Tax Consequences of Crowdfunding

Aug 15, 2016
Bill

Background

Crowdfunding has quickly become a popular alternative to venture capital. In fact, a recent report published by Goldman Sachs described the practice as “potentially the most disruptive of all of the new models in finance.” Yet little is known about how such models are taxed. In a recent Information Letter, the IRS looked to general principles of income inclusion to explain the tax treatment of crowdfunding. However, given the fact-specific nature of crowdfunding arrangements, uncertainties still remain.

What Is Crowdfunding?

Crowdfunding is a way for businesses and entrepreneurs to solicit online contributions from multiple parties. This is typically accomplished through a crowdfunding platform such as Kickstarter (www.kickstarter.com) or AngelList (www.angel.co). Depending on the program, participants may receive “rewards” for their contributions. These are usually items of nominal value such as t-shirts or concert tickets. In some circumstances, contributors may receive an equity interest in the business or a right to have their contribution repaid with interest.Initially, crowdfunding was used primarily by musicians and filmmakers to fund projects that were unlikely to yield a profit. However, following the enactment of Title III of the Jumpstart Our Business Startups (JOBS) Act in 2012, the practice has expanded to a variety of industries. Title III created a federal exemption under the securities laws to permit companies to offer and sell securities through crowdfunding. Since that time, crowdfunding platforms have grown considerably, generating billions in capital for startups and small businesses.

Tax Characterization of Crowdfunding Contributions

As a general proposition, crowdfunding contributions are includible in income under IRC Sec. 61. This includes contributions constructively received by a company. However, depending on how the arrangement is structured, contributions may fall into one of the income exclusions provided by the Code. Accordingly, contributions characterized as loans, gifts, or capital contributions may be excluded.Loans. Crowdfunding contributions structured as loans are generally excludable from income. However, the arrangement should have sufficient debt-like features, such as an unconditional promise to pay, a fixed interest rate, and a specified maturity date. Arrangements where repayment depends on the financial success of the company or a particular project may be questioned by the IRS. Funds transferred without a bona fide repayment obligation will be includible in the recipient’s income, even if the parties characterize the deal as a loan.

Gifts. Crowdfunding contributions constituting gifts for federal tax purposes are excluded from the recipient’s income under IRC Sec. 102 . Gifts generally proceed from a “detached and disinterested generosity.”  Therefore, quid pro quo contributions in which the donor receives an economic benefit will not qualify as gifts.

Observation: Some crowdfunding platforms offer “rewards” in exchange for contributions. It is uncertain whether receipt of a reward negates an individual’s donative intent, especially when the item’s value is inconsequential. Although not directly on point, the IRS’s guidelines on quid pro quo charitable donations (which aren’t deductible) may be helpful. According to Rev. Proc. 2015-53, a benefit is de minimis and charitable contributions are fully deductible if the value of all benefits received by the donor is not more than 2% of the contribution, or $106 for 2016, whichever is less. In addition, if the contribution is at least $53 for 2016, and the donor receives token benefits costing no more than $10.60, the benefit is de minimis and the contribution will be fully deductible. Presumably, similarly de minimis rewards would not negate the donative intent for crowdfunding purposes.

If the contribution is a gift, the donor may be subject to gift tax depending on the amount of the contribution. Currently, there is an annual gift tax exclusion of $14,000 per person. Given that crowdfunding platforms generally attract multiple investors with often limited resources, it is likely that most participants will not pay gift tax.

Capital Contributions. The taxability of funds characterized as capital contributions generally depends on the tax classification of the business and whether the donor receives an equity interest. In the case of a corporation, gross income does not include any contribution to its capital.  If the donor receives stock as part of the deal, the corporation recognizes no gain or loss on the receipt of cash or other property. However, the donor may have to recognize gain if he contributes appreciated property to the corporation and does not own at least 80% of the entity following the transaction. This scenario is unlikely, however, because crowdfunding platforms generally support cash transactions only.

If the business is classified as a partnership for tax purposes, and the donor receives an equity interest as part of the deal, crowdfunding contributions are generally tax-free to both the entity and the donor.  Capital contributions to a partnership by nonowners, however, are generally includible in income.

Deductibility of Crowdfunding Expenses

Crowdfunding expenses commonly include service fees charged by the platform tasked with raising the funds. For example, Kickstarter charges a 5% fee if the project is successfully funded. There are also legal fees and other expenses, such as the rewards offered to contributors.As crowdfunding is typically associated with startup companies, some question whether such initiatives rise to the level of a trade or business under IRC Sec. 162(a). This stems from the fact that many projects are pursued with no reasonable expectation of profit. For businesses lacking a sufficient profit motive, crowdfunding expenses will be subject to the Section 183 hobby loss limitations.

Companies meeting the definition of an active trade or business will be allowed to deduct all ordinary and necessary expenses, including crowdfunding expenses. However, startup expenses are not immediately deductible. The taxpayer may elect to deduct up to $5,000 of these costs, but this is reduced by the amount by which total startup expenditures exceed $50,000 [IRC Sec. 195(b)(1) ]. Any startup costs remaining may be amortized ratably over 15 years.

Reporting Concerns

Crowdfunding participants may wonder if contributions are reported to the IRS. In general, payment settlement entities are required by IRC Sec. 6050W to annually report the gross amount of payments made in settlement of credit card, debit card, and other payment card transactions on Form 1099-K. Transactions handled by third-party payers, such as crowdfunding platforms, may be exempt from filing Form 1099-K if the payments to the payee are under $20,000 or there are fewer than 200 transactions with the payee within the calendar year.Observation: As a practical matter, many crowdfunding platforms will be exempt from reporting requirements. However, some crowdfunding websites publicize contribution amounts for a particular project and may disclose the names of contributors as well.

Information Letter 2016-0036

In Information Letter 2016-0036, the IRS examined the tax consequences of crowdfunding. As is common with Information Letters, the facts have been redacted. However, it appears the taxpayer received crowdfunding contributions to purchase a company. Aside from the taxability of the contributions, the taxpayer questioned the applicability of the constructive receipt doctrine because funds may have to be returned to participants.As you would expect, the IRS concluded that the tax consequences of a crowdfunding effort depend on all the facts and circumstances surrounding that effort. In general, revenues from crowdfunding are includible in income unless they constitute loans, capital contributions in exchange for equity interests, or gifts. (The IRS clarified that a voluntary transfer without a quid pro quo is not necessarily a gift for federal income tax purposes.) In addition, crowdfunding revenues are taxable if they are received for services rendered or represent gains from property sales. In the end, the IRS looked to general principles of income inclusion to arrive at a somewhat vague conclusion.

Conclusion

To date, there are no court cases or IRS rulings that directly address the taxability of crowdfunding contributions. However, Information Letter 2016-0036 provides some insight into how the IRS views the subject. For now, it is safe to say that crowdfunding contributions will be taxable unless they are loans, gifts, or capital contributions. Practitioners will need to pay particular attention to the facts to determine proper treatment.