up the market, and become household names. Mutual funds and hedge funds invest in various security types, but venture capital funds focus on a distinctive type of early-stage investment. Additionally, these risky investment opportunities can work to bring profitable returns in the form of financial return on investment and tax optimization.
What are Venture Capital Funds?
Generally, venture capital funds are pools of investment capital managed by investors with an interest in investing in startups, small businesses, and mid-sized companies with high growth potential. These investments are, most often, high-risk/high-return in nature. For this reason, the utilization of tax exemptions incentivizes investors to partake in these riskier investment opportunities.
Tax Incentives Designed to Benefit Investments in Early-Stage Companies
Startups backed by venture capital (VC) may qualify for tax-favorable Qualified Small Business Stock (QSBS) incentives under IRC Section 1202. Capital gains from qualified small businesses (QSB) are eligible for a 100% federal tax exemption up to the greater of $10 million or ten times the taxpayer’s original adjusted tax basis. Venture capital fund investors may be able to claim the full Section 1202 gain exclusion, 100%, if the fund makes a QSBS-eligible investment after September 27, 2010.
QSBS benefits work as an effective incentive for investors, which ends up encouraging riskier investments in the startup marketplace. Over a decade, venture capital investors could see an annual return of up to 33.3%. In comparison, hedge fund investors may only see an annual 7.5% return, and investors in global real estate could see a 15.2% annual return.
These returns can be even more lucrative from an after-tax basis. During a study between 2008 and 2018, venture capital investors saw a return on investment of over 50%.
Along with the potential tax incentives that qualified investors can take advantage of through QSBS eligibility, investors can also benefit from provisions in IRC Section 1244. This tax provision protects investors from incurring capital losses by allowing taxpayers to deduct certain QSB capital losses against ordinary income benefits.
Are Your Funds Investing in Optimizing for After-Tax Returns?
When investing through VC funds, it’s crucial to know how the funds handle after-tax returns. For starters, funds are required to report their Internal Rate of Return (IRR), but this is calculated before tax impacts.
For clarity, suppose you have two funds with the same IRR, but one generates about 30% higher after-tax return for their Limited Partners than the other fund. Most investors presented with this situation would choose the fund that provides the greatest after-tax return.
Funds Devoted to Tax Optimization
There are specific funds that make tax optimization central to their investment thesis. However, it is first essential to differentiate tax planning from tax optimization.
Tax Optimization vs. Tax Planning
Tax planning centers on analyzing and designing steps for future financial preparation based on your tax burden. In contrast, a tax optimization strategy refers to making decisions that will result in the lowest amount of taxes owed now and in the future.
Examples of Funds Focused on Tax Optimization
- HIP360 is a venture fund that is devoted to tax optimization. The HIP360 Fund is designed to utilize Qualified Opportunity Zones (QOZ) and Qualified Small Business Stock (QSBS) investments combined with federal tax subsidies and incentive plans to leverage Healthcare Technology business ventures. The fund makes leveraging eligible tax incentives a more streamlined process for current and potential investors.
- GRASS (Growth Resources, Assets, Safety, and Stability) is an OZ (Opportunity Zone) fund that promotes itself as a “qualified small business” under Section 1202. They focus on capital investment opportunities in the technology innovation and development realm. The fund makes tax incentives a centerpiece of investment structure, making potentially lucrative investments highly transparent to investors.
- Bam Capital is the private equity division of Bam Companies, an institutional real estate acquisition and management company. The fund provides transparent investment management and tax advantages and incentives that help investors build diverse portfolios and long-term wealth.
The Benefits of Tax Optimization VC Funds
These VC funds, along with others, make tax optimization a central component of their investment framework. Indicating tax advantages and breaks could be a way to encourage more capital investment in the startup marketplace by taking much of the upfront research and guesswork out of certain types of venture investment opportunities. This idea has sparked conversation in the realm of private equity investment and the startup landscape, causing many people to ask:
Should all venture funds be committed to tax optimization, or at least pinpoint ways that investors can benefit from forms of tax optimization?
Reach out and let us know what you think.
At Capgains.com, we are committed to contributing to a health startup ecosystem that impacts founders and investors and benefits the national economy and job market. If you need assistance uncovering ways you or your corporation can increase your tax optimization investment strategies, we are here to help. Our team of QSBS experts specializes in aiding investors in determining and actively maintaining QSBS eligibility over the lifetime of qualified stock.
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This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.