Losers and Tax Returns
We hate it, but it happens: that promising company with the brilliant founder we invested in has failed. At least we can take a loss for tax purposes. However, if you have invested through an SPV, it adds insult to injury to have to pay the professional fees to file the tax return in order to pass the loss through to the syndicate members.
But does a syndicate have to file a federal tax return to pass the loss through to the investors?
Not necessarily. Under certain circumstances the members can just write off their investment in the syndicate as a loss on their personal returns, rather than paying to file a tax return for the SPV. So what are those circumstances?
Let’s begin with a safe harbor provision in the tax law. If an SPV should have filed a tax return, but fails to do so, the penalties can be quite severe. (Note: this is different from determining whether to file a tax return for an ongoing LLC that had no income, expense or credits. Please see our blog post on this topic.) When the investment made by the SPV fails, then there has been a transaction.
The safe harbor provision says penalties won’t be assessed even if you should have filed a tax return so long as:
a. There are ten or fewer members of the SPV. b. All members are individuals, estates of individuals or C Corporations. Note, in many syndicates, members invest through LLCs. If the syndicate has a member which is an LLC, then the syndicate is not eligible for the safe harbor provision and should file a return. c. Each member must have fully reported its respective share of income, deductions and credits of the syndicate. This shouldn’t be a problem as up until the write off the syndicate didn’t have any income, deductions or credits to report. d. Each member must have timely filed their tax returns.
So, in determining whether or not you need to file a final tax return, we recommend you first decide if the syndicate qualifies for the safe harbor. If it does not, then file a return. If it does, then look to the following:
1. Has the syndicate ever filed a tax return? If so, you will need to file a final tax return to close the file with the IRS.
2. Does the syndicate have any other assets or liabilities (e.g. holds cash reserves, or owns investments in multiple companies or a Fund)? If so, then the syndicate will continue even though it is writing off an investment and it will file its normal return.
3. Is the investment eligible for section 1244 tax treatment? If so, a tax return will be filed to pass this favorable treatment on to the investors.
4. Has the security been held for more than one year? If at least some of the underlying investment was purchased within one year of it becoming worthless, then you will need to file a return in order to pass through the short-term capital loss.
A final consideration – depending upon the state in which your SPV is organized, that state may require a tax return regardless of whether a federal return is required or not.
If the SPV qualifies for safe harbor, and if the answer to the four questions above is NO, then the managing member may consider telling the members to simply write off their investment in the syndicate on their personal returns rather than filing a tax return for the SPV to pass the loss through to the members. We recommend you consult with your tax advisors on the exact facts of your situation before making the decision to file or not to file. Loon Creek provides guidance on this decision for all SPVs managed by us, and may be able to assist even those that are not.
Loon Creek specializes in syndicate formation and management services for private investors (and for the companies in which they invest). You can learn more about our services on our website.