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Sohodojo Advisory Board Member
Jim Schneider
The Taxman86 Speaks...
29 June 2000
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Raising Capital the Angel Way; Do Tax Incentives Work; What is an Empowerment Zone Investment.

1. We have all heard the term Angel, what is it?

The discussions of Angel Investors has been around for sometime and the SBA Web Site provides an opening for those looking for startup investors. However, an article in yesterday's New York Times is a real eye opener, with a potential market of 1M Angel Investors with over $40B. It is clear that the Internet is playing an important role in the effort to match buyers and sellers of risk capital. Check out Garage.Com or VentureHighway.com or Redherring.com to get the flavor of what is going on with Angel investments on the WEB.

Where is this all going? Information is king we have been told, and thus with the flood of information the market becomes smarter, as set forth in the Cluetrain Manifesto.

How many people today know that if you have invested in a C Corp. since August 10, 1993, and it had less than $50M in gross assets when you were issued the stock, that you more likely then not own IRC Section 1202 Qualified Small Business Stock [QSBS] which then allows you to sell and reinvest the capital gains into another QSBS, since the fall of 1997? This includes stock received under an Incentive Stock Option [ISO] or Non qualified Stock Option [NQSO]. However, to get this tax free roll over benefit you MUST reinvest within 60 days.

Where are these other QSBSs for reinvestment purposes? Is there a Web Site for QSBSs looking for venture capital? Are there Angels looking for QSBSs who currently own QSBS ready to be reinvested? We assume it may be found in the Incubators that are being formed by the more agressive Angels as the New York Times article sets out or in the groups of Angels that are being formed.

Next comes the issue of UP FRONT tax incentives, a sure winner for seeking Angel Investors, to wit, the Doctors and Lawyers, and others as the New York Times article suggests.

2. UP FRONT tax deductions where art thou?

In the pre 1986 days it was very common to find investments that would provide up front deductions that could be used to off set ordinary income but as we know those days are gone. IRC Section 469, the Passive Loss limitation suspends all passive losses and credits until there is passive income, and salaries do not count, nor does portfolio income--e.g., dividends and interest--nor the gains from the sale of stocks and bonds.

The key to these rules is the issue of 'material participation' which generally requires 500 or more hours [husband and wives who work together get double time] on the passive activity.

What is interesting with the New York Times Article is that the Angels are providing other things besides money, and that these groups are then moving into the incubator concept. In short it appears that the Internet is allowing people to materially participate and satisfy the 500+ hours via the NET. If that is so then the losses, and its clear that most Dot-Com startups have losses, may be taken by those Angel investors who materially participate.

However, if you want the benefits of a QSBS, as noted above, the investment must be made into a C Corp. and the capital gains roll over requires the purchase of stock in another C Corp. Thus Limitied Liability Companies [LLCs] do not cut it. How about the new proposed capital gains roll over for Empowerment Zone Investments? See below.

3. Empowerment Zone Investment under IRC Section 1397B.

If you go to the definition of Enterprise Zone Business under IRC Section 1397B or to the definitions under IRC Section 1400, et.ct. for D.C. Enterprise Zone Investments we find that sole proprietorships, partnerships, S Corp.s and C Corps. are included.

As such it is not surprising that under the definition of Empowerment Zone Investment for purposes of the proposed capital gains roll over the same applies. Thus you can move your gains from one Empowerment Zone Investment to another, with commercial real property included. It also covers a much broader list of activities, including service activities, such as legal, accounting, consulting, artists, actors, entertainers, sports people, etc., so long as the other rules are satisfied, including 35% of the employees [full or part time] are from the Empowerment Zone, or Enterprise Community, as the case may be.

[Mel Gipson apparently can get $25M per movie we are told, but was paid standard rates for an upcoming movie called Million Dollar Hotel, which was filmed in the Los Angeles Federal Empowerment Zone, as are many movies are today. Is it possible that his percentage interest in the movie company Million Dollar Hotel, LLC (most are LLCs) is an investment in an Empowerment Zone Investment if made after January 1, 2001?]

In summary, the creative ones will be looking at Empowerment Zone Investments very closely if it suddenly becomes the investment of choice for the Angels in the New Economy. Now that will be exciting to see, all these creative types running around dark, dirty and dangerous Empowerment Zones and possibly Enterprise Communities, on the Web, of course, if the Distressed Communities legislation passes, and it will, this year.

Jim Schneider, LL.M.

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