How do investors benefit from the Maine Seed Capital Tax Credit?
posted on December 2nd, 2014 in Category:
The Maine Seed Capital Tax Credit has been in effect since the early 1980s as an incentive to get investors to put their capital to work in Maine-based businesses. While the program took an unexpected hiatus beginning in 2013 due to the State’s fiscal difficulties, it is available again as of August 2, 2014 with some significant changes designed to expand the capital available to Maine entrepreneurs.
The program provides investors with a credit against Maine income taxes equal to 50% of an eligible investment, spread out over not less than 4 years. Yes, that really does mean that investors get half of their capital back regardless of whether the company receiving the investment is successful! More details of the revival of the program are available here.
The question is often asked what the real value of the credit is to an investor on an after-tax basis, especially in the worst case scenario where a company fails and there is no return on the investment. With the caveat that every taxpayer’s situation is different and investors should consult with their tax advisers, it is reasonable to make some assumptions that give investors a pretty good idea of what their downside risk is.
Let’s assume an investor makes an investment of $100,000 in the Maine Coffin Company, and in five years the company lives up to its name and is no longer above ground. The investor is out $100,000. But for the past four years she has been able to take a credit against her Maine income tax in the amount of $12,500 each year, or $50,000 in total, reducing her out-of-pocket loss to $50,000. For the tax year in which the company failed, she is also able to take a long-term capital loss of $100,000 on her Federal and Maine tax returns. That capital loss offsets $100,000 of her other capital gains, saving $20,000 in capital gains tax. If she doesn’t have enough capital gains in the year of the loss, the capital loss is carried forward to offset gains in future years. That offset of capital gains also saves her $7,950 of tax on her Maine return. Assuming she is subject to the Alternative Minimum Tax (AMT) on her Federal tax return, her net out-of-pocket loss is only $22,050*.
Using the same analysis, and assuming an AMT-paying taxpayer and a company that is not a complete write-off, the investor’s breakeven point is approximately $30,600. In other words, if the investor recovers $30,600 from the investment in the form of interest, dividends or return on sale of the company, she essentially breaks even on her investment and any return on top of that amount puts her into plus territory.
Figuring the after-tax return on a successful investment with a positive gain becomes more complicated as more individual variables come into play. However using the same basic examples as above, the Seed Capital Tax Credit is a significant benefit on the upside. In our example, the credit increases the investor’s return by $50,000 if she is subject to the AMT. But in addition, the gain on eligible stock held for five years or more is subject to a reduced capital gains tax rate under Section 1202 of the Internal Revenue Code, reducing the usual capital gains tax rate of 20% to about 15%.
To recap, the typical investor using the Seed Capital Tax Credit limits her after-tax out-of-pocket loss to only about 22.05% of her investment. Put another way, she is risking $22,050 to get the upside on a $100,000 investment. The Seed Capital Tax Credit changes the risk/reward analysis for a prospective investor in an eligible business. The State of Maine effectively helps to cover more than three quarters of the risk on the downside while juicing the return on the upside. This benefit makes the decision on whether or not to invest easier, and has often encouraged investors to invest more than they otherwise would have invested. The credit does not make a bad investment into a good one, but it does make an attractive investment opportunity much more attractive, reducing risk and enhancing return.
Written by Tim Agnew, MVF Board Member
*In the scenario above, our taxpayer is paying Alternative Minimum Tax on her Federal return. If she was not paying the AMT, her Federal tax return would be slightly higher due to the fact that she would deduct less from her Federal taxes for her reduced Maine State tax liability. This would increase her Federal tax bill by around $16,000 (assuming she is in the 33% tax bracket), increasing her effective out-of-pocket loss to about $38,500.