Your investment in a startup is not tax deductible. You can’t write it off like a business expense. But if the investment loses value or becomes worthless, you may be able to claim a loss if it meets certain IRS rules.
There are three possible outcomes of your startup investment: an ordinary loss, a capital loss, or a tax-free gain. Each of these depends on various factors, including the type of stock, your holding period, how it performed, and the company structure.
Section 1244: Deducting Startup Losses as an Ordinary Loss
Section 1244 lets investors deduct losses on small business stock as ordinary losses instead of capital losses. This is more valuable because it offsets ordinary income like wages and business profits.
What Qualifies?
To claim a Section 1244 loss, your investment has to meet strict IRS rules:
- The stock must come from a US-based corporation.
- You must be the original buyer. The stock must be issued directly to you for cash or property, not in exchange for services or other stock.
- The stock can’t be inherited, gifted, or bought secondhand.
- The company must have raised less than $1 million when it issued the stock.
- Over half of the company’s income must come from active business operations, not from things like rent, dividends, or royalties.
How Much Can You Deduct?
If you sell the stock for a loss or the stock loses all its value, you can deduct up to $50,000 if filing single or $100,000 if married filing jointly. This deduction must be taken in the tax year that you incur the loss.
Why It Matters for Startup Investors
Section 1244 helps investors recover losses faster than waiting to use capital losses over future years. It was designed to encourage investment in small businesses by offering tax relief when those investments fail. This part of the IRS tax law helps startups attract funding by giving investors a safety net, increasing the odds of successful entrepreneurship and job creation.
As an investor, this deduction lowers taxable income directly, providing a bigger tax benefit than a capital loss. It rewards your risks of early investing by letting you recover some losses faster.
Documentation
You’ll need proof of the stock’s original purchase price, the company’s capital structure, and evidence that you sold the stock at a loss or that it became worthless. Without this, the IRS will disallow your Section 1244 deduction.
In the event of a loss, a firm that specializes in startup CPA services will have the necessary experience to determine whether your stock qualifies for Section 1244 treatment and guide you in claiming the correct deductions. They’ll also ensure all documentation and reporting requirements are met.
Section 1244 Scenario
Say you and your spouse invested $100,000 in a qualifying startup. The company fails two years later, and the stock becomes worthless.
Because the stock qualifies under Section 1244, you and your spouse can file jointly and deduct the full $100,000 as an ordinary loss in the year the company failed. If you’re in the 32% tax bracket, that would lower your tax bill by $32,000.
If the stock doesn’t qualify, you can only deduct $3,000 per year against ordinary income. It would take over 33 years to match the tax benefit of a Section 1244 loss.
Section 165: Claiming a Capital Loss on Worthless Stock
Section 165 lets you deduct a capital loss when your C-corp stock becomes completely worthless. If the company fails and your shares have no value, you can report this loss on your tax return.
When Can You Claim It?
You must claim the loss in the year when the stock becomes totally worthless. You can’t claim a loss just because a company is struggling and your stocks declined in value [see § 1.165–4 (a)]. The IRS requires clear evidence that the investment has zero value.
How Much Can You Deduct?
The loss counts as a capital loss and follows a set deduction order.
First, it offsets any capital gains you have for the year. If your loss exceeds your gains, you can deduct up to $3,000 against ordinary income, like your salary or business income. Any leftover loss carries forward to future years.
You’ll Need Documentation
You’ll need solid proof like bankruptcy filings, canceled stock certificates, or a formal notice from the company confirming the stock is worthless. The IRS won’t just take your word for it.
Capital vs Ordinary Loss
Capital losses are only allowed to offset capital gains plus $3,000 of ordinary income each year. This means it can take many years to deduct large investment losses.
Ordinary losses allowed under Section 1244 will reduce your taxable income directly. That gives you faster and larger tax savings. This difference makes Section 1244 especially valuable for startup investors facing total losses.
But not every startup investment ends in a loss. Some deliver major returns and the tax code rewards investors who hold qualified stock long enough to realize those gains tax-free. That’s where Section 1202 comes in.
Section 1202: Tax-Free Capital Gains With QSBS
QSBS is stock issued by certain US-based C-corporations with less than $50 million in assets. You must buy the stock directly from the company, not on the secondary market, and hold it for at least five years. QSBS treatment is available to all taxpayers except C corporations. That includes individuals, partnerships, trusts, and S corporations.
The company must use 80% of its assets in an active business [see Section 1202(e)(1)]. Some industries, like consulting, finance, hospitality, and farming, don’t qualify.
What’s the Tax Benefit?
If you bought qualified small business stock (QSBS) after September 27, 2010, and held it for at least five years, you may exclude 100% of your capital gains from federal capital gains tax.
The exclusion is capped at the greater of:
- $10 million in gains, or
- 10 times your original investment
Any gains above those limits are taxed at a maximum of 28%.
Net Investment Income Tax and Alternative Minimum Tax
These gains are also exempt from the 3.8% Net Investment Income Tax (NIIT) and the Alternative Minimum Tax (AMT), making Section 1202 one of the most powerful tax breaks available to startup investors.
Why It Matters for Startup Investors
QSBS offers a powerful tax benefit to early investors who hold long term. It rewards patience by allowing a tax-free exit on gains, increasing your net return, and encouraging continued investment in startups.
For example, you could turn a $100,000 investment into $1 million and pay no federal capital gains tax on the $900,000 gain. Without QSBS, you’d owe up to $180,000 in capital gains tax.
State Tax Considerations
Check your state’s rules because some states tax these gains fully or partially. That means you may still owe state tax even if you qualify at the federal level.
Documentation
Keep records of when you bought the stock, how long you held it, and proof that the company met QSBS requirements at issuance. These documents are essential to claim the exclusion.
Want the Full Breakdown?
For an in-depth look at how to qualify, maximize the exclusion, and avoid common QSBS pitfalls, check out our full Qualified Small Business Stock Overview.
How Entity Structure Affects Your Tax Benefits
If you invest in a C corporation, your stock may qualify for Section 1244 ordinary losses, Section 165 capital losses, or the QSBS exclusion under Section 1202.
Investments in LLCs or S-corps don’t get these perks. Instead, income and losses pass through to you. You might deduct losses if you actively participate, but passive investors usually cannot.
Check the company’s entity type before investing. It affects how you report losses and which tax benefits you may qualify for.
What to Document for Startup Investment Tax Claims
The IRS requires proof of your investment, its value, and the company’s status to approve your deduction.
Keep these key records organized and accessible:
- Purchase agreement showing your cost basis and date of investment; or stock ownership certificate (electronic or paper) showing your ownership and date of issuance
- Company documents showing its legal structure and total stock issued (to prove eligibility for Section 1244 or QSBS)
- Cap table showing the date and amount of your investment
- Proof that the stock was originally issued to you directly (required for Section 1244 or QSBS)
- Records of any stock sale, including the date sold and the amount received, to show that you sold the shares for less than you paid (required for Section 1244 loss claims)
- Strong evidence that the business failed, such as shutdown notices, bankruptcy filings, canceled stock certificates, or official dissolution documents (needed for Section 165 claims)
Common Mistakes to Avoid
Startup investment tax rules are complex, and small missteps can cost you major deductions. Here are key mistakes investors make:
- Assuming all startup losses are deductible. Not every investment loss qualifies. The rules for Sections 1244 and 165 are strict and must be followed carefully.
- Forgetting to document your stock purchase. If you don’t have clear proof of when and how you acquired the shares and their fair market value at the time, your claim will likely be denied.
- Investing through the wrong type of entity. Using an LLC, trust, or fund to invest in a corporation will disqualify you from Section 1244. To qualify, the stock must be held directly by an individual.
- Reporting the loss in the wrong year. You must claim a Section 165 capital loss in the year the stock became worthless. For Section 1244, the ordinary loss must be reported in the year you sold the stock or it became worthless.
- Missing the QSBS exclusion after a profitable exit. Section 1202 can wipe out your capital gains taxes, but only if you claim it!
When to File an Amended Return
Missed claiming a startup loss under Section 1244 or 165? Or didn’t realize the stock was worthless when you filed your tax return? You may still have time to fix it.
You usually have three years from your original filing date or two years from when you paid, whichever is later, to amend your return. Be sure to include updated documentation and the correct IRS forms, as incomplete filings are often rejected. Since amended returns can get complicated, it’s smart to work with a tax professional who understands startup investments.
Make Every Startup Investment Count at Tax Time
Investing in startups carries risks, but knowing the tax rules will help you protect your investment and maximize benefits. Understanding Sections 1244 and 165 lets you turn losses into valuable deductions, while Section 1202 allows you to keep more of your gains tax-free.
Always keep thorough records and work with a knowledgeable CPA to ensure you claim every deduction or exclusion you qualify for. Smart tax planning is key to making your startup investments pay off—even when things don’t go as planned.
