Investing in the stock of a private company can be a risky endeavor, but it does deliver tax benefits, regardless of whether the risk results in a gain or loss. The corporation must meet standards defined by the Internal Revenue Code for the stock to receive special tax treatment. Keeping a record of your cost for purchasing the stock is crucial to determining the tax consequences from either losing money on your investment or realizing gain from selling the stock.
Qualified Small-Business Stock
Special tax treatment is available for investing in private stock that meets the definition of qualified small-business stock. This is stock issued by a U.S. corporation after August 10, 1993, when that corporation is a “qualified small business” and the company issued shares to the stockholder in exchange for his services, cash or property other than stocks. A qualified small business has C corporation tax status and gross assets of less than $50 million. The corporation must conduct an active business rather than merely invest in other ventures or real estate.
Capital Gain or Loss
When you sell stock, the difference between sales proceeds and your cost is either a gain or loss. A sale occurs when you give stock back to the corporation in exchange for cash or other property. You have zero sales proceeds when stock becomes worthless because the corporation stops operating and has no assets to liquidate. Gains from selling stock are taxable income. Stock losses offset taxable gains from other investments. Also, a stock loss is deductible against other sources of income up to $3,000 per year. Excess is carried forward to the next tax year.
You’re generally allowed to exclude from tax 50 percent of the gain realized from selling qualified small-business stock that you held for more than five years. The amount of exclusion is limited to the greater of $10 million or 10 times your cost for the stock. You can exclude this maximum on each qualified small-business stock you sell in the same year. The exclusion is 75 percent of the gain on qualified small-business stock that you purchased after February 17, 2009, and before January 1, 2011. Part of the excluded gain is counted as income in calculating the alternative minimum tax, which is a different tax system applicable to some high-income taxpayers.
Under certain conditions, you can deduct a loss on private stock from ordinary income without the annual restriction of $3,000 per year. The maximum amount you’re allowed to claim per year under this provision is $50,000 (or $100,000 for a joint tax return). You must have purchased the stock for cash or other property directly from the corporation. The company must be established in the U.S. and have C corporation tax status. In addition, the corporation cannot derive more than half of its gross receipts from passive investing for the five years preceding the stock loss date. A corporation designates a maximum of $1 million in stock as qualifying for this special tax treatment.