Although crowd-funding has become more and more common, it remains a tricky area for tax professionals. The IRS has not issued clear guidance on many areas of crowd-funding, and tax pros are often left to rely on other tax laws and their best judgment when they determine how to report money from crowdfunding. In this post, we’ll cover the basic types of crowdfunding and the most common ways crowdfunding income is (or isn’t) taxed, so you can make informed decisions for your clients.
What Is Crowdfunding?
Crowdfunding is used to solicit financial contributions from a large number of people, referred to as backers, over the internet. The financial contributions are used for a variety of projects including business ventures, social causes, and support for individuals with a special need. Funds are gathered using a platform such as Kickstarter, Indiegogo, or GoFundMe. Funds are then held and paid out by a Third Party Settlement Organization (TPSO) such as PayPal or Amazon Payments. The platform and the TPSO will typically receive 3 to 5% of funds each as their fee.
Is crowdfunding income taxable?
The short answer: it depends. Crowdfunding projects can be divided into three main types: donation-based, rewards-based, and equity-based. Donation-based crowdfunding is usually done for private individuals, and the proceeds are usually considered non-taxable gifts. Businesses usually engage in reward-based or equity-based crowdfunding, which have different tax implications.
Crowdfunding taxes for individuals
Typically, if an individual receives money through crowdfunding and does not offer anything in exchange, the donations are considered non-taxable gifts. Crowdfunding campaigns like this most often occur when an individual is facing difficult financial circumstances due to medical expenses, funeral expenses, or personal tragedies like a house fire. The crowdfunding campaigns are often set up by family members or friends but are sometimes set up by the individual themselves.
If a single donation is large enough to meet the gift tax limit, it might be subject to the gift tax, which is paid by the donor.
Crowdfunding taxes for businesses
When businesses raise money through crowdfunding, they usually run reward-based campaigns. Most, if not all, of these funds will be considered taxable business income. Another type of crowdfunding, known as equity-based or regulation crowdfunding, is becoming an increasingly popular way for startups to raise capital and has different tax implications than reward-based crowdfunding.
In reward-based crowdfunding, the backer will receive something for their contribution. The reward can be as little as an on-line thank you, or a nominal item such as a coffee mug or t-shirt, or something more valuable such as a first run item of the product. Oftentimes, the reward will increase with the amount contributed.
If the reward was something of value, the funds will almost certainly be considered business income. If the reward was not something of value or the value is difficult to determine (such as a handwritten thank you note from the business owner), the contribution could possibly be classified as a non-taxable gift. However, the business would likely need additional support to make a compelling case for why the money should be considered a gift instead of income.
Equity-based crowdfunding, or regulation crowdfunding, offers the backer a financial stake in the company. This type of crowdfunding is highly regulated by the Security and Exchange Commission (SEC) and is most commonly used by startups.
Because a business is issuing securities instead of offering a good or service, these funds are not considered business income and are not subject to business taxes.
Note: The information below on state taxes, business expense, and reporting crowdfunding income only applies to rewards-based crowdfunding, not equity-based crowdfunding.
State sales tax, income tax, or use tax could apply to your client’s crowdfunding income. The specific rules vary state-to-state, so be sure to check your state’s requirements.
Deducting business expenses
Remember, even if all of the crowdfunding income will be considered taxable business income, your client can still deduct their business expenses. In many cases, crowdfunding is used to cover the considerable expenses of getting a business off the ground. These expenses could significantly reduce their total profit from the campaign and, consequently, reduce their taxable income.
If the business is new, you’ll want to make sure all startup expenses are deducted properly. Typically, only $5,000 in startup costs can be deducted in a business’s first year, and the rest must be amortized over several years. For more on what counts as a start up cost and how to properly deduct these costs, see IRS Publication 535.
Business owners can run into trouble if they raised crowdfunding money at the end of the year but didn’t start incurring expenses until the following year. In this case, they may owe far more in taxes on their crowdfunding money than they would have had the campaign and expenses occurred in the same year. (When expenses and income are recognized will depend on whether the business uses a cash or accrual basis accounting method).
How is crowdfunding income reported?
Until the end of 2021, if a crowdfunding campaign’s funds exceeded $20,000 and the number of transactions exceeded $20,000, the Third-Party Settlement Organization was required to issue a Form 1099-K, Payment Card and Third-Party Network Transactions to the recipient of the funds. Starting in 2022, that threshold is significantly lower, and 1099-Ks are now required for payments that exceed $600 and any number of transactions. As a result, many more crowdfunding recipients can expect to receive a 1099-K going forward.
Of course,1099-Ks are only an informational form, and they don’t offer guidance on how to report the income (if it even needs to be reported at all). Again, for most businesses, the funds are considered business income, and the IRS advises: “you should consider the amounts shown on Form 1099-K, along with all other amounts received, when calculating gross receipts for your income tax return.”
If the funds are a gift to an individual, however, they likely do not need to be reported as income even if they did receive a 1099-K.
Are crowdfunding donations tax deductible?
In most cases, no. Crowdfunding contributions are only tax deductible if the donation went to an organization that is recognized by the IRS as a qualified charitable organization. For example, if your client gave to a local humane society’s crowdfunding campaign, these donations would be considered tax deductible. If they gave to an individual or business – no matter how noble the cause – the contribution is not considered tax deductible.
Glossary of Terms:
Backer. A backer is someone who provides a donation to a crowdfunded project.
Crowdfunding. Crowdfunding is the practice of soliciting financial contributions from a large number of people especially from the online community.
Deductible charitable contribution. A deductible charitable contribution is a donation or gift to an organization that is recognized by the Internal Revenue Service as a qualified charitable organization.
Donation model. Donation model is a method of funding a crowdfunded project where the backer receives a reward that has a value that is typically well below the value of what the backer gives.
Equity model. Equity model is a method of funding a crowdfunded project where the backer receives an ownership stake in a project in return for a contribution.
Gift. A gift is any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.
Platform. The platform is an organization that connects backers and project creators for purposes of funding and launching a crowdfunded project.
Project creator. The project creator is an individual or organization that is seeking support for a project.
Sales tax. Sales tax is an excise tax that is levied by a state government on a business that sells goods or services to the public.
Use tax. Use tax is an excise tax that is levied by a state government on a resident that purchases an item that is not subject to the state’s sales tax.
The information in this article is up to date for tax year 2021 (returns filed in 2022).