The Access to Capital for Entrepreneurs Act of 2007: an extension of the impact of tax policy on informal venture investing.

White, John B. ; Lockwood, M. Jill ; Miles, Morgan P. 等

"(D)oes a tax credit 'really lead to investments? Does it make an investor invest in bad deals? Does it make people who should not be investing invest?"'

(Preston quoted by DeBaise 2007: R6).

Government policy makers often look towards the small and medium sized business (SMEs) sector for job creation and other economic development benefits such as increasing the tax base. U.S. Congressman Don Manaullo's January 19 press release on creating anew federal tax incentive for early stage business angel investment notes that four jobs are created for each angel investment, resulting in net job creation and economic development benefits. Even without federal tax incentives to encourage additional angel investing the informal venture investment market grew by 10% during 2006 (Wright 2007).

The U.S. Small Business Administration has championed the cause of SMEs through management development and training programs such as the Small Business Development Centers, Service Core of Retired Executives (SCORE), including management training opportunities available on-line through SBA's web portal. However, while both management and marketing capabilities and opportunities define an entrepreneurial venture's success, the limiting factor for many entrepreneurial ventures is simply the lack of early stage seed and risk capital. Wise and

Miles (2003: 11) suggest that:

"Policy makers in the U.S. and Europe understand that entrepreneurship by large and small corporations can be influenced both by regulatory controls and reward stmctures.. .Government policy makers, globally, tend to rely on two major categories of tolls to induce entrepreneurial activities by corporations (or SMEs): (1) tax incentives; and (2) direct government support."

The Access to Capital for Entrepreneurs (ACE) Act of 2007 is designed by government policy makers as a private sector solution to increase the supply of early stage seed capital for high potential entrepreneurial venture by creating a tax incentive for "qualified investors" to take equity positions in SMEs. The ACE act of 2007 follows the example of several states which have allowed individual angel investors or angel investment pools to benefit from a 25% tax credit, up to a maximum credit of $250,000 for informal venture investment held for at least three years. This investment tax credit has created an economic incentive to encourage additional angel investing.

HOW DOES THE PROPOSED TAX CREDIT FUNCTION?

Individuals and investment partnerships made up of only "qualified investors" are entitled to claim an investment tax credit when making informal venture investments in a "qualified small business." SMEs are qualified by size standards, domicile in the U.S., and corporate control (see HR 5198).

A recent paper by White, White, and Miles (2006) suggests that the topic of angel investing has recently become much more important to small businesses and government policy makers and explores the question: "Is informal venture investing an economically rational decision?" This study updates that discussion in light of the proposed Access to Capital for Entrepreneurs (ACE) Act of 2007. Specifically, this study incorporates the implications of the proposed federal investment tax credit for informal business angel investments on potential rates of return. In this case, the internal rate of return on informal venture investments is evaluated in a scenario where the business angel can benefit from the financial effect of ACE.

The proposed legislation for Angel Investments proposes to allow a qualified investor a 25% tax credit for an equity investment in a qualified small business. This means that a qualified investor who makes a $1,000,000 investment in a qualified small business will receive a $250,000 tax credit. This tax credit lowers the investor's federal tax liability by $250,000. This means that an investor who owes $300,000 in federal income taxes will have his tax liability reduced to $50,000 [$300,000 -$250,000]

The investor's tax basis (investment) in the equity investment is reduced dollar per dollar by the amount of the tax credit. This means that the investor in the above example will have an adjusted basis of $750,000 [$1,000,000-$250,000]. If the investor sells the equity investment at a gain, the gain will be measured as the difference of the Amount Realized (gross sales price less cost of the sale) (1) and the investor's adjusted basis in the investment (cost plus capital additions less capital recoveries) (2) Accordingly, if the investor sells the investment for $2,000,000, the investor will realize a gain of $1,250,000 [$2,000,000-$750,000].

If the investor is an individual, the investor will be entitled to a capital gains preference depending on how long the investor held the stock and how the investment is classified for tax purposes. If the stock is classified as IRC Section 1202 stock (stock in qualified small businesses) the stock is entitled to a 50% exclusion from tax if the stock is held for more than five year. The regular tax rate for Section 1202 stock is 28%. Therefore the effective rate is 14% after the 50% exclusion.

If the stock is not classified as Section 1202 stock, the individual investor is allowed a tax preference that will tax the gain at a maximum rate of 15% providing the stock is held for more than a year. (3) Corporate investors who are taxed under the rules of subchapter C of the Internal Revenue Code receive no tax preference on capital assets regardless of the holding period.

If the investor sells the stock at a loss, the amount of the loss allowed in any given year depends on a number of different circumstances. If the stock qualifies as small business stock under IRC Section 1244 the maximum loss allowed in any year is limited to $50,000 ($100,000 if filing a joint return). Therefore, if the stock in the small business becomes worthless, the investor realizes a $750,000 loss [$0-$750,000]. If the investor is not married, the investor is allowed a $50,000 loss the first year and the rest of the loss is treated as a long term capital loss. Individual investors are allowed a maximum deduction of $3,000 per year on net capital losses. If the investor was married and reports the loss on a joint return, the investor may deduct $100,000 in the year of the loss and deduct the rest as a long term capital loss. The $100,000 loss is allowed regardless of whether the stock was held by one spouse or by both spouses. Any loss not used in the year of sale is treated as a net operating loss and may be carried back two years and/or forward 20 years. 4

If the investor is single, the investor will have $700,000 in long term capital losses [$750,000 $50,000]. If the investor is married, filing a joint return, the amount of the long term capital loss is $650,000 [$750,000-$100,000]. These losses can be carried forward indefinitely but will die with the taxpayer. Of course the investor may use these long term capital losses to offset current capital gains. The best use of the loss would be to offset current short-term capital gains which receive no preferences and are taxed an ordinary income rates. (5)

If the investment is treated as a passive activity, there are additional complications. If an investor invests in a partnership or in an S corporation, either entity passes gains and losses through to their investors. If the investment makes money, the income flows through to the investor who is currently taxed on the income regardless of whether or not the income is distributed to the investor. If the investment looses money, the losses pass through to the investor. However, if the investor is a limited partner or does not materially participate in the investment, the investment is treated as a passive activity. (6)

Losses from a passive activity are suspended unless the investor has income form a passive activity to offset the losses. Even if there is income from a passive activity, the loss will be disallowed if (1) the loss exceeds the investor's basis or (2) if the investor is not at risk with respect to the basis.

If the investor invested in a passive activity, our investor will not be able to deduct losses passing through to him if the losses exceed his basis (currently $750,000). If the investor borrowed money to purchase the investment and the loan is characterized as a non-recourse loan (the lender has no recourse beyond the collateral) the investor will not be able to deduct losses beyond the investor's economic risk. (7) For example of our investor borrowed $700,000 as a non-recourse loan with the stock as the only collateral, our investor is only at risk to the extent of $300,000 [original investment of $1,000,000 less $700,000) Since $250,000 of the basis was reduced by the credit, our investor is only at risk to the extent of $50,000.

If there is no passive activity income to use as an offset, the losses are suspended indefinitely until the investor sells his entire investment in the passive activity in a taxable transaction.

RATES OF RETURN UNDER ACE 2007

Consider a project that requires an angel investor to commit $1 million dollars with a 10% probability of a maximum upside return of $20 million in five years. The expected value of the investment is $2 million. In the absence of any special tax treatment of angel investments, the investment has an expected return of 14.8%. This investment is shown on the timeline below.

[ILLUSTRATION OMITTED]

However, that same project's return would increase to 21.7% if the project qualified for the ACE 25% investment tax credit. This investment is shown on the timeline below.

[ILLUSTRATION OMITTED]

This rate of return is nearly 46% higher than the same investment without the proposed federal ACE investment tax credit. It is not unreasonable to assume that investors will respond to such a dramatic increase in returns. Projects that were marginal without the ACE investment tax credit become very attractive if the returns rise by over 40%. It should be noted that this increase in returns is not the result of an increase in the project's risk. In fact, while the risk of the later cash flows is unchanged, the cash flow resulting from the tax credit is immediate and risk free. Therefore, the project's overall cash flow risk has decreased.

CONCLUSION

It is clear that the ACE proposal will make angel investing significantly more economically attractive. Increased angel investing will provide more seed and start-up funds for promising entrepreneurial ventures resulting in an increase in economic activity and job creation. In addition, our analysis suggests that the ACE investment tax credit will not create disincentives for investor due diligence as the tax credit is limited to 25% of the first $1,000,000 invested. Angel investors by regulation and definition are sophisticated investors who have the resources and capabilities to properly vet investment opportunities, and the desire to achieve high portfolio rates of returns. The ACE federal investment tax credit proposal will simply reduce the downside risk for angel investors in an effort to stimulate additional investment into high potential entrepreneurial firms. Enactment of the ACE federal investment tax credit will benefit entrepreneurs, angel investors, and the nation's economy.

REFERENCES

DeBaise, Colleen (2007), "On Angels' Wings," Wall Street Journal, Monday March 19, R6.

White, E.P., White, J.B. & Miles, M.P. (2006) "Is it as risky as it seems? A short note on how tax policy impacts informal venture investing," Academy of Entrepreneurship Journal, 12(1): 109-117.

Wise, S., & Miles, M. (2003). "The R&D tax credit and its implications for SMEs," Journal of Applied Business Research, 19(3): 11-17.

Wright, Lori (2007), "Angel market grows 10 percent in 2006," Press release, Whittemore School of Business, University of New Hampshire: Durham, N.H. March 19, 2007.

ENDNOTES

(1) IRC Section 1001(b).

(2) IRC Sections 1011 and 1016.

(3) IRC Section 1(h).

(4) IRC Section 1244(d)(3)

(5) IRC Section 1222.

(6) IRC Section 469.

(7) IRC Section 465.

John B. White, United States Coast Guard Academy

M. Jill Lockwood, Georgia Southern University

Morgan P. Miles, Georgia Southern University