Kentucky’s angel investor tax credit program is touted as a way to encourage investment in start-up companies. But because it is overly generous to investors, fails to target start-ups exclusively and lacks adequate evaluation mechanisms, there are reasons to question its cost-effectiveness.
Angel investor tax credit programs are offered in more than 20 states. They are promoted as a way to encourage investors to support start-up and early stage ventures for which it is sometimes difficult to access the capital needed to begin or expand operations — especially in risky or experimental situations. Kentucky created its angel investor tax credit program in 2014 with the first credits awarded in 2015.
The critical question that must be asked in considering the effectiveness of and need for angel investor tax credits is whether they are truly necessary for investment to occur – Will investment happen anyway if the ideas and plans are good enough? Could governments achieve the same results with a less generous credit, or without any credit at all, simply by helping investors and companies seeking investments connect?
Here are some key concerns with Kentucky’s program:
It is not sufficiently targeted to viable start-ups needing assistance.
Kentucky’s angel investor tax credit program differs from most other states because it is not limited to assisting start-up and early stage companies. Instead, Kentucky’s program focuses more broadly on small businesses, which are defined as legal entities in good standing and holding all necessary licenses or registrations engaged in a qualified activity within the state that have:
- Less than 100 employees;
- A net worth of $10 million or less or net income after federal income taxes for each of the 2 prior fiscal years of $3 million or less;
- More than 50 percent of assets, operations and employees in the state; and
- Not received investments of more than $1 million in the aggregate that are eligible for the angel investor tax credit program.
To receive investments that qualify for the tax credit program, companies must be approved by the Kentucky Economic Development Finance Authority, which reviews the application for compliance with the statutory requirements set forth above but does not examine or comment on the viability of the company or whether the company will expand or hire more people.
Importantly, there are no requirements that companies demonstrate an inability to access traditional financing sources prior to being accepted into the program.
It lacks accountability to stated purposes.
Kentucky’s angel investor tax credit program’s key stated purposes are to support:
- The establishment or expansion of small businesses;
- Creation of additional jobs; and
- Fostering the development of new products and technologies. 1
Yet companies receiving investments through the program are not required to assert they will do any of these things as a condition of acceptance into the program. Companies are required to file an annual report for five years with the Kentucky Economic Development Finance Authority that lists the number of new jobs created, increased sales or economic activity, other private investment attracted and any other information requested by the authority. However, the authority is not required to analyze, use or report the data or to evaluate the effectiveness of the tax credits in achieving the stated goals of the program.
The generous credit excessively reduces investors’ risk at significant cost to the state.
To participate in the program, investors must be qualified as investors under federal law, cannot own more than 20 percent of a company and cannot be employed by the qualified business prior to making the investment (but could be after making the investment) — nor can the investor be the parent, spouse, or child of such a person. The investor also must be seeking a financial return from the investment.
Once accepted, investors receive a very generous credit of 50 percent of the amount invested if the company is in a distressed county, or 40 percent of the amount invested otherwise. Once earned, the credit may be freely transferred to any other person by the investor who earned it. A transferable credit is more attractive to investors because they can still fully benefit even if they do not have a sufficient Kentucky income tax liability to use the credit (as would be the case by an out of state taxpayer) by selling or trading the credit to someone who can use it.
The credit dramatically reduces the investors’ risk, increasing the potential upside for the investor by the amount of the credit. If the qualified company simply maintains its current value, the investor achieves a remarkable 40 percent return on investment because of the tax credit. If the business completely fails, the investor will still receive the tax credit, in addition to the deduction of any other eligible losses suffered as a result of the failure of the business. Such a generous credit may result in promoting what would otherwise be imprudent investments. And it means a large subsidy to already-wealthy individuals. As an investor told The Courier-Journal recently, “it’s a good tax credit.”
The fact the program applies to already-established businesses and is not limited to start-ups increases the likelihood that the investor will make money simply because of the credit — and weakens the claim that the credit is necessary for the investment to occur.
Total credits awarded in each calendar year are limited to $3 million overall, and individual investors cannot receive more than $200,000 in credits in any calendar year. The total program is capped at $40 million. 2 To date, the state has awarded $33.7 million in credits, which mean the program will run out of money within the next few years and legislators will have to consider whether it should be expanded. The overly generous design of the credit results in the annual cap being reached very quickly every year.
The only possible recapture of state subsidy dollars happens if the company fails to have 50 percent or more of its assets, operations and employees in the Commonwealth, fails to be actively and principally engaged in a qualified activity, or receives an aggregate amount of qualified investments of more than $1 million in tax credits. If the company becomes insolvent or ceases to exist, the credits are not subject to recapture.
Economic development incentives like the Angel Investor Tax Credit reduce the revenue Kentucky would otherwise collect and invest through the state budget in education, public safety, infrastructure and other public goods that businesses benefit from. The program, like other tax breaks that litter the state’s tax code, should be closely scrutinized and trimmed or ended to make possible those public investments that we know pay off.