Today, we bring you a guest blog from TaxSlayer Pro partner TheTaxBook to help tax professionals learn more about crowdfunding in relation to tax returns. Paul Roberts is an Enrolled Agent who has worked in the tax research publishing industry for more than 20 years. Paul is currently an editor for TheTaxBook series of publications. He began preparing tax returns professionally in 1985, and has spent the last several years assisting low-income and senior taxpayers working with AARP through the IRS VITA/TCE volunteer tax preparer program.
The purpose of this article is to increase awareness of issues that tax preparers may encounter when dealing with clients who create or contribute to crowdfunded projects. In many cases, rules related to federal and state taxation have not been firmly established. Future IRS letter rulings and court decisions will likely be required to provide guidance. In the interim, it will be up to each tax preparer to make determinations based on an analysis of facts and law.
This article provides an overview to crowdfunding and identifies rules that may apply. This article does not determine the application of tax law in particular circumstances.
Glossary Terms: The following is a list of terms that apply to discussions about crowdfunding.
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.
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. By using the internet, projects can gain access to funds outside of traditional sources such as banks or capital markets. A number of organizations, referred to as platforms, connect someone seeking funds with those who have an interest in contributing.
The platform will make the presentation available to a large number of backers via the internet. There are hundreds of platforms available to project initiators. Some of the larger platforms are Kickstarter, Indiegogo, Crowdfunder, RocketHub, Crowdrise, and appbackr. Due diligence on the part of the project initiator is necessary to find the platform most suited to particular project and avoid scams or other issues.
Backers can make a pledge using a credit card. If the campaign meets the funding requirement by the deadline, funds are released to the project. The funds are typically held and then released to the project or returned to the backers by a company such as Paypal or Amazon Payments. The release of funds can be based on an All or Nothing (AoN) or Keep it All (KiA) method. If the AoN method is used, then funds are released only if the funding goal is met. If the KiA method is used, then funds are released at the deadline and the project initiator is responsible for deciding whether to use or return the funds.
The platform will typically receive 3 to 5% of funds. The company holding and paying out the funds will typically charge 3 to 5% of the funds.
Third-Party Settlement Organizations (TPSOs)
A third-party settlement organization, such as Paypal or Amazon Payments, is required to issue Form 1099-K, Payment Card and Third-Party Network Transactions, to the recipient of the funds if the gross amount of total reportable payment transactions exceeds $20,000 and the number of transactions exceeds 200.
Crowdfunding for gaming, music and movie projects have raised some of the largest amounts of funding. High tech projects are also very common. Some examples include the Pebble E-Paper Watch, Formlabs 3D Printer, and Oculus Rift. The Tile app for finding lost items received support from crowdfunding. The ALS Ice Bucket challenge is an example of a recent campaign to raise money for a cause. Numerous campaigns have successfully raised money for individuals afflicted with diseases, accidents, and other misfortunes.
Projects commonly operate on either a donations or equity/debt model.
Donation model. Typically, the reward that a backer receives is below the value of the 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. Often times, the reward will increase with the amount contributed.
Equity/Debt model. The equity or debt model offers the backer a financial stake in the company. In the case of a project using an equity campaign, the backer will receive ownership interest in the company.
Tax issues for project creators. Some of the potential issues include determination of taxable income, self-employment tax, state and local income taxes, and excise taxes. The timing of income and matching of expenses may be particularly important. If the business receives funding late in the year, the project creator may face unexpectedly large tax liabilities. If the creator has other sources of income, the additional income from crowdfunding may be taxed in a higher bracket. State sales taxes can be very complex depending on the state, type of business, and location of the backers.
Tax issues for backers. Some of the potential issues relate to the deductibility of donations, gift tax returns, capital gains/losses, loans/interest, and use tax.
Other issues. The use of crowdfunding raises several issues for a business or service project initiator. The use of the internet for fund raising creates intellectual property risks. The idea can be copied. The project initiator may soon face management, legal and accounting issues that they may not have anticipated.