Tax Proposals Attempt to Bridge the “Valley of Death” for Small Research Firms

A new coalition of trade associations, The Coalition of Small Business Innovators, has developed two innovative tax reform proposals designed to help small research companies attract more investors, even if they are many years away from profitability. These proposals would allow passive investors to take advantage of losses and research credits generated by the company and allow companies to carry net operating losses forward even when they raise new financing. The former proposal has already been included in broader bills aimed at boosting innovation and economic activity. If enacted, the proposals could increase investment in small, research-intensive firms by $14.1 billion and create 72,000 jobs in eligible companies.

Although the U.S. financial system is the most sophisticated in the world, it still contains at least one significant gap. Small, capital-intensive companies often find it very difficult to raise the additional capital needed to go from start-up through the long development phase until they are near enough to profitability to conduct an initial public offering or be attractive to a prospective buyer. This period is commonly known as the “valley of death.” Firms in this position may have a very good concept and be making steady progress toward a viable product or service, but they are not attractive to venture capitalists, who usually want a clear opportunity to sell their ownership interest within three to five years. Two tax reform proposals in particular could help to address these challenges

The first proposal would amend Section 469 of the Tax Code to permit passive investors to take advantage of the net operating losses and research tax credits of companies in which they invest. The Tax Reform Act of 1986 severely limited this ability because it was seen as a way for high-income individuals to reduce their taxes by investing in operations that were never meant to be profitable. Under the reform, investors could immediately use their share of net operating losses, as well as any credits for research and development. The percentage of losses or credits that could be passed through would be limited to the portion of investment that was specifically targeted for qualified research activities as determined for purposes of the research and development tax credit. In order to qualify, the company would have to devote at least half of its expenses to research and development. The company would also have to have less than 250 employees and less than $150 million in assets. A recent study by Ernst & Young, Economic impact of tax proposals affecting research-intensive start-up businesses and qualified small business companies, estimates that this change would increase investment in these companies by $9.2 billion, allowing them to create 47,000 jobs. The proposal is currently contained in both the Start-up Jobs and Innovation Act (S. 341) and the COMPETE Act (S. 537).

The second change would make it easier for small companies to carry net operating losses forward even as they continue to attract new investors. Small, research-intensive companies often go through several rounds of financing as they rack up expenses while getting nearer to their goal of profitability. Unfortunately, Section 382 of the Tax Code prevents companies from carrying net operating losses forward if they undergo an ownership change. This eliminates one of their possible attractions to investors. It also means that the company will start paying taxes on its revenue long before its total revenues exceed it total expenses. Under the proposal, Section 382 would not apply to net operating losses that are generated by qualifying research and development conducted by a small business. The Ernst & Young analysis estimated that this change would increase direct investment in these companies by $4.9 billion and boost their employment by 25,000 jobs.

Most experts agree that the U.S. tax code needs fundamental reform. It is too complex, creates perverse incentives, and the marginal rate on corporate taxes is too high. The fundamental thrust of any reform must be to broaden the tax base by eliminating tax expenditures and lowering the marginal rate. But it would be a mistake to impose the same rate on all business activity. In some cases, a substantial body of economic literature shows that lower rates have broad social benefits. One of these cases is research and development, especially by new companies. Not only does the research these firms conduct create spillover benefits, these firms are the main candidates for rapid job creation if their research is successful. Tax policy should favor investments in these companies in order to offset the high levels of risk they bring. The proposals sponsored by the Coalition of Small Business Innovators would make it easier for investors to justify the risk involved in finding the breakthroughs that will improve tomorrow’s living standards. They would also boost America’s competitiveness, both by making this country a more attractive place to conduct research and by increasing the pace of technological change.