Tax implications for Common Types of Crowdfunding
More and more small business and startup company owners are turning to crowdfunding in the hopes of generating cash as well as creating a buzz around their business. Websites such as Kickstarter and Indiegogo make it super easy to find a platform to launch your project, however it is just as easy to overlook the related tax, compliance and administrative implications! Let’s review the common types of crowdfunding businesses use as well as the potential pitfalls and issues to try and avoid.
Reward Based Crowdfunding
Reward based crowdfunding is basically as it sounds. The backer, or person making the monetary pledge, receives an item for their pledge. Essentially, they are giving you money for something in return in the future. This is a reward or perk like, a signed album, digital download, or a performance at your home.
With this type of crowdfunding, there are two important tax items to take into consideration.
#1. The first is income tax. In general, the amount that you receive for reward based crowdfunding is considered income for IRS and State purposes. If accounting decisions were not made properly, you could get stuck with a hefty tax bill
For example, say you have a great idea and have revolutionized the saucepan. You go up on a crowdfunding site and say that for a $100 pledge you will ship them a saucepan. Everyone is super excited and you raise $200,000 in 2019. Your projected product ship date is June 2020. The main issue with this scenario is that if the proper accounting decisions were not made, you will have to pick up that $200,000 into income in 2019 and pay tax on it!
Many will be thinking, “Wait! I will have expenses to offset the $200,000 so it will not be that bad”. The problem here is that since you aren’t ready to ship any items in 2019, the IRS does not let you take any business expenses until you have product to ship. This means you pay income tax of around $60,000 in 2019 even though your profit would have been significantly less once you take into account the cost of the saucepan and other business expenses.
To avoid this pitfall, with proper accounting planning, you could defer recognizing the $200,000 of revenue until you ship the items. In that case, there would be no tax for 2019 and your 2020 tax would be much lower since you would be able to deduct the cost of the saucepan. (Caveat: Even if you do not ship the saucepan for multiple years, the IRS may make you pick up t
he income before you ship it under the mandatory revenue recognition rules of 1.451-5(c).)
This is a great example of how working with a CPA early in the business development process can dramatically improve the chance of long term success.
#2. The second consideration with reward based crowdfunding is sales tax. If your item or service is taxable and you meet certain rules for each state, you may have to register and pay sales tax on the items that you ship to that state. This could potentially be a large administrative and monetary burden.
Building on the above example, say you are located in NYS and receive a $100 pledge from a NYS backer, you now have to remit sales tax on that item. Since you already charged the customer $100 but did not charge sales tax, NYS will consider that $100 to include sales tax (at a rate of ~8.5%). This means that instead of receiving $95 ($100 less the crowdfunding website fee of around 5%), you will only receive $86.50 ($100 less the 5% fee less $8.50)! And that does not even include the income tax that you have to pay on the profit! (Note: Sales Tax requirements, particularly for online sales, expanded dramatically with the South Dakota vs. Wayfair Supreme Court decision. This is another important discussion point with your CPA.)
Going along with this theory, say for a $5,000 pledge you will personally travel to the persons house and make them dinner along with a full array of saucepans. By traveling to that state, you likely just subjected every purchase (not just the $5,000) to not only sales tax, but also income tax. So instead of potentially having a large pledge, in the end you could have been better off not receiving it due to the sales tax ramification on all your other sales to that state.
The next common type of crowdfunding is equity crowdfunding. Under this type, investors contribute money for an ownership % in your business. One of the largest changes that happens when equity vs reward crowdfunding is used is that you now have to listen to and operate the business in the best interest of not only yourself, but also the other owners. There are numerous Securities and Exchange Commission (SEC) legal rules and procedures that must be followed when equity crowdfunding is used.
For example, in order to raise the funds, you pay fees for commissions, marketing fees and legal fees among numerous others. Unfortunately, the costs to raise the funds are not deductible for income tax purposes.
In addition to these one-time costs, you will also have annual administration costs such as accounting reviews and investor relations, as well as other ongoing reporting requirements.
Since you are not selling a product or service, but instead are giving up an ownership interest in your company, there are no income or sales tax implications in this type of funding. This means that you can raise as much equity financing as you like and not have to worry about the IRS. However, some states may charge a yearly fee depending on how much equity is raised.
Debt Based Crowdfunding
Debt based crowdfunding is similar to equity based crowdfunding in many of its requirements and also has SEC requirements. As the name implies, instead of offering ownership interest, you are offering debt in your company. The funds are loaned by the backer to your company with repayment and interest requirements. Typically you would offer your own personal assets as collateral to guarantee the loan will be paid off.
This method of crowdfunding can be preferred if you don’t want to give an ownership stake in your company but have a need to raise money. Similar to Equity crowdfunding, since you are not selling a product or service, there are no income tax considerations.
However, there will still be costs associated with raising the funds. If the funds being raised are strictly debt, the costs of raising the money are deducted over the life of the debt. That is unless the debt has a convertible feature (the debt can be converted to equity shares vs being repaid) then the decision on deducting the expenses for raising the convertible debt is delayed to ensure there is no deduction for equity financing.
Debt & Equity Based Crowdfunding Note
As I mentioned above, both equity and debt based crowdfunding have securities and investor reporting laws and the laws can change based on the size of the equity/debt raised as well as the states that are involved. Considering this, it is always wise to consult with an attorney experienced in these areas before embarking on an equity or debt funding campaign.
Amount of money to raise
Since you have been looking into the types of crowdfunding, you may have a preliminary idea of how much money you were thinking of raising. As I am sure you can imagine, the amount of funds to raise varies for each business. A general rule of thumb is to attempt to raise enough funds to get the business through the initial milestone(s) in order to finance the ongoing business easily on favorable terms. Experts can disagree on how much “runway” or “cushion” that should be factored in to allow for potential delays. The main thing to keep in mind is that it is dramatically more difficult to secure favorable terms for a project which 95% of the way of reaching its important milestone, such as completion of a clinical trial or its first sales, than a project that has full achieved a milestone.
To summarize each of the common types of crowdfunding:
- Pre selling your product/service vs directly raising funds
- There are income and sales tax considerations as well as other potential taxes depending on the state
- Is likely the easiest and cheapest crowdfunding option
- Selling ownership of your company
- SEC Compliance is required
- There would be no income or sales tax considerations
- You now have investors to listen to and be concerned with their goals/needs
- You are taking on debt similar to a bank loan
- It must be paid back with interest and your assets are generally used as collateral
- SEC Compliance is required
- You do not have to provide a product or service for it and you are not giving up an ownership interest
Would you like to discuss this topic further? Contact us at firstname.lastname@example.org or 716-633-7022.