If you are an entrepreneur building a business in South Carolina, or investor who might invest in a South Carolina-based company, you need to know about the South Carolina Angel Investor Tax Credit.
In our earlier article, we provided the “Beginners’ Guide” to the credit. In this follow-up, we’ll expand the coverage into the “Complete Guide to the South Carolina Angel Investor Tax Credit.”
For the basics of what the credit it, who can get it, what companies are “Qualified Businesses”, how investors can apply for it, how much is available and how much can be used, where you can learn more about the credit, and why early stage founders in South Carolina need to know how to get full benefit from the credit, we’ll refer you back to the previous article.
Now we’ll take the guide a stage deeper to cover Q&A about the details of several aspects of the credit, dig into its “transferability questions”, examine its impact and usage, and more.
Questions? As ever with taxes, the devil is in the details. Here are a few questions we hear a lot about people investing the credit, and our best efforts at answering them.
Types of investment
1. The credit is for equity or subordinated debt. Does that mean LLC units are allowed?
Yes, any kind of equity interest — C-Corp shares, S-Corp shares, or LLC units — are all allowed.
2. The credit is allowed on subordinated debt. What about for convertible notes?
A convertible debt investment is eligible for the credit, as long as the debt is subordinated (i.e. more junior to something else, so that something else must be paid out first in the event of a liquidation scenario). Senior secured bank debt would not be allowed; a subordinate mezzanine loan would; convertible debt would.
3. For a convertible debt investment, is the investment in the debt eligible for the credit, or is it when the debt converts into equity (even if that conversion occurs after the company is older than five years)?
The investment in the debt is eligible — it does not matter when (if ever) the convertible debt converts to equity.
4. Would “sweat equity” — founder time and effort given in exchange for shares in a company — be allowed?
No, the investment must be a direct cash investment.
5. Would reinvested cash dividends or cash interest be allowed?
Yes, as long as the reinvestment was of cash, this should be allowed.
1. Does the company have to be incorporated in South Carolina?
No, it just has to be headquartered in South Carolina. Delaware corporations can get the credit, as long as they are headquartered in South Carolina and registered with the secretary of state correctly.
2. Does the five-year clock start running for the start-up when the company is first registered in South Carolina, or when taxes are first filed for the company?
When the company is first formed and registered with the SC Secretary of State.
1. How long does the paperwork approval process with the SC secretary of state usually take?
It takes about five minutes to fill out — then you need to get it notarized.
2. Does it cost anything?
No, other than $5 to get the application notarized for the Secretary of State, and 46c for a stamp to mail it in!
3. How about when renewing the approval?
Approval is for a maximum of one year, and so you will need to submit a renewal application if you want to remain as a Qualified Business. Again, it is an easy form.
Transferability. One of the cleverest features of the tax credit is that it is “transferable” — that is, it can be bought or sold. Many angel investor tax credits are not, but the South Carolina legislators had the foresight to allow the credit to be transferable.
This was clever because it makes the credit useful for investors who do not live in South Carolina — which is most of them! The credit encourages non-South Carolina investors to invest into South Carolina-based companies, thereby dramatically increasing the capital available to South Carolina companies — an obvious good thing. The investor then gets the benefit by selling the credit.
1. How easy is it to sell tax credits?
Selling the credit is fairly easy. The transfer requires a “transfer agreement” and a filing with the Department of Revenue to approve it. This is, overall, fairly straightforward, the paperwork not burdensome, and the process quick. Credit is due to the legislature for including this feature and the Department of Revenue for making it easy.
2. Is there standardized transaction paperwork?
No. The Department of Revenue gives good guidance on what a notification to them must include. There are also precedent documents you can find for other types of tax credit buying and selling. But as far as we know there isn’t standardized transaction paperwork. However, we have some!
3. What are the other key obstacles?
Finding a buyer. Transactions are still a fairly rare practice: most people that claim the credit can use it so have no need to sell it; and most people that could be buyers (i.e. all South Carolina taxpayers) don’t know about the credit.
4. What is the sale price?
The sale price is set between the buyer and the seller. In our experience, most sales occur at around 80c on the $ of credit. That is, you can buy a $10,000 of credit for $8,000. The buyer gets “the spread” as benefit (e.g. 20c on the $ of credit, or $2,000 in this example). The seller gets cash for an otherwise unusable “asset.”
5. Where can I learn more about these transfers? Surely there are more details?
What is all this about credit recapture?
OK, now things are getting harder! When the credit was created, it included Section 11–44–65 which outlines what happens when an investment pays off. Essentially, if the investor recognizes a capital gain, some portion of the original credit must be repaid.
The idea is this “pays for” some of the cost (in terms of reduced tax revenue) of having the credit. By penalizing investment, though, it partly undermines the point of the act.
When does this apply?
When the investment made by the angel investor sees a return — typically when the company that received the investment is acquired.
How do we calculate this?
This depends. The SC Department of Revenue’s Revenue Ruling #14–6 (section III) gives the ultimate guide. SC taxpayers can deduct 44% of the net* capital gain from their SC taxable income (per SC Code Section 12–6–1150). If there is a capital gain on the investment that created the tax credit, the amount of the deduction reduces.
(* Net capital gain is long term capital gain less any short term capital losses in the year.)
Where can I get help understanding the calculation?
We need help with this too! You should consult your tax advisor or a well-qualified accounting firm in South Carolina (we suggest Bauknight, Pietras & Stormer in Columbia) for more assistance on the calculation.
What about if I lost money on the investment?
The same theory applies, just in reverse: the amount that a taxpayer can claim as a net capital loss is reduced. The same Revenue Ruling #14–6 is the place to start.
Does this apply if I’ve bought (or sold) a credit?
The credit recapture rules all apply to the original investor. If you bought the credit, you don’t have to worry about any of this; if you sold your credit, you do. Hopefully, it’s a nice time to do this calculation though — you received cash from your original credit sale years ago, and now you’ve made money on your investment, so you’re winning.
Bottom line: how much of the 35% tax credit am I effectively getting if I receive a nice capital gain?
It depends on the multiple of return (and probably many other things). We estimate that if you make a 2x return on the investment, the effective tax credit is 32%; if you make 10x, it is closer to 20%.
Are people using these credits? Yes, it does appear that the credits are getting well used. One clue to that is the “proration factor” that is included on the credit award letter.
Recall how the credit is for “up to” 35% of the investment, but if more than $5M is claimed in total then all the applicants are scaled down. Below is a table over the proration factors for 2015 to 2019, and the implied amount of tax credit applications (and therefore total investment amount) each year.
In 2015, 2016, and 2018, there was no proration, meaning less than $5M of credits were applied for. In 2017, more than $5M of credits were claimed for the first time.
In 2019, the proration factor was less than 0.5 — meaning people applied for over $10M of angel investor credit. As only $5M can be awarded, applicants received less than half of what they hoped. That also means for the first time over $30M of investments were made into eligible startups in South Carolina.
(This is actually a floor each year, because of the $100k per applicant per year limit. It could actually have been higher if some people exceeded their application maximum. That’s possible but in my opinion probably rare.)
So yes, it seems people are making the investments and making the applications for these credits.
We don’t know for sure that this means they are using the credits, but it seems fairly likely!
That brings us to the end. Between the Beginners Guide, this Guide, and the FAQs linked above, hopefully you have everything you need to know to start using the credit. Remember:
- Make sure the business is a Qualified Business BEFORE you invest
- Make sure you submit your application BEFORE the end of the year
- Consult your tax advisors for more information and advice you can actually rely on!
- Give us a call if you want to buy or sell a credit!