The uncertain future of a state angel tax credit threatens to undermine entrepreneurial activity in the commonwealth, which already has declined in the last few years, business insiders say.
A local venture capitalist said the credit was critical to attracting investments in startups, and a state official said the credit had pumped millions of dollars of out-of-state investments. But the program’s popularity will provoke its own demise, at least without government intervention, which, a state legislator who supports the credit said, is uncertain, in part because of Gov. Matt Bevin’s call for changes to the tax code.
The Kentucky Angel Investment Act Program allows investors to offset their state income tax bill with at least 40 percent of their investment into startups in certain sectors, including bioscience, energy technology and health.
For example, if a Louisville-based venture capitalist owes state income taxes of $100,000, he can nullify that bill by investing $250,000 into a startup.
Marty McClelland, a Louisville venture capitalist and president of Regent Investment Management, said the credit, first made available three years ago, had made investments in Kentucky startups much more compelling.
Before the credit, Kentucky venture capitalists faced tying up their investments in high-risk ventures with an expectation of a single-digit return, McClelland said. In that scenario, it’s smarter to invest in the stock market, which is less risky, can produce a comparable return and gives the investor much easier access to the capital.
However, McClelland said, the tax credit, which the state has capped at $3 million total per year, pushes the potential return on a startup investment into double digits. Coupled with the intangible benefit of being able to help the local community, the credit makes investments in local startups more compelling, he said.
“It changes the economics of investing in a Kentucky small business,” McClelland said.
He said he understand when people ask why “rich dudes” get tax credits, but it comes down to economics: Without the credit, investors will take their money elsewhere, which hurts Kentucky entrepreneurs and communities because it reduces economic activity.
“Nobody’s getting rich from these kinds of investments that I know of,” he said.
Sean O’Leary, a local entrepreneur and investor, said the credit had helped him get funds for a business — and also had prompted him to make investments.
O’Leary, chief executive of Edj Analytics, said when he sought funding for the venture last year, the tax credit helped him obtain funding more quickly.
“Raising capital is extremely time consuming,” he said.
Startups inherently do not have enough staff or time to devote to raising funds, he said, and getting cash for Edj Analytics in a short period allowed him as an entrepreneur to get back to what he does best: executing a business plan.
The credit also has made investing in Kentucky startups interesting for venture capitalists who live outside of the state, because they can sell their credit to Kentuckians. Jack Mazurak, communications director for the Kentucky Cabinet for Economic Development, said that about 25 percent of the credit had gone to investors from outside Kentucky.
That means people from Indiana, Ohio and other states are pumping hundreds of thousands of dollars into Kentucky’s economy and are contributing to the state’s entrepreneurial culture, he said.
“Those are good things,” he said.
In its first year, the credit was relatively unknown, but by its second, the request for credits exceeded $3 million by the third quarter. This year, in its third year, essentially no credits remained after January.
“It’s a very popular program,” Mazurak said.
But that popularity also poses a problem, McClelland said, because what used to serve as an investment incentive, has turned into a disincentive: Investors who now would like to invest in a Kentucky startup are unlikely to do so, because they will want to wait until they can apply for the tax credit in January, which means the startup is unlikely to get money for up to 11 months.
“The limit is a disaster,” McClelland said. “The last thing you want is a limit.”
Investors and chambers of commerce are trying to get lawmakers to tweak the credit program. The local chamber, Greater Louisville Inc., identified the lack of any changes to the program in the most recent legislative session as a “missed opportunity.”
McClelland said he understands that lawmakers have to walk a fine line: They cannot keep the cap in place because it serves as a disincentive to investors and hampers startups — but they also cannot just eliminate the cap, because they risk depleting the $40 million total that has been made available for the credit and another economic development incentive.
Lawmakers could reduce the tax credit — to 30 percent, for example — which would make it last longer because it would take more investments to hit the $3 million cap, but McClelland said that if legislators reduce the cap too much, they would undermine the whole program and prompt investors to take their money elsewhere.
And if state lawmakers raise or eliminate the cap, they risk losing additional tax dollars on a program whose return on investment is difficult to calculate.
Mazurak said that the state sends a survey annually for five years to companies that received the investments to make sure that at least 50 percent of a company’s assets, employees and operations remain in Kentucky — otherwise the credits can be rescinded.
The state also seeks information about jobs, sales growth and other data that it plans to enter into a database that is being built, but Mazurak cautioned that determining the impact of the credit can be challenging in part because startups often take years until they reach profitability and significant job growth.
State Rep. Ken Fleming, R-Louisville, told Insider that he likes the credit and said that while it initially reduced the state’s income tax collection, ultimately it pumped money into the state and prompted the creation of more businesses. That means more purchases of land, buildings and equipment and more jobs, all of which improve the economy and tax collections.
Fleming introduced a bill in the last legislative session that would have eliminated the $3 million cap. He said he has discussed with other legislators how to adjust the program to retain its effectiveness. Those adjustments also could include reducing the tax credit percentage, he said.
But Fleming said the future of the credit depends in large part on whether the state legislature meets in a special session this year to address one of the governor’s priorities: changing the tax code.
“Will this be included in tax reform? It’s definitely on the table,” he said.
The Associated Press reported Tuesday that Bevin expected a special session no sooner than Aug. 15 and that he had “made no final decisions with respect to any changes to the tax code or pension structures.”
If the legislature does not meet this year in a special session, Fleming said lawmakers likely would look at tweaking the investment tax credit program next year.
If lawmakers want to keep the program, they’ll have to make changes soon. Under current law, the program will run out of funds as soon as next year: Of the original $40 million the state has allotted for the credit and another program, only $6 million remain.