Angel tax credit

SC angel credit trading season

Last week’s post about the after-tax returns of angel investors was prompted partly by Malay and partly because it’s the time of year when people buy and sell 2018’s angel investor tax credits.

Our members and others want to buy these credits, so if you have some but can’t use them we would love to talk about it. Our intro guide, and the series of blog-posts from the archives (beginning here), particularly the FAQs for buyers and sellers, are popular this time of year.

If you have any for sale, please get in touch - we can help.

Angels' post-tax returns

Across our series of posts last month, we tried to slay the myth that most angels lose money. Most VentureSouth angels do not.

An avid reader and successful angel suggested we consider the post-tax returns (thanks Malay), so here we go.

First, taxes on successful investments reduce gains, of course. But they don’t turn gains into losses, so looking at the post-tax returns can’t increase our 10% proportion.

In fact, taxes likely reduce that proportion still further. Really Paul? 

Well, actually, yes. Angel investing enjoys many interesting tax benefits, as almost everyone recognizes the benefits of early stage companies getting funded. This isn’t a policy paper, though, so here are just two tax issues particularly relevant to failing angel investments: Section 1244 and the SC angel investor tax credit.

Before you click away, trust me this isn’t that boring and you’ve already nearly finished reading this post.

1)    Section 1244 loss: if you invest as part of the first million dollars in a company and lose money, you can deduct what lost as an ordinary income loss. This is amazing. Caveats apply and the detail is complicated; but the bottom line is that this is a remarkable silver lining in failed angel deals. The benefit is [the loss]*[marginal income tax rate] – which definitely reduces the loss (so that 0.6x ROI portfolio might have been more like 0.7x post-tax) and could even be enough to turn a small loss into a post-tax gain.

2)    SC angel tax credit: if you invest in some SC-based companies, you might get a 35% state income tax credit. Invest $10,000 in a qualified SC angel round; knock $3,500 off your state taxes in future years. Again, caveats and complexities apply – our guide covers a lot of them(and oddly you lose some of this benefit if you lose money on the investment!) – but this is another silver lining. As a credit against income, the reduction of the loss is even greater: you essentially (simplifying a bit) make a 0.35x ROI even if you lose all your investment. That could easily be enough to turn a loss into a post-tax gain.

And yes (1) and (2) stack! So, post-tax, in the right deals done correctly, even angels that lose money might make money.

SC angel tax credit - December deadline and Q&A

Our recent series of posts about the South Carolina angel investor tax credit (summary here) and Crowdr video (here) about the tax implications of angel investments prompted several people to email with questions. Below are our attempts at answers. As always, discuss with your tax advisor.

And do that soon. If you want to get the credit for an investment you made in 2016 you need to apply to the Department of Revenue BEFORE THE END OF DECEMBER. If you leave it until next year, you’ll be too late. (Don’t be one of the not-approveds!)

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1. For a convertible debt investment, is the investment in the debt eligible for the credit, or is it when the debt converts into equity (even if that conversion occurs after the company is older than five years)? The investment in the debt is eligible – it does not matter when (if ever) the convertible debt converts to equity.

2. Does the five-year clock start running for the start-up when the company is first registered as an LLC in SC, or when taxes are first filed for the company? When the company is first formed by registering with the SC Secretary of State.

3. How does a founder document their investment in order to claim the angel investor tax credit? As part of forming the company, the incorporation documents should specify the kinds of shares available and who owns them. A company bank account statement showing receipt of funds and/or a personal account statement showing sending of funds is probably sensible to retain too.

4. How long does the paperwork approval process with the SC secretary of state usually take?  It takes about five minutes to fill out - then you need to get it notarized.

5. Does it cost anything? No, other than $5 to get the application notarized and 46c for a stamp to mail it in!

6. How easy is it to sell tax credits? How many angel investors have done it this year and is it a common practice? What amount of tax credit would be worth selling?  

  • Selling the credit is fairly easy if you have the paperwork and a buyer lined up! The transfer requires a “transfer agreement” and a filing with the Department of Revenue to approve it.
  • It is still a fairly rare practice, as most people that claim the credit can use it so have no need to sell it. We don't know how many investors sold a credit this year, though we know around $30k of credit has been transferred between our members.
  • You can sell as little as you like – but remember the buyer is only really getting “the spread” as benefit (e.g. 15c on the $ of credit), so it may not be worth a buyer’s effort to buy only a small amount of credit.

The SC angel investor tax credit - a summary

Over the last couple of weeks, I think we’ve told you everything we know about the SC angel investor tax credit.

As a quick reminder, it is a credit against your South Carolina income tax liability, of up to 35% of the amount you invest in a qualified South Carolina Company. Here’s the overall guide for more of an introduction, along with our FAQs on buying or selling a credit; an intro to the credit recapture provisions; and an update on its usage so far.

What have we missed? What would you like to know about the tax credit, or about anything else relating to tax issues affecting early stage investing?

We had a Crowdr session on tax issues relating to angel investing, where we covered this credit more. You can review the video here and if you have other questions please let us know.

The SC angel investor tax credit - how it is used

Continuing our series on the SC angel tax credit, this post updates our data on the use of the credit. This is publicly available information, but I don’t think it is summarized in one place, so we hope it is useful.

Qualified Businesses

The chart below updates our slides from last year on how many businesses have applied to become eligible for the credit. After a strong start, the number of companies applying to be qualified (as QBs - Qualified Businesses) fell a little in 2015 and 2016 (with data below shown through August).

Why? Our guess is that 2014 saw the “backlog” of applications from companies that wanted to become qualified but couldn’t because the credit was not yet available. Around forty companies (the 2015 and estimated full year 2016 levels) is probably at the “mature” amount that we’ll see now this backlog has passed.

Interesting to see that “Silicon Harbor” has fewer qualifying businesses than Greenville County so far. Wonder if Lowcountry Angels can help change that?

Credit Awarded

The credit is definitely being claimed. In 2015, the full $5 million of credits were issued for the first time, a 75% increase over the $2.9 million awarded in 2014. Over 150 investors applied to get the credit (up 64% over 2014), and most were successful (141, or 90% of the applicants - the highest so far as people fully understand the rules).

In fact, a total of $15.4 million of qualified investments were made: the final credit was 32.4% (rather than 35%) as all applicants were pro-rated down, meaning over $15 million was applied.

Based on our investment activity so far this year, we suspect the full $5 million will again be used in 2016 – with VentureSouth companies like Crowdr, ActivEd, and TipHive joining other SC companies in successful fundraising efforts.

We thought it interesting to see that the vast majority (90%) of investor applicants were from South Carolina. (A portion of the 10% “out of state” were members of our Asheville Angels group.) This demonstrates that there is capital here to invest in early stage companies. But it is also good to see that SC companies can attract out-of-state investors to invest here.

There is no publicly available data on what proportion of the awarded tax credits were actually used.

Takeaways:

Entrepreneurs: apply to be a qualified business before you try to raise capital. It’ll show you’ve done your homework.

Investors: make sure the business you plan to invest in is qualified BEFORE YOU INVEST!

The SC angel investor tax credit - "credit recapture"

When the “High Growth Small Business Access to Capital Act” was passed and created the SC angel investor tax credit, it included Section 11-44-65 which outlines what happens when an investment pays off. Essentially, if the investor recognizes a capital gain, some portion of the original credit must be repaid.

Why? The idea is this “pays for” some of the cost (in terms of reduced tax revenue) of having the credit. By penalizing investment, though, it partly undermines the point of the act.

When does this apply? When the investment made by the angel investor sees a return – typically when the company that received the investment is acquired.

How do we calculate this? This depends. The SC Department of Revenue’s Revenue Ruling #14-6 (section III) gives the ultimate guide. SC taxpayers can deduct 44% of the net* capital gain from their SC taxable income (per SC Code Section 12-6-1150).  If there is a capital gain on the investment that created the tax credit, the amount of the deduction reduces.

(* Net capital gain is long term capital gain less any short term capital losses in the year.)

I need help understanding the calculation. This is probably beyond our ability to assist. You should consult your tax advisor, or one of our accounting sponsors, for more assistance on the calculation.

What about if I lost money on the investment?  The same theory applies, just in reverse: the amount that a taxpayer can claim as a net capital loss is reduced. The same Revenue Ruling #14-6 is the place to start.

Does this apply if I’ve bought (or sold) a credit? This all applies to the original investor. If you bought the credit, you don’t have to worry about any of this; if you sold your credit, you do. Hopefully, it’s a nice time to do this calculation though – you received cash from your original credit sale years ago, and now you’ve made money on your investment, so you’re winning.

Bottom line: how much of the 35% tax credit am I effectively getting if I receive a nice capital gain?  It depends on the multiple of return (and probably many other things). We estimate that if you make a 2x return on the investment, the effective tax credit is 32%; if you make 10x, it is closer to 20%.

The SC angel investor tax credit - a seller's FAQ

SC angel investor tax credit – a sellers FAQ

If you made an investment in a qualified South Carolina company and received an angel investor tax credit but don’t have any South Carolina income tax liability you can sell your credit. This FAQ explains how.

We are not tax advisors or giving tax advice: consult your own advisors and don’t rely on “experts” like us before you do anything with a tax credit! And read the last question below.


I can sell a SC angel investor tax credit? Yes.

Why would I do that? To turn an asset that is currently worth nothing into cash.

Give me an example. Say you were awarded a $3,000 credit for an investment you made last year. If you don’t have a South Carolina income tax liability, the credit is useless for you. But you can sell it. Let’s say someone would give you 85 cents on the dollar of face value: you get $2,550 in cash. You could use that to buy an annual membership in an angel group.

How do I know if I have a credit? You should have received a note of an award from the Department of Revenue in February of the previous year. (If you’re a member of a VentureSouth group, the credit was on your SC K-1 from the investment entity.)

How much can I sell? As much or as little as you want. You don’t have to sell it all at once.

This sounds difficult. How do I learn more? It isn’t. We have helped many people (both our members and others) buy and sell credits, and are happy to help you too. Start with our guide and if that’s not enough, contact us.

I’ve had the credit for a few years. Is it too late to sell? No. A buyer can use your credit for up to 10 years from when the original investment was made.

How do I find a buyer? Contact us and we’ll help you.

What impact does selling the credit have on my original investment? None whatsoever. If you invested $10,000 in a company, it is still worth $10,000 regardless of whether you buy, sell, use, or forget about the credit.


Some “extra credit” questions:

What if I already used some of the credit? You can sell whatever you have left.

What happens when my original investment pays out? The credit is subject to some “recapture” if the investment makes a payout. The rules on that are complicated, but they are not impacted if you sell the credit.

This is all too good to be true. What’s the catch?

(1) There’s some paperwork and it’s an illiquid market so there will be some expenses along the way.

(2) If the Department of Revenue invalidates the original credit, the buyer will have recourse against you as the seller. Use good transfer documents and keep good records.

(3) Once you sell the credit, you can’t get it back – even if you get a SC income tax liability in the future.

(4) There may be capital gains to pay for selling a “tax credit asset,” or other implications. Ask your tax advisor for a full run-down before you buy or sell a credit.

The SC angel investor tax credit - a buyer's FAQ

Anyone can purchase a SC angel investor tax credit to save money on their SC income tax bill.

I’ve tried to create an easy-to-understand FAQ. I’ve probably failed, but hope perhaps the below is helpful anyway.

Note: We are not tax advisors or giving tax advice: consult your own advisors and don’t rely on “experts” like us before you do anything with a tax credit! And read the last question below.


I can buy a SC angel investor tax credit? Yes.

Why would I do that? To save money on your SC income tax bill.

Give me an example. If you buy $3,000 of credit, you can take $3,000 off your SC income tax liability. If you paid 85 cents on the dollar of face value, it would cost you $2,550 in cash. The difference ($450) is your spending money.

Who can buy one? Anyone. You do not need to be an accredited investor. (Unlike the original investment, anyone can purchase the credit to reduce their tax liability.) Companies can buy them too. (But check with the Department of Revenue before you buy them with an LLC because it’s possible they cannot be “passed through” if they’ve been purchased.)

How much can I buy? As much as you want. (There’s a maximum of $5 million of credit each year, and most investors want to use them rather than sell them. But if it’s available, you can buy it. You can’t use more than your total SC tax liability in any given year, but you can carry unused credits forward to use later.)

This sounds difficult. How do I learn more? It isn’t. We have helped many people (both our members and others) buy and sell credits, and are happy to help you too. Start with our guide, which we think is a pretty good overview on the tax credit. If that’s not enough, contact us.

I have a credit from being the founder of a qualified company. Can I sell mine? Yes. You can use your credit for up to 10 years, so you might want to wait a while before you decide to sell. Or a bird in hand…

How do I bid on a credit? Contact us and we’ll help you with the process.

Why is this possible? The credit is designed to encourage people to invest in early stage companies in South Carolina. Where the capital comes from is less important. If we attract risk-tolerant early stage investors to support our companies from out of state, that is OK; so the credit was deliberately available to investors outside of SC. But out-of-state investors often can’t use it because they don’t have a SC income tax liability. So to encourage them to invest anyway, the credit was made “transferable.” Essentially a non-SC person can sell it to someone that can use it.

How do I actually use the credit? Once you’ve bought the credit and have all the paperwork, you have to file a regular “tax credits” form as part of your state tax return. You’ll need a SC Form 1040TC “Tax Credits” or SC Form 1120-TC “Corporate Tax Credits”. (A transferred credit is not reported on Form TC-56, “Angel Investor Credit.”)


Some “extra credit” questions:

Can I only use 50% of the credit in the year I buy it? No, you can use 100%. (The original credit owner can use only 50% of the credit in the first year after receiving the investment. A buyer can use 100% of the credit on the taxes of the year in which the buyer bought the credit.)

Wait, what tax year do they relate to? Purchasers use the credit on the tax return for the year in which they buy the credit. So if you want to reduce your 2016 tax amount, you have to buy them before December 31. If you wait until next year, you’ll be buying to reduce your 2017 tax burden.

When do they expire? The credits must be claimed within ten years of their original date. So if a seller held it for four years then sold, you have to use it within the following six years (not ten).

Is the credit subject to recapture? Yes – but for the seller not the buyer, so a buyer doesn’t have to worry about it. (Explain that: If the original investment really pays off and generates a capital gain for the original holder of the credit, the original holder has to repay some of the original credit. That requirement stays with the seller even if they sell or transfer the credit.)

This is all too good to be true. What’s the catch? There are, of course, some wrinkles.

(1) If you make a mistake and buy credit you can’t use, that’s tough luck – you can’t sell it again because it’s transferable only once.

(2) There’s some paperwork and it’s an illiquid market so there are some expenses along the way.

(3) If the Department of Revenue invalidates the original credit, you can’t claim it. (Your recourse is against the seller, so use good transfer documents and keep good records.)

(4) There may be capital gains tax on the “spread” and if you don’t take a standard deduction on your federal taxes a change in your state tax this year might impact your federal tax next year. (There’s still a spread between a state credit and a federal deduction.) There may be other implications too. Ask your tax advisor for a full run-down before you buy or sell a credit.

The SC angel investor tax credit - what you need to know

There aren't many places to go to learn about the SC angel investor tax credit. Our intro guide tries to explain what the credit is for, but there are nuances and some aspects of the credit that the guide doesn't cover.

How do I sell a credit I can't use? How do I find a buyer and where can I find some "transfer paperwork"? What are the implications of buying a credit? How do I make sure my credit is real? What happens when the original investment pays off?

Over the next series of blog posts, we are going to address some of these questions. We definitely won't answer everyone's questions, though. We would love to hear about what we missed (or explained badly) at our upcoming Crowdr session on the tax implications of angel investments. Join us there and see if you can stump us.

First, a quick reminder to company founders: don't forget that you can get the credit (if you incorporate and get your company qualified before you invest in the company). And even if you missed that boat, get your company qualified before you raise capital - it might make your life easier.

Angel tax credits - for founders

Last week saw the window close for claiming the SC angel investor tax credit for 2014, and last week Matt and Lowcountry Angels ran seminar explaining how the tax credit works. We have an introduction to the credit on our "tax credit" page.

These events prompted another look at an overlooked aspect of the credit - how it can be used by founders of companies.

The credit is limited to "accredited investors" based on the SEC's rules about who is allowed to invest in companies that are not "public companies". "Accreditation" is usually based on wealth or income criteria.

But another way to be accredited is to be "a director, executive officer, or general partner of the issuer of securities, or any director, executive officer, or general partner of a general partner of the issuer."  That enjoyable legalese basically means founders of companies are automatically accredited investors in their own companies.

Therefore you, as a founder of a company, could get a state income tax credit of up to 35% of what you invest (in cash) in your startup - if you follow the other rules about the credit.  We know many founders start companies from an existing job (it's the main reason why SC improved so much on this ranking): the tax you paid on income from that job, or from the consulting work you do to pay the bills, can be reduced - giving you more resources to develop your high growth startup (so you can hopefully pay lots of capital gains tax later!).

Too late to claim it this year, but if you're starting a company in 2015 and going to put your own money in, get the business qualified before you do!