The Crowdfunding Craze: A Primer for Tax Professionals

By:
Sean Mathey, Esq.
Published Date:
Dec 1, 2015

Background

The popularity of Internet crowdfunding has exploded in recent years.  As individuals and businesses turn increasingly to this alternative form of financing, the regulatory response has been outpaced, leaving tax and legal advisors on uneven ground regarding client counsel.  This article provides an introduction to the players and processes of crowdfunding, and introduces some of the common issues that tax professionals can expect to encounter as their clients join the trend.  Finally, it summarizes the SEC’s recent adoption of final rules regarding equity-based crowdfunding.

Crowdfunding is the solicitation of financing--whether for personal, business, or charitable purposes--from the general public and through Internet intermediaries known as “platforms.” “Creators” or “campaigners” who join such a platform can publish a campaign page that explains the purpose of the project, details any benefits that contributors or “backers” might receive, and contains a platform-generated payment mechanism.  Typically, platforms charge a nominal fee per contribution or will take a percentage of the gross amount raised. 

Types of Crowdfunding

On rewards-based platforms such as Kickstarter, entrepreneurs and creatives present a specific project or product for funding by backers.  Backers typically have a personal interest in the success of the project, such as when fans of a filmmaker band together to fund the filmmaker's passion project, or when barbecue enthusiasts pledge support for an inventor developing a coveted new grilling gadget.  Backers are commonly offered special perks based on the size of the contribution rather than equity or another financial interest in the venture, such as early access to a product or bonus materials associated with a project. 

Fundraising-based platforms like GoFundMe, on the other hand, are increasingly popular vehicles for personal and group fundraising.  Campaigns cover a myriad of causes, from the payment of medical expenses for loved ones to disaster relief, and even personal pleas such as donations for the purchase of a new car.  These platforms typically include a program through which tax exempt organizations can self identify to potential backers.

Fundraising platforms are perhaps more widely known. Due to the campaign subject matter, which is often moral or religious and therefore controversial,  they frequently make the news cycle. Among the most publicized examples was the campaign for the Memories Pizza restaurant in early 2015.  The pizza parlor declared that it was forced to shut down in the face of lost business revenue due to public backlash after the restaurant pledged that it would not cater a hypothetical same-sex wedding.  Media attention turned Memories into a cause célèbre and, according to the campaign’s GoFundMe page, sympathetic contributors donated over $844,000 in 29,245 separate donations to “relieve the financial loss endured by the proprietors’ stand for faith.”

Other types of crowdfunding have gained popularity but are not covered at length in this article.  Debt-based, or “peer to peer” crowdfunding, is used by individuals to solicit loans from the “crowd” using a platform that automatically gauges the applicant’s credit risk for fellow crowd members to consider.  Finally, equity-based crowdfunding refers to a company’s solicitation of equity investment from the “crowd.” The SEC has very recently adopted rules pertaining to this practice, which are summarized at the end of this article.

General Tax Implications of Crowdfunding

As crowdfunding becomes more popular and more diverse, the tax implications of these transactions have become increasingly murky.  Moreover, platforms are loath to give information that might be considered tax advice. While the platforms’ websites typically offer a “frequently asked questions” page, taxes are only tangentially mentioned and users are largely left to their own devices in determining the tax implications of their campaign.  Accordingly, commentators frequently bemoan the lack of guidance on this front.

With regard to rewards-based campaigns, the following issues have become points of interest for tax professionals when advising clients:

- Was the campaign initiated by a business or an individual, and is the campaign creator affiliated with its purported beneficiary?

- If the creator is a business, should the proceeds be considered business income, and may they be offset by expenditures related to the project?

- What if a particular backer’s contribution was made without the intention of getting something in return, but instead out of the backer’s sense of generosity or desire to simply foster innovation?  In this case, could the contribution be considered a gift, and not income?

- What if the project does not lend itself to the business expenditure offset, such as a campaign to support a young writer as he or she completes a self-published novel?  In those cases, would the creator not be subject to tax liability on the funds received?

In a vacuum, these questions might be answered with relative ease; however, the nuances of a crowdfunding campaign can quickly obfuscate these issues.  A well-publicized albeit whimsical Kickstarter campaign from 2014 illustrates this concern.  Titled “Potato Salad,” the campaign’s creator sought contributions to develop just that – potato salad.  Once the humorous campaign went viral, thousands of backers jumped at the chance to be a part of an Internet fad.  When all was said and done, the campaign had received over $55,000 from nearly 7,000 backers.  The project delighted many by offering quirky “perks” such as the chef offering to say backers’ names aloud while making the salad and posting videos of himself doing so.  But what happens when the taxing authorities examine such transactions with more scrutiny than whimsy? They might wonder:

- Was the creator’s intention to actually turn the potato salad into a business venture, or was the campaign created just for a lark?

- Could the would-be potato chef reasonably offset even a small portion of the income through expenditures associated with the research and development of a potato salad recipe?

- Could it not be argued that the vast majority of the contributions were made not to receive something of equal value in return, but simply as a fun way to be involved in an Internet phenomenon?  If so, could much of this money not be characterized as gifts?

According to an analysis by the Tax Foundation, had the campaign closed at its peak amount of $70,000, the creator could be liable for over $21,000 in federal, state, and local income taxes. Rather than commenting on the IRC or the pace of regulation updates to address alternative financing, the real moral of this story is that there is little guidance available to participants of crowdfunding campaigns and, when the Internet is involved, it is very easy for a very funny project to turn into a very real tax liability.

It may seem reasonable to the campaign creator to rely on the statements made by the platform itself.  As of this writing, Kickstarter’s site offers an informational page addressing taxes, but it only covers general information regarding expenditure offsets, the issuance of a 1099-K for certain campaigns, sales tax, and the suggestion that contributions might be considered gifts. The page also states that the provided information is for “U.S.-based financial professionals,” and does not include a statement encouraging users to seek professional advice regarding the tax implications of their campaign.  The quality of the content aside, it is clear that tax professionals should consider taking a proactive role with their crowdfunding clients. Adding the subject to client questionnaires and intake forms would be a good place to start. 

The Memories Pizza campaign mentioned above also raises interesting tax questions with regard to charitable crowdfunding.  In this case, the campaign was actually created by an unaffiliated but widely followed third party, who pledged on the site that “all money, save whatever percentage GoFundMe takes, will be transferred directly to whichever bank account the [owners of the restaurant] wish to use.” This statement alone creates several ambiguities, the only certainty being that a tax professional will have their work cut out for them in sorting out how to handle this series of transactions.  If the participants or beneficiaries looked to the platform for guidance, they would only find a statement from GoFundMe that “most donations on GoFundMe are simply considered to be ‘personal gifts’ which are not taxed as income in the U.S.” It is also quite evident here that the earlier a tax professional is consulted in connection with these transactions, the fewer unexpected and undesirable tax consequences will befall crowdfunders.

Equity Crowdfunding

As opposed to the forms of crowdfunding discussed above, equity crowdfunding has the potential for much greater stakes and therefore more complex legal and tax implications.  In this realm, however, we now have more concrete guidelines as to the rights and obligations of participants.  On Oct. 30 of this year, the SEC announced its adoption of final rules regarding the sale of securities through crowdfunding platforms, a practice called “equity crowdfunding.”  The SEC’s authority to promulgate these rules was granted by Title III of the 2014 JOBS Act, which created a federal securities law exemption for this popular form of financing.  To those familiar with the current rules and regulations regarding the offering of securities, the nuts and bolts of these rules will look familiar, but they have been adjusted for the democratized world of crowdfunding, where the companies offering such securities and the investors purchasing them are generally smaller and more financially diverse.  Under the new rules, U.S. companies in good standing with the SEC who are not covered under the Exchange Act and who have a “specific” business plan would be allowed to raise up to $1 million of capital by the sale of restricted securities through a registered crowdfunding platform.  Furthermore, participating companies would be subject to several disclosure and reporting rules having to do with the financial condition of the company, pricing methods for the offered securities, the planned use of the proceeds, and information concerning the officers, directors, and major shareholders, among other disclosures.

Investors purchasing crowdfunded securities are also subject to certain qualifying criteria and limits on their overall investment.  Somewhat akin to the “accredited investor” rules that have governed an individual’s ability to invest in a company exempt from registration, investors in crowdfunded offerings must limit their investment to the greater of $2000 or 5% of the lesser of their annual income or net worth.  If, however, an investor’s annual income and net worth are both over $100,000, then they are limited only by a cap of 10% of their net worth or annual income, whichever is lesser.

It will come as no surprise to those familiar with securities law that it is the crowdfunding platforms themselves that are the subject of the bulk of the rules.  In addition to registering with the SEC as a funding portal and becoming a member of FINRA, these platforms will also be subject to a myriad of rules reminiscent of those governing the behavior of traditional broker-dealers, such as:

Providing comprehensive educational materials explaining the rules, processes, and restrictions involved in an offering;

- Developing internal measures to reduce the risk of fraud in the offering and with regard to companies offering securities through the funding portal

- Complying with the Commission’s rules regarding client accounts, funds, investor qualifications, and trade completion and cancellation; and

- Refraining from dealing with any company in which the portal has a financial interest, unless certain conditions are met, and following other such rules.

Funding portals will also have to provide communication channels through which users of the platform may discuss the offerings available on the platform – a rule that suggests that the SEC is keen to integrate Internet-age behaviors into their rule making.  The entire text of the announcement and more a more complete summarization can be found here.

As the crowdfunding craze spreads to an increasingly large and diverse group of users and platforms, it would behoove tax professionals and attorneys to follow the trend with a weather eye to the nuances of their clients’ crowdfunding activities.  While it is perhaps a welcome trend in that it provides opportunities and relief to many, unaware participants can easily discover a fly in their potato salad in the form of unexpected tax consequences. 


MatheySeanSean Mathey, Esq., has extensive experience in dealing with the opportunities and challenges facing business owners and families, and he is committed to helping them protect what they’ve worked so hard to achieve.  Sean’s practice is focused on providing general counsel services to small businesses, and estate planning services to individuals and families.  Prior to entering private practice, Sean served as Chief Operating Officer and General Counsel of a national public relations firm.  Sean received his undergraduate education at Boston University and his J.D. at Fordham Law School.  Sean is admitted to practice in New York and before the United States Tax Court. He can be reached at smathey@matheytreellp.com or (917) 667-3567.

 
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