Crowdfunding: Where Can We Go From Here?

Nov 24, 2015

In 2014, pop star Kenny Loggins launched a campaign on the crowdfunding site Kickstarter to finance the recording of a new album. As is typical of crowdfunding campaigns, rewards were offered to various levels of donations. If someone was willing to contribute $10,000 to the campaign, Loggins would perform a concert in the donor’s living room. One particularly dedicated Loggins fan started a Kickstarter campaign of his own to fund a contribution large enough to get a concert in his living room, raising over $30,000 in the process.

Whimsical? Certainly. However, crowdfunding has become serious business. In a tight credit market, it is an attractive, streamlined alternative method of raising capital for small businesses. Crowdfunding can be a useful means of assessing demand for a new product or service. In total, $16.2 billion was raised via crowdfunding platforms such as Kickstarter and GoFundMe in 2014, up from $6.1 billion in 2013, financing a wide variety of causes, projects, and new products.

What forms can crowdfunding take? There are three main categories: donation-based, equity, and reward-based.

Donation-based crowdfunding is for individuals, groups, and non-profit organizations to raise funds for causes such as medical bills, school trips, or disaster relief. Typically, funds raised through donation-based crowdfunding would be considered non-taxable gifts to the creators of the campaign. If the recipient is a charity, the donor would be able to deduct the gift on their tax return.

Equity-based crowdfunding provides an opportunity for businesses to offer their securities to a broad pool of investors. The Securities and Exchange Commission cleared the way for this process in March 2015 with new regulations allowing businesses to raise up to $50 million in a 12-month period and accept investments from unaccredited investors. The regulations created two tiers of companies based on offering size: Tier 1, for companies seeking $20 million or less, and Tier 2, for companies seeking $20 million to $50 million. Tier 1 companies must have at least a reviewed financial statement while Tier 2 companies must have their financial statements audited and publish annual reports. Individual investments to a Tier 1 company are unlimited while individual investments in a Tier 2 company are limited to ten percent of the greater of their annual income or net worth.

Perhaps the most familiar form of crowdfunding is reward-based crowdfunding, offering products, services, or other perks in exchange for pledges from potential backers. Companies set a fundraising goal to be achieved within a set timeframe. Generally, this is an all-or-nothing proposition – if the goal isn’t reached, the campaign creator doesn’t receive any money. If the goal is reached, the campaign creator receives their funds, less the fees to the crowdfunding platform and its payment processors. Most likely, this would be regarded as taxable income to the campaign creator. Regulatory guidance has been slow in coming from the Internal Revenue Service in this area though other regulatory bodies have started to weigh in. Washington state has indicated that crowdfunding proceeds may be subject to state sales and business taxes. Canada also generally requires reward-based crowdfunding proceeds from carrying on a business or profession to be included in income.

If crowdfunding proceeds are considered income, the question of the extent to which expenses can be deducted against those proceeds is raised. Several factors come into play:

1. Is the activity a business or a hobby? If the crowdfunding activity is a business, then all trade or business expenses should be deductible. If it’s a hobby, expenses are only deductible to the extent of the income.
2. Is the activity a startup? Some of the startup costs over $5,000 may have to be amortized under IRC sections 195, 248 or 709 over a 15-year period.
3. What method of accounting does the activity use? Income from the campaign would be taxable in the year that it is received, but the expenses of fulfilling the obligations to backers may not be incurred until the following year. Cash-basis taxpayers especially should be mindful of the timing of their campaigns, ending them early in the year to allow the opportunity to incur expenses against those proceeds.
4. What are the rewards to the backers worth? If the value of any of the rewards offered is difficult to assess (for example, a campaign creator may offer to come to a donor’s house to tend bar for a party), then some or all of a pledge may be considered a nontaxable gift or other contribution.

Until further guidance comes from the Internal Revenue Service, a common-sense assessment based on the above factors will be necessary to correctly report crowdfunding income and related expenses.

Jacob Freppel, CPA

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