How to treat contributions given and received
The perfect storm of inflated housing markets and imploding financial markets during 2007 and 2008 created a massive financial crisis that caused a recession of historic proportions. This global recession led to the worst economy the United States has experienced since the Great Depression. With traditional sources of funding vanishing, entrepreneurs were no longer able to turn to banks or investors to meet the financial needs of their businesses and various endeavors. In the seemingly endless sea of bankruptcies, foreclosures and unemployment, crowdfunding was born. Its birth, in the form we now know, was the social reaction to this historic financial crisis. However, this bootstrap solution has caused many headaches for the tax professional community. We swim in the muddy waters of how to treat funds received and given.
What Is Crowdfunding?
The first instance of crowdfunding can be traced back to the U.K. in 1997, when a rock band financed its tour by soliciting donations from their fans via the internet. In 2000, ArtistShare became the first internet based crowdfunding platform. Crowdfunding as we now know it began in the United States with Kickstarter back in 2009. Since then, crowdfunding has expanded to more than 450 platforms all over the globe. Crowdfunding changed the game. Using the internet, crowdfunding allowed for-profit as well as non-profit organizations to fund their businesses by drawing on small contribution from a large number of individuals instead of seeking one large amount from a bank or investor. Everyone and anyone could do it…and they did!
Crowdfunding has changed the role of the customer from simply a user of the product, to an active investor and participant in product development. Each individual provides a small amount of funding and development input. Crowdfunding also allows the entrepreneur to tailor the funding to meet their specific goals. These goals include not only raising funds but also include raising awareness of the product, to connect with others, and to maintain control of the business they are starting up.
A new term, crowdsourcing, was coined to describe the process of using a network to obtain not only funding, but to obtain resources such as ideas, solutions, and various other types of intellectual contributions. The rapid rise of crowdfunding and associated crowdsourcing has caused an uptick in scholarly research. Even with this new research, crowdfunding and crowdsourcing is still not well understood. The true potential of crowdfunding is not merely raising funds, but raising awareness via public outreach.
Models of Crowdfunding
Currently there are four models of crowdfunding. They include equity based, lending based, donation based, and reward based. In the Unites States, crowdfunding tends to focus more on donation and reward based than equity and lending based models. Equity based campaigns raise capital for companies. The SEC issued rulings in October 2015 that allow companies to use crowdfunding to offer and sell securities. Lending based campaigns allow the entrepreneur the opportunity to raise funds in the form of loans that will be paid back over a predetermined amount of time and at an agreed upon interest rate. The model allows the entrepreneur to raise funds without giving up any equity in the business. Donation based campaigns are generally used as a means of personal fundraising. An example of this type of crowdfunding can been seen with a campaign focused on funding an individual or family after a tragedy such as a medical issue, fire, or loss of a parent or spouse. Reward based campaigns are often used for creative enterprises. This could be a musician looking for funding for studio time in order to complete a music CD or an independent movie director looking to fund his or her next film. Reward based projects usually provide various levels of rewards to the contributor. The rewards increase as the contribution to the project increases. In the case of a musician, rewards could include a free download of the CD and escalate to include a private concert for the contributor and their friends.
Thousands of businesses and individuals have been successful at raising funds via various crowdfunding platforms. It’s not unusual for us to log on to our social network of choice and see a variety of requests from friends, family and acquaintances, asking for donations or contributions to some cause via a Kickstarter, GoFundMe, or an Indiegogo campaign. We often give, and our clients often receive, these funds with little thought to the tax implications. To make matters worse, Congress and the IRS have not specifically addressed crowdfunding. This leaves very little guidance to tax professionals who are trying to advise their clients. However, although specifics have not been provided, we can apply current tax principles to our clients’ situations and advise our clients appropriately. Our discussion of tax implications will generally focus on the receiver of the funds. How we handle that will often lead in to how the giver of the funds should handle their side of the transaction.
Let us first discuss the gifting aspect of crowdfunding via the donation model. If a contributor gives money to a bon afide charitable organization, the donation is deductible per the rules of Section 170 of the Internal Revenue Code. With crowdfunding, we must keep in mind that these contributions are often reward based. Therefore, we must take into consideration the value of any goods received when the contribution was made. The charitable organization will record the income as they would normally record any other contribution.
It becomes a little tricky when it comes to contributing to an individual. Let us use the example of a tragedy in which a family loses all their belongings in a house fire. The community rallies to support the family and creates a Kickstarter campaign to raise funds to help pay for temporary housing and replacement of personal items such as furniture and clothing. Contributors are making what they consider a donation to the campaign, but it is not a deductible donation in the tax-sense of the word. With no specific guidance provided by the Internal Revenue Service, we must rely on established gifting rules and guidance provided the Internal Revenue Code. In our example, the recipient would not claim the gift as income, and the donor would need to consult with their tax advisor to see if there is a gift tax return implication.
We could travel a little further down the rabbit hole to consider casualty losses in our example. Let us assume our family has a $5,000 casualty loss. Do the funds from the crowdfunding campaign offset the casualty loss like insurance proceeds would? If the crowdfunding campaign raised $6,000, does the family now have a $1,000 personal casualty gain? Or, is the $6,000 still considered a non-taxable gift? My instinct tells me it is still a non-taxable gift. However, the conservative approach would be to offset the loss with the funds raised.
Reward based crowdfunding campaigns promise rewards for various levels of donations. Let us use an individual who creates furniture out of lightweight upcycled materials as our example. Our entrepreneur needs to raise $10,000 for the legal fees for the startup of his new business and for the costs associated with developing various prototypes of new furniture. He successfully raises $10,000 via a crowdfunding campaign. He has created two reward tiers for his contributors. For those who have contributed up to $100, they receive a free upcycled chair made out of cardboard. Those who have contributed up to $300 will receive the chair and an upcycled cardboard desk.
How do we treat the $10,000 our entrepreneur has raised? Is it a nontaxable gift or is it taxable income under Internal Revenue Code 61? If it is taxable income, what expenses can we use to offset the income? The answers all depend on a variety of factors that will differ from client to client.
Generally, gift treatment would not be allowed when the campaign promises a reward of any value. This is because a gift is generally defined as an amount given out of detached and disinterested generosity. If the contributor is expecting a reward, then the contribution does not meet the definition of a nontaxable gift. We must then move to the next step and determine if the entrepreneur’s activities are considered a trade or business, or a hobby. If it is a trade or business, then the $10,000 would be taxable income and all allowable trade or business expenses would be deducted against the income per Section 62 of the Internal Revenue Code. If it is deemed to be a hobby, then only the expenses to the extent of the income will be deducted per Section 183 of the Internal Revenue Code. Since this is a start-up business, we must also consider the capitalization of startup expenses under Internal Revenue Code Section 195.
So What’s Next?
With countless thousands of new crowdfunding projects starting each year, it is inevitable that a tax professional will work with at least one client who has either income from a crowdfunding project or has contributed to a project. In the absence of specific guidance addressing crowdfunding income, we must rely on what we do have… existing tax laws and our ability to apply them to our clients’ unique situations.