Mitigating Startup Investors' Risk with Federal and State Tax Benefits

In today's investment climate, startups must not only convince investors that their business model is viable, they must compete against other, often unrelated, startups for capital. A startup can significantly improve its attractiveness to potential investors by fully leveraging Federal, state and local tax benefits and incentives, thereby mitigating the risk associated with the investment. A well-tax-leveraged startup can limit an investor's net economic risk to less than 40% of the amount invested, while a poorly tax-leveraged startup can put nearly 87% of the amount invested at risk. Assuming similar success potential, the startup with the lower failure risk has the advantage.

Overview

There are numerous tax benefits and incentives administered through the Federal, state and local tax systems designed to encourage investments in startups by sharing the risk with investors. An example of a combination of a Federal and state program that would significantly reduce an investor's risk is Ohio's Technology Investment Tax Credit (TITC) program combined with a Federal deduction under Sec. 1244. It is important to keep in mind that there are countless combinations of programs that can yield similar (or superior) results.

Ohio's TITC Program

Since 1996, the Ohio TITC program has been an integral part of Ohio's economic development strategy, providing businesses and individuals an additional incentive to invest in small, research and development, and technology-oriented firms, subject to specific requirements. The Ohio TITC program provides a tax credit for 25% of the amount of the investment to the investor, up to a maximum of $37,500 per investor, per investment. The maximum amount of credit per startup entity is $250,000 ($1 million in investment funds). Nearly any Ohio entity with less than $1 million in gross revenue or net book value as of the end of the last completed fiscal year is eligible for the credit. Any Ohio taxpayer can offset its Ohio tax liability with the credit; unused amounts can be carried forward for future use.

Sec. 1244

Under Sec. 1244, the loss on the sale or exchange of stock is converted from capital to ordinary, thereby making the loss available to offset ordinary income (without regard to the current $3,000 per-year conversion limit). Sec. 1244 is available directly to individuals (or indirectly through a partnership) that recognize a loss on Sec. 1244 stock originally issued for money or property by a domestic small business corporation.

Sec. 1244(b) limits the amount of capital loss that can be converted to ordinary loss. The limit is $50,000 per taxpayer ($100,000 for married couples filing a joint return).

The example below illustrates the significant advantage a well-tax-leveraged startup can have over a poorly tax-leveraged startup.

Example: X is a married taxpayer filing a joint return, with a Federal tax rate of 38% and an Ohio tax rate of 8%. He wishes to invest $100,000 and has no other capital gains.

As shown in the example, the economic risk can be reduced by nearly 56% by the use of Sec. 1244 and the Ohio TITC Program.

Summary

There are a large number of Federal, state and local tax benefits and incentives that can be combined to significantly mitigate the net economic risk associated with investing in a startup. These risk reductions can act as a significant competitive advantage when competing against other startups for potential investors.

From Drew Sparacia, CPA, J.D., Cohen & Company, LTD, Cleveland, OH