A couple weeks ago I made a public New Year’s resolution to invest in one startup each month. (Update: 1 investment made. Will announce soon.)
After publishing that article, a number of startups reached out to pitch me. Most were outside the U.S. and I politely had to say no.
Some looked like promising and in exciting fields with competent founders and reasonable valuations. But they were outside the US. So I still had to say sorry, no.
I’m not one of the bigots who thinks America can innovate better than anywhere else. There are problems to be solved, smart people to solve them, and money to be made everywhere in the world. But I can’t invest in startups outside the US for 3 reasons.
Reason 1: Tax Benefits for Investing in U.S. Corporations
The U.S. federal income tax rate for high earners is 37%, plus an additional 3.8% for investment income. (There are separate state and local taxes that aren’t relevant to this discussion.)
For an investment held for more than 1 year, the capital gains tax rate is 20%, plus 3.8%.
However, in an incredible tax break known as Section 1202, I pay ZERO tax on the investment in a startup if I hold it at least 5 years.
There’s also Section 1244 that allows me to write off failed investments (of which early-stage investors like me have many) against regular income instead of capital gains. I’m grateful for that one every year.
Unlike most countries, US citizens (and permanent resident) have to pay tax on total worldwide income. If I make $1M on an investment in Canada, I have to pay the 40.8% income tax or 23.8% capital gains tax on it. On top of that, I may also have to pay taxes in the local country.
So, I can invest in a great startup in Munich and pay income tax on the earnings, or I can invest in a U.S. startup and not pay any tax. Easy choice.
(Note: these tax benefits only apply to equity investments in C-Corps. They don’t apply to LLCs or S-Corps, and don’t apply to convertible notes until they convert to equity. Just as I don’t invest in non-U.S. corporations, I don’t invest in LLCs or S-Corps either, and want any convertible notes to convert to equity as soon as possible to start the 5 year clock running.)
Reason 2: Foreign Account Tax Compliance Act — the Stupidest Law Ever
It turns out some rich Americans were hiding income in overseas accounts to avoid paying taxes. And so were drug dealers.
So the U.S. government passed a law requiring all Americans with more than $50K overseas to report all their international bank accounts and investments to the IRS and Treasury Department every year.
Each investment has to be declared, including its highest value over the year.
What’s the value of the investment I made 3 years ago in Acme Corp? If they were public, I could look them up, but early-stage startups are impossible to value.
Do I pay a fine if I forget to include an investment on the form or get the valuation wrong? Nope — the government confiscates 50%! It’s insane. It was meant for tax cheats and drug dealers, but mostly it gets people like me.
In the end, the paperwork is a pain to fill out, I won’t have the information I need to fill it out correctly, and the penalty for not filling it out correctly is the government takes 50%. It’s not worth the hassle when there’s plenty of great startups to invest in at home.
Reason 3: Foreign Laws
If I invest in a startup, am I responsible for the company’s debts if they fail? Can I be sued personally for the company’s mistakes? If I invest in a corporation, no. If I invest in a partnership, yes. So I don’t invest in partnerships. End of story.
Outside the US — no idea.
What rights do minority shareholders have if the founders want to wipe us out? How difficult is it to enforce those rights in court? What do the terms of the investment agreement mean and are how binding are they if the founder wants to change them?
The U.S. legal system is a disaster, but at least I know the rules. And have lawyers available who can provide advice, and if necessary, file a suit. The same is not true with foreign investments.
This can be solved by hiring local lawyers and accountants. But it’s hardly worth the time and cost for a small investor in an early-stage startup.
Solution: Incorporate in the US
There’s a simple solution. If you want me to invest, incorporate your startup in Delaware.
It doesn’t matter if all of the operations are overseas. Make the local entity a subsidiary of the U.S. corporation. The local company is the operating organization while the U.S. parent is for investment. If the startup has customers or employees in the U.S., being structured as a U.S. corporation will make doing business easier, too.
With a U.S.-based corporation, it becomes possible not only for small angels like me to invest in early rounds but opens up later investment to the many US-based VC firms that only invest US corporations.
So before pitching me, be sure to set up a Delaware C-corp as the investment you’re pitching.
Note: I’m not a lawyer and not a tax accountant. Just a small investor explaining why I have to say no to your great startup in Munich.
Author: DC Palter