Ernst & Young recently released a study to determine the potential impact of three tax proposals to help innovative small companies secure sustained private investment.
The study models the direct, indirect, and induced impact that the three legislative proposals would have on investment and employment in small, R&D-intensive companies.
Below is a summary of the proposals, as well as the potential impact if enacted:
Proposal 1: Section 469 R&D Partnership Structures. Reforming the passive activity loss (PAL) rules in Section 469 would allow tax assets generated by innovative research to flow through to an R&D project’s investors. Under this proposal, small companies would be able to enter into a joint venture with an R&D project’s investors. The losses and credits generated by the project would then flow through to the company and investors, who would be able to use the tax assets to offset other income. Relaxing the PAL rules to allow investors to enjoy a more immediate return on their investment would incentivize them to invest at an earlier stage in a company’s development.
E&Y Study Findings: If enacted alone, the R&D Partnership Structures proposal would increase investment by $10.3 billion per year, resulting in 156,000 new jobs. This proposal has the highest investment impact of the three, as the study shows that small, early-stage innovators would take advantage of this proposal early in their life cycle, when seed and start-up capital is the most important and impactful.
Proposal 2: Section 382 Net Operating Loss (NOL) Reform. Exempting NOLs generated by qualifying small business R&D from Section 382’s ownership change restrictions would allow innovative job creators the freedom to raise capital for innovative research without fear of losing valuable NOLs. Currently, Section 382 restricts the use of NOLs by companies that have undergone an “ownership change.” This overly broad definition often encompasses private financing rounds, IPOs, mergers, and partnerships – all of which are extremely common for growing innovators.
E&Y Study Findings: The reform of Section 382 would increase investment by $5.5 billion per year, resulting in 85,000 new jobs. The study found that nearly two-thirds of venture-backed companies in R&D-intensive industries are likely to have undergone a Section 382 event, which would trigger loss limitation.
Proposal 3: Section 1202 Capital Gains Reform. Making the current 100% capital gains exclusion for the sale of qualified small business stock under Section 1202 permanent would allow more growing innovators to qualify and thus be able to attract investors to fund their research. Small companies also would benefit from amending the qualified small business definition to allow investors in companies with gross assets up to $150 million or with valuable IP to qualify for Section 1202’s capital gains rates.
E&Y Study Findings: The reform of Section 1202 would increase investment by $3.6 billion, resulting in 350,000 new jobs. Note that this proposal is not restricted by R&D-intensity tests, so a broader range of companies could benefit by attracting potential investors. Therefore, the overall economic impact is larger, but the jobs and investment are spread over more companies than just small business innovators.
If enacted together, these three proposals could result in new investments totaling $20.6 billion and create 623,000 jobs in affected companies.
Innovative small companies are often pre-revenue and therefore pre-tax. As such, innovation and investment incentives in the current tax code do not stimulate R&D in these small businesses. Modernizing the current U.S. tax code to recognize and promote small business innovation is fundamental to the long-term growth of the U.S. economy.