Bandals International Inc., a maker of women's sandals, raised roughly $100,000 in capital from so-called angel investors last year.  When meeting with potential investors, the owners of the Rochester Hills, Mich., business touted the state's special tax break for angels—a term used to describe wealthy individuals who provide capital to start-ups. The Michigan incentive at the time allowed angels to seek tax credits of 25% on their 2011 investments in qualified start-ups.  Tom Sesti, president of Bandals, says the tax credit was key to helping the three-year-old company raise the funds. "It's almost like offering a money-back guarantee," he says.  Tom Sesti is president of Bandals, a Michigan sandal maker that raised $100,000 from angels last year.  Tax breaks for angel investors have cropped up in recent years in about two dozen states as a means of stimulating job growth. But the effectiveness of the incentives—which range from breaks on 15% of funding in Colorado to 100% in Hawaii—are coming under greater scrutiny, particularly as states face budget pressure. Many states' programs expired at the end of 2011, were stripped of funding or were placed under a moratorium.  The incentives "can be controversial," said the National Governors Association in a 2008 brief, adding that "even angels are in disagreement as to the economic growth benefits of tax credits."  U.S. companies are booking higher profits than ever. Yet corporate tax receipts as a share of profits are at their lowest level in at least 40 years. Damien Paletta reports on Markets Hub. Photo: AFP.  "People rarely make a high-risk investment solely for tax reasons," says Scott Shane, a business financing researcher at Case Western Reserve University, and a member of the North Coast Angel network. He says tax credits likely do very little to boost investing—and even less to create jobs. "If I think I'm going to lose my money, a tax credit isn't going to make up for that," he says.  In the first six months of a program launched in Minnesota in 2010, 67 businesses received $28 million in total funding from a mix of individual investors and certified funds, according to a 2011 report by the Minnesota Department of Employment and Economic Development. The program offered angels a 25% tax credit.  Yet together, the businesses that received funding created only 47 new jobs, the report found.  "These are emerging companies, so they don't necessarily rush out and hire new employees," says Jeffrey Nelson, the state program coordinator.  However, Mr. Nelson pointed to a so-called spillover effect, as newly funded firms hire local contractors and other third-party services.  Minnesota's program is now growing, he says. Last year, investors claimed all $16 million in available tax credits under the program, which is set to expire in 2014, pending a review by state lawmakers.  "I've heard from entrepreneurs who say 'I would not have funding without this program,'" he says.  Brook Eddy, founder of Bhakti Chai in Boulder, Colo., which sells tea at Whole Foods and other grocery store outlets as well as cafes, says the state's 15% tax-credit program helped her raise $125,000 in funding in 2010.  "When we met with potential investors, it was like having an extra bonus to offer them," she says.  Colorado's angel program expired at the start of 2011.  Of course, only a fraction of the nation's small businesses are high-growth start-ups that might draw the attention of angel investors.  In one survey by Pepperdine University of more than 10,000 small-business owners last August and September, only 3% cited angels as a source of financing. Roughly half said they tapped credit cards and bank loans.  Meanwhile, Michigan's angel investor tax credit expired Dec. 31, leaving some entrepreneurs in the state disappointed.  "Investing is risky, but if you have a trump card to play, like a tax credit, it helps," says David Weaver, whose Ann Arbor, Mich., medical device firm, Blaze Medical Devices, raised $250,000 in a funding round in 2011. He says he believes the tax credits helped persuade local investors to act before the Dec. 31 deadline.  Eli Thomssen applied early to the state's economic development agency to have his biotech firm, also based in Ann Arbor, on a list of that state's eligible small-business investments. But before his firm, Armune BioScience Inc., could begin looking for investors, state lawmakers killed the 25% tax credit. The firm, which is developing a diagnostic test for prostate and other cancers, needs about $400,000 to keep its lab running until the tests are ready to bring to market, Mr. Thomssen says.  A spokeswoman for the Michigan governor says there is a replacement incentive program in the works, though it won't be structured as a tax credit.  "We're going to try a new path that the governor feels confident will make Michigan a place where people want to do business," she says.
Many start-ups say they were able to secure funding thanks to tax breaks for angel investors, but the incentives' effectiveness is coming under scrutiny.