With the new crowdfunding rules taking effect in May of 2016, many are anticipating a groundswell of interest in early stage investing. Before you jump in as an investor, however, make sure you understand the implications — especially when it comes to taxes.

There are a few things you want to consider before investing, including the types of company structures you can invest in through crowdfunding, the vehicles you can invest through, and how the U.S. Tax Code applies to both the company structure and the investment vehicle.

There are many moving parts involved in the U.S. tax system. Interaction between these parts is where many of these complexities arise. Due to the geographical range of investors and the associated complexities with countries and states’ different tax regimes, this article will solely cover parts of the U.S. federal tax system as it relates to crowdfunding startups.

Types of Companies you can invest in:

Corporate structure is the first thing you want to note as an investor. There are two types of corporations that are most common: Limited Liability Company (LLC) and C-Corporation (C-Corp). There are also S-Corporations, however, new S-Corporations are rare since the establishment of the LLC.

Both types of incorporations protect individuals from liability, but differ when it comes to the tax implications. An LLC is a pass-through entity, meaning that all gains and losses sustained by the company are “passed through” to the partners (including the investors) in the company. This means you will pay or deduct the taxes on your personal return at your marginal rate. Also, all partners in an LLC are “equal”– as in there is no legal difference between the first investors and the most recent. Lastly, all investors in the LLC may be required to file income tax returns in any state where the company does business, which can be a hassle.

A C-Corp also provides protection against individual liability. C-Corps have an advantage for startups in that they allow for different classes of shares to be sold, most often preferred vs. common. This is one of the reasons it is rare for a VC or large professional firm to invest in an LLC. Additionally, there is a specific provision in the U.S. Tax Code, Section 1202, that is only applicable to a C-Corp. Section 1202 will be discussed in more detail below.

One major disadvantage of a C-Corp is double taxation. If the business is profitable, the company pays a first tax on its profits. Then, if it distributes those profits to its investors, they again pay a tax on those profits. This is often not an issue for a high-growth business that is spending more than its revenue. These losses are held by the company to be used to offset the C-Corp’s income in the future.

Vehicles that can be used for investments:

There are different types of investment vehicles that investors can use to invest in a startup. There are four common vehicles that are used by investors on crowdfunding platforms. They are:

1. Personal Investment – A personal investment from a brokerage or a bank account is thought to be the most common way for crowdfunding investors to invest. It is the quickest and easiest to complete and has the least hassles (dealing with fewest investment institutions, fewest forms, etc.).
2. Partnerships – A partnership is also fairly common and allows for another level of liability protection, as well as shifts any tax gains and losses to the different partners (members) in the
3. Trusts – Trusts are often used for investments and allow for one generation to protect, control, and pass assets to future generations without invoking the estate tax – a big advantage.
4. IRAs – The standard benefits of IRAs also apply when they invest in startups. Gains are tax-free until withdrawn, allowing for compounding interest without capital gains taxation (Roth IRAs are currently tax-free even when withdrawing). However, using an IRA to invest in a small company or startup often requires a substantial amount of time and effort, and the brokerage fees can be quite high. Most large brokerage houses will not permit investments in startups through an IRA, and the IRA must be transferred to a smaller company that will allow the investment to be made.

A few notable Tax sections:

The U.S. Congress has decided that encouraging investment in small, new companies is a worthwhile activity. Thus, they have added sections to the tax code to encourage investment in smaller companies. Three of the main sections that an investor can often use when investing in small, crowd-funded companies are Sections 1045, 1202, and 1244.

When possible, applying Sections 1045 and 1202 to your investments is most advantageous. Section 1045 allows for the profit from certain qualified small business investments to be rolled over into new investments in qualified small businesses – allowing the investor to not pay taxes for the first investment. Section 1202 allows for investments from certain qualified small business investments to be sold tax-free up to a value of $10 million. There are a number of qualifications that must be met for Section 1202 to be used, which I detail in this Section 1202 focused article but if it can be applied, it is extremely lucrative.

Under certain circumstances, Section 1244 allows an investor to deduct up to $50,000 from a loss in an investment to be applied to the investor’s tax return as an ordinary loss instead of a capital loss. This may be met when investing in a crowd-funded business. This is important because capital losses receive different tax treatment than ordinary losses. Capital losses can only be used to offset capital gains, which are taxed at a lower rate than ordinary income. Ordinary losses can be used to offset ordinary income, which is taxed at a higher rate.

Investing in small businesses is inherently risky, as I outline in the article How to Become an Angel Investor. As always, an investor should be prepared (mentally and economically) to lose everything in a startup investment. There are many things that an investor should keep in mind when investing in early stage startups. As always, consult with your financial and tax advisors when undertaking angel investing to know how these rules can be applied to your personal situation.

The information given here is meant to be informational only – it holds no legal weight.