Best Practices: Federal & State Tax Incentives for Venture Capital Investors

Kelly Williams, CDVCA

"Fill the capital gap by using tax policy, securities regulation, and pension law to increase the pool of individual investors who will consider investments in Entrepreneurial Growth Companies or to free up more of EGC company earnings for reinvestment." A Recommendation of the National Commission on Entrepreneurship, American Formula for Growth, Federal Policy & the Entrepreneurial Economy, 1958-1998, October 2002.

Tax policy as a means of encouraging angel investment in under served communities

Tax policy has always been a powerful tool for capital formation for American businesses; individual investors enjoy significantly lower tax rates (10% to 28%, depending on the individual's tax bracket) on capital gains than ordinary income, which contributes to a perception that such investing can offer exceptional returns. The National Commission on Entrepreneurship noted that " . the Tax Reform Act of 1986 drastically reduced the number of tax shelter schemes available to individual investors. As those evaporated, individuals' investment dollars sought other high-return opportunities, finding them in venture funds and direct equity investments in entrepreneurial companies." (National Commission on Entrepreneurship, American Formula for Growth, Federal Policy a then Entrepreneurial Economy, 1958-1998, October 2002.)

Most practitioners are familiar with federal tax relief given to individual investors in the form of IRC Section 1202, which allows non-corporate taxpayers to exclude 50% of the gain from the sale of Qualified Small Business Stock if a five year holding period is met and the stock was issued after August 10, 1993, effectively reducing the tax on their gain from 28% to 14% (One-half of excluded gain is a preference item for alternative minimum tax purposes, thus reducing the value of the exclusion)

Qualified Small Business Stock is defined as stock of a qualified small business having aggregate gross assets at the time of issuance of the stock of no more than $50,000,000. Certain types of businesses cannot qualify for the credit, such as those involved in the performance of personal services, such as legal, accounting or medical practices, or in certain industries including finance, real estate, farming, mineral extraction, lodging and restaurants, as well as mutual funds and REITs Moreover, capital gains from the sale of qualified small business stock held longer than six months may be rolled over into other qualified small business stock.

State Tax Credits

In recent years, several states have put together tax credit packages intended to spur investment in local businesses by individuals and firms and at least two other states are considering new legislation and appropriations to spur angel activity. An analysis prepared for the National Governors' Association in 2000 reported that five states offered tax credits for direct investments in local businesses and sixteen states offered tax credits for investment in privately managed funds with qualifying restrictions on investment activity; the report has not been updated and in several cases these programs are now inactive or are fully invested. (Robert Heard and John Sibert, Ph.D.,"Growing New Businesses with Seed and Venture Capital: State Experiences and Options," National Governors' Association 2000, p. 49.)

Tax credit packages are most appropriate for states with high marginal personal and corporate income tax rates and low levels of private equity investment, either state-wide or in areas of particular need.

The Minnesota state legislature recently considered adopting a 25% tax credit for individual investors in local seed capital funds. An analysis by MIN-Corp. of the impact on personal income tax and corporate sales tax revenue generated by portfolio companies of two such established funds in Minnesota revealed that an additional $454,800 in tax revenue resulted from the $2,314,000 invested in these two funds (19.6% of the total amount invested).

Using this real-life example, if $100,000 in equity financing results in additional tax revenue of $19,600 per year, then granting a tax credit of $25,000 on the $100,000 invested results in an annual return to the state of $19,600. Assuming that these businesses remain viable for five years, and without taking into account the general benefits of increased employment and future capital gains taxes, with a discount rate of 10%, the net present value of the state's $25,000 "investment" is $74,000. Or, to view it another way, it would take the state only 16 months to break-even on its $25,000 "investment".

On the other hand, it is not possible to say with certainty that every dollar of tax credit results in incremental investment above what would have otherwise occurred: the existence of a tax credit does not transform a bad business plan into a good one, and an investor who qualifies for a credit still has the bulk of his capital at risk. Because tax credits effectively come directly from state coffers they ideally should be targeted at the most under-invested and neediest areas.

The following is a sampling of various state tax credit incentives for individual investors and is not meant to be exhaustive.

Oklahoma: Generous Incentives for Investments in Funds or Direct Investments

The State of Oklahoma has authorized an Oklahoma state income tax credit of 30% of equity or nearequity investment for investing in an Oklahoma small business venture, either through a qualified rural small business capital company, or by an angel investor in conjunction with investment made after January 1, 2000 by a qualified Oklahoma rural small business capital company. Credits are available for tax years between December 31, 2000 and January 1, 2008, can be taken immediately or carried forward for as long as ten years.

Although the Oklahoma legislation contemplates a cap on the amount of credits available, an official from the Oklahoma Department of Commerce said that as of April 2003 there is no cap on the credits, rather, they are hoping to spur as much investment as possible and thus no cap is being contemplated. A 20% tax credit is offered to investors in qualified (non-rural businesses), either through a qualified small business capital company or by an angel investor in conjunction with an investment by a qualified small business capital company. Oklahoma also offers a Qualified Venture Capital Company Tax Credit, which the state describes as "freely transferable," in an amount equal to 20% of an investment in a qualified venture capital company. A qualified venture capital company must have been organized prior to July 1, 1992, and 75% of its capital must be invested in Oklahoma business ventures. The credit may be carried forward three (3) years or may be transferred (presumably, sold) to another taxpayer.

Iowa: Allocations of Tax Credits for Individual Investors

In 2002, the State of Iowa allocated a total of $10 million in tax credit incentives for fiscal years 2002, 2003 and 2004 for investments in qualifying businesses and community-based seed capital funds. The legislation provides a tax credit for a corporation, individual, financial institution, credit union and insurance company of 20% of the taxpayer's investment in a business, not to exceed $50,000 per business; no taxpayer can claim credits for investments in more than five businesses. The credit can be claimed three years after the investment and carried forward for five years after that. The credits are allocated by the Iowa Capital Investment Board. In order to qualify as a community-based seed capital fund, the fund must be organized as a limited partnership or a limited liability company and must have total capital commitments from investors and investments in qualifying businesses of at least $500,000 but not more than $3,000,000, and must have no fewer than 10 individual investors who are not affiliates, with no single investor owning more than 25% of the fund. The Iowa Capital Investment Board recently approved nine entities, seven businesses and two seed capital funds to receive the first allocation of credits. 13 13 Des Moines Register, 3/08/03,"Nine Iowa Startups Are in Line for New Tax Credits."

Maine: Credits for Individuals Making Direct Investments or Investments in Funds

Since 1996, the State of Maine has offered a tax credit to individual investors of up to 40% of the cash equity they provide to eligible Maine businesses, either directly or through private venture capital funds, and effective July, 2002, investments in eligible

businesses in high-unemployment areas can qualify for a tax credit of up to 60% of the investment. Investments of up to $5.0 million per business are eligible, provided the investment is at risk for no less than five years and the investor owns less than 50% of the business. Immediate relatives of the principal owners are not eligible for credits. For investments made before July 2002, investors can claim 15% of the authorized credit for the first six years of the investment and 10% in the seventh year. For investments after July 2002, 25% of the authorized credit can be claimed in each tax year beginning with the year the investment was made. Eligible businesses must be located in Maine, have gross sales of $3.0 million or less per year, be the full-time, professional activity of at least one of the principal owners, be a manufacturer or service provider with 60% of sales derived from outside the state or to out-of-state residents, or develop or apply advanced technologies, or must bring significant permanent capital into Maine.

Maine also offers tax credits to individuals who invest in private venture capital funds of 40% of the amount of cash actually invested in or unconditionally committed to a fund if the Finance Authority of Maine, which administers the credits, determines that the private venture capital fund is located in Maine, is owned and controlled primarily by residents of Maine and has designated investing in eligible businesses of Maine as a major investment objective. If fund investments are made in designated high unemployment areas, investors may qualify for tax credits of 60% of the amount invested. The amount of credits claimed by investors in a fund cannot exceed 40% (or 60% in the case of businesses located in high unemployment areas) of the amount of cash actually invested by the fund in eligible businesses.

Unfortunately, these credits have fallen victim to Maine's current fiscal woes: while the legislature authorized the issuance of tax credits of up to $8.0 million through 2001, the expansions authorized by the legislature have been suspended through June 2005. Coastal Ventures II LLC, a CDVCA member fund located in Portland, Maine, reports that it has received allocations of the Maine Seed Capital Tax Credit for eligible investors in its fund.

New York: Tax Credits in Empire Zones

New York State offers a 25% tax credit against personal or corporate income tax for contributing or purchasing shares in an Empire Zone capital corporation or for a direct equity investment in a certified Empire Zone business. New York State has designated 71 communities as Empire Zones in order to encourage economic and community development, business investment and job creation through a package of tax relief measures. Investments must be certified by the Commissioner of the Empire State Development Corporation, and the maximum credit allowed to a single taxpayer may not exceed $300,000. The entire 25% credit can be claimed the first year or carried forward, subject to some limitations, and is not refundable.