With many states continuing to use tax credits to seed entrepreneurial growth, entrepreneurs and legal counsel must understand the applicable state-sponsored programs and position qualifying businesses to take advantage of these programs. Some government officials and scholars debate the extent to which government policy should seed entrepreneurial activity. Nevertheless, many states continue to view early stage investment tax credits as a “win-win-win” because early stage businesses receive capital, investors receive a tax credit, and states enhance the local economy through increased employment and innovation. Each state-sponsored tax credit program is unique and commonly differs in important aspects, including (1) the types of businesses that qualify under the programs, (2) the amount of tax credits given to investors, and (3) whether investors are compensated with refundable or non-refundable tax credits.
Of the early stage tax credit programs within approximately 20 states, each state’s program varies based on the types of businesses that qualify under the program. States generally require the same qualifications to ensure businesses are truly early stage businesses and are predominately located within the state. However, each state varies based on the principal industry of the business allowed under the program. Some states create a narrowly defined focus of acceptable industries, such as bioscience, advanced materials, information technology, and clean technology. Other states allow businesses from a broader range of industries, as long as they promote the purposes of the program. Most states define industries that automatically do not qualify for tax credits, including real estate, professional services, and financial services.
Additionally, early stage tax credit programs vary on the percentage of the investment that will qualify for tax credits. Historically, the percentage of the investments qualifying for tax credits has varied significantly, ranging from 4% to 100%. Many states provide 25%. Some states use a tiered structure and provide a general tax credit with a slightly higher credit for investments in specific industries or geographic locations.
Lastly, states vary on the compensation given to investors by offering either refundable or non-refundable tax credits. Tax credits directly reduce state tax liability. Most states offer non-refundable credits for qualifying investments. If non-refundable credits are more than the tax, the state does not refund the excess to the taxpayer, meaning tax liability never dips below zero. For example, an out-of-state investor generally cannot use non-refundable tax credits because the investor does not have tax liability within that state. While less common, some early stage tax credit programs compensate investors by offering refundable tax credits. If refundable credits are more than the tax, the excess is refunded to the taxpayer. Because an out-of-state investor can claim the tax credits regardless of state tax liability, refundable tax credit programs may attract a significant amount of out-of-state investments.
Before raising capital, an entrepreneur and legal counsel must understand the nuances of the applicable state program to ensure the business is initially and continually qualified to offer tax credits to potential investors. Early stage businesses may benefit from participating in these programs by improving the probability of receiving an investment and by attracting more investors to select the best strategic investor or most favorable financing terms. These benefits could make a significant difference in the viability and success of the early stage business.