Understanding Crowdfunding Taxes

There are so many fundraising websites cropping up all across the internet. This method for raising money from large groups of like-minded donors has never been more popular. The way it works is very simple.

Anyone seeking to finance a wide variety of projects and products initiates a campaign on a website. These include Kickstarter.com or Indiegogo.com. There, they advertise for backers who can donate a certain amount of money to help fund that campaign. There is a range of similar sites where people can try to raise money for personal or charitable reasons. A reward or product is not always offered in return.

There are many purposes of a crowdfunding campaign. If you are successful in reaching your financial goals, you’ll receive the amounts set forth in the donations on your campaign. Thus, you will need to consider how this may affect the taxes. That includes yours personally or any business that you establish to take in these funds.

As of now, the tax code doesn’t contain specific language to acknowledge this form of income. Therefore, there are no hard and fast rules governing how this money may be taxable. That has left tax professionals little direction on advising their clientele in the ways to report these earnings. That is simply because there are so many different agreements within the typical crowdfunding dynamic.

However, that shouldn’t leave taxpayers completely in the dark. The current IRS laws contain language that can be referred to when trying to determine how to report this income. Plus how to pay what might be owed.

It is better to address the issue now. Report accordingly for the applicable tax year. You should not ignore the quandary. You can potentially face fines and other penalties down the road. In order to assist you in paying your fair share, here are the important factors that will give you a better understanding of crowdfunding taxes.

Crowdfunding Arrangements

Although you have options as to where you set up a crowdfunding campaign, most of them can be classified under one of three categories:

  • Creative endeavors for a movie project or consumer product.
  • Personal Fundraisers where you can take donations towards medical expenses or some other personal reason.
  • Equity-based crowdfunding which is designed for businesses to raise the capital they need in order to operate.

The Securities and Exchange Commission established a set of regulations on this sort of funding. Businesses must be in compliance with these rules. Donors can submit payments through third-party processors such as PayPal or Amazon. That is because these companies both operate in accordance with the IRS and under the statutes of the Patriot Act. That is with respect to the mandates dictating data-collection.

Typically, principal owners of a crowdfunding campaign raise more than $20,000 and perform 200 or more transactions in one year. Therefore, they are issued a Form 1099-K. It reports the unadjusted gross revenue of the enterprise.

However, there is a part where it begins to get specific. That is whether or not the donor submitted the amount as a donation or in exchange for some type of reward. Both are common crowdfunding endeavors. Though, the former is usually considered a nontaxable gift. Consequently, the latter will be subject to income tax considerations for the creator of the campaign.

Income Tax Ramifications

Taxes are discussed on many of the more popular crowdfunding sites online. Yet, none of them really provide a comprehensive and focused explanation. They don’t describe what campaign creators can expect when they start taking in large sums of money.

Most of them simply address the fact that, yes, this is income that campaign principals may be responsible for reporting on their return. Some of them suggest that any expenses associated with the crowdfunding campaign could be deductible against what is raised. Still, others claim that donations could be considered as gifts, which are not subject to taxes under the law.

The bottom line is there are no clear-cut rules for reporting this money. That’s because the IRS has not yet defined them. Thus, it is left up to the campaign creator to settle on similar laws within the tax code. That is done to provide a clearer picture of keeping compliant. Many are still left wondering about filing their federal taxes. They haven’t yet considered what may be owed for state and local taxes, sales tax and use tax, where applicable.

State and Local Tax Responsibilities

Crowdfunding has become a lucrative business model for thousands of projects. It’s raised nearly two billion dollars on Kickstarter alone. That doesn’t take into account the millions more that have been raised on the other popular sites.

That’s a significant amount of money. It can be tapped into by state governments. They may be entitled to a portion of those funds due to state tax statutes across the country. Things are still a bit murky on the federal level. Many states have set up their own guidelines for collecting taxes on donations made through crowdfunding methods. It may not be a coincidence that some of these states are also considered among the best states to retire.

One of these agencies is the Washington State Department of Revenue. They provide advice on what campaign creators can expect when raising money through crowdfunding resources. Plus, guidance on the tax implications that may result. The most prevalent concern for taxing this income is through state sales and use taxes.

Taxability Standards

States that collect sales taxes typically do on so retail sales of products and services. When shopping at a store, you may be assessed a sales tax. That’s in addition to the prices of the items that you are purchasing.

Washington is one of many states that consider the electronic distribution as retail items. This includes digital items like books, music, and videos as retail items. Thus, they are subject to sales tax. This is important because many crowdfunding campaigns provide items like these as rewards for donations.

As a result, any crowdfunding arrangement in which an item is given out in exchange for financial contribution is considered a retail purchase. Then, a sales tax can be assessed. There are exceptions that may vary from state to state. They pertain to certain items which may be exempt from taxation.

For the purposes of assessing a use tax, some states find the campaign creator makes taxable use of such rewards as a promotional item. Therefore, they will be liable for a use tax on that item. As far as Washington is concerned, giving out such an item in exchange for a contributing donation counts as a retail purchase. Thus, it is taxable.

Yet, it also depends on what the reward item happens to be. Sending a letter of thanks or including a donor’s name in online records or in film credits do not apply in this instance. That would make the contribution strictly a donation.

Taxable Base

A reward that is issued in conjunction with a crowdfunding campaign could have a taxable base. Determining what that is, if any, depends on the item and the donation given. The state of Washington delineates a taxable base as the value of the item or the service being provided as a result.

Any money submitted beyond the value is considered a donation, which is not taxable. For instance, let’s say a campaign offers a DVD. It is a copy of a film that is being produced by the campaign creators. It’s given to each contributor who donates at a $20 level to the campaign. However, if a donor contributes $40 to the campaign, the initial $20 is taxable as a purchase transaction. The remaining $20 is viewed as a donation that is nontaxable.

When to Report?

Crowdfunding campaigns don’t always succeed, despite money being donated by a number of contributors. If the goal is reached, then the money is vested. Only then is a retail transaction taking place. Thus, that income is accepted. Washington guidelines dictate that taxes are to be reported when the funding goes through.

However, not all states concur. Some may be more insistent upon taxes being reported sooner. Additionally, if the funding does fall through, then a credit could be issued after the fact. These guidelines aren’t entirely clear. Not even for Washington. That state only addresses the timing on reporting for fixed crowdfunding campaigns.

Those campaigns that are done contemporaneously by way of a flexible crowdfunding initiative are not as clear under the rules. Reporting this income may need to be done at the time it is received. Conversely, it may be postponed until the funding goal is reached.

Federal Taxable Income

There are no specific determinations for reporting crowdfunding contributions on a federal return. Taxing this income could fall under Section 61 of the code. Hence, it may be reported by the campaign creators for the year it was received. Yet, if this income is to be taxable, then that brings up a number of questions. These include the reasons for creating the campaign and the purposes for which the money is being raised.

Should these funds be considered part of federal gross income, other factors come into play. The money is subject to tax. Then, what deductions should be made available with respect to expenses and other components that are typically considered deductible in similar situations?

Making those determinations require taking certain concerns into account. These include whether the crowdfunding campaign is considered a trade, a hobby, or a business. That is in addition to whether the purpose of the funding is for a startup business, the accounting methods employed by the campaign creators, and the actual value of the rewards that are being distributed in exchange for contributions.

Determining Between Trade, Business, or Hobby

Perhaps the campaign activity is classified as a trade or a business. Then, the expenses allowable under the IRS tax code should apply as deductible against the received income. That is per Section 62 of the law.

However, if it’s considered a hobby, the deductible expenses are limited to the extent of the income as per Section 183. This is where it becomes important to create a clear delineation. Doing so may lie in the details of the activity in question. There are limits and prescribed concerns in Section 183. They can be applicable to individuals, S corporations, and partnerships. Conversely, C corporations are exempt.

A list of criteria is in place to make this determination, including the way the business is run. It takes into effect if the owner is knowledgeable or experienced in the type of business being run. It takes into account whether the activity is being pursued for recreational purposes. There are also other additional factors. The business activities being conducted are analyzed by these criteria. Then, the determination can be made as to whether you’re running a trade or business, or simply a hobby.

Accounting for Costs and Deductions

Perhaps, the crowdfunding activity is deemed a startup business or trade. In this case, it’s possible that the principals behind the enterprise incurred startup and/or organizational costs associated with the endeavor. Taxpayers must capitalize such expenses.

That is unless they choose to make an election under Section 195 of the IRS tax code for applicable startup costs. They may also select Section 248 for corporations or Section 709 for partnerships to take a deduction on up to $5,000 of organizational costs. That becomes reduced by any amount over $50,000.

This deduction is to be claimed for the tax year in which the trade or the business is claiming startup costs. This is also the case if the partnership or corporation goes into business and claims organizational costs. The remainder of these costs is then amortized over a period of fifteen years. It starts from the month the trade or business is active or the corporation or partnership begins conducting normal business operations.

The taxpayer must elect to deduct or amortize their applicable expenses or otherwise decide to capitalize them on their return. In order to deduct startup or organization costs, the enterprise has to be deemed an active business. The courts have had to make determinations as to when a taxpayer is officially involved in an active trade or business.

These such decisions have hinged upon at what point a business is considered a “going concern”. Similarly, at what point it has started to manufacture the product or provide the service for which that business was legally formed.

In this manner, setting up a crowdfunding campaign may not necessarily qualify as being involved in an active business. Therefore, any expenses related to the crowdfunding campaign may not be deductible in the year they were received. It must be for the year in which the business is deemed active.

Accounting for Income

Crowdfunding campaigns don’t necessarily result in the completion of the project or product that is being funded. Thus, when the funds are received by the campaign creators that money is now in their hands. Hence, they can do whatever they want with it.

Under the claim-of-right doctrine, this income is now deemed as taxable for the year it was received. It doesn’t matter what kind of accounting procedures are utilized by the campaign principals. This may present a problem for the creators of the campaign.

That is because the income is taxable for the year it was taken. Though, the applicable deductions may not qualify to be claimed until the following year. That is because the enterprise is not considered active until that time. That may hinder the production of the project due to lack of available sufficient funds once taxes are paid on the received income.

One way to avoid this potential issue is to time the campaign properly. Ending it well before the end of the year will enable the principals to incur their operating expenses in the same year the campaign was funded. Therefore, their costs can be deducted for the same year they are paying taxes on the funding income.

Reward Value to Donors

For tax purposes, the value of a reward is important to ascertain for each crowdfunding campaign. If the donor receives something in return for their contribution, the value assigned to it could be up for interpretation. As discussed previously, the reward could be a thank you note. It can also be inclusion in the credits of a film or other creative endeavor and these don’t have much of any actual value for tax purposes.

However, many campaigns do offer something of value in return for backing. It can be an actual product purchased through a donation or some other reward related to the campaign as a tangible item. Let’s say the value is unable to be adequately identified or determined to have a value that is less than the amount donated or no value at all. In that case, the item may open to further evaluation. It may be classified as a nontaxable gift or something else entirely which may be deemed as taxable.

Nontaxable Gift Contributions

Some of the crowdfunding sites attempt to distinguish what constitutes a nontaxable gift as part of a campaign. This form of income may be exempt from federal income tax if it is given without specific expectation of a reward. It must be offered instead as a generous contribution.

Nonetheless, this does not apply should a reward be given with a value that is equal or greater than the amount contributed. The bottom line here is that any donations provided with an expectation of a reward with at least partial value are unlikely to be deemed a nontaxable gift. Perhaps a backer is entitled to a reward but declines acceptance. In that case, the money could fall under the standards of a nontaxable gift. Though, it would still be up to interpretation.

Donations from Nonshareholder Parties

Where corporations are concerned, we refer to Section 118 of the tax code. It allows for certain types of receipts to be considered as nontaxable contributions to capital by an individual who counts as a nonshareholder. However, this probably wouldn’t be applicable toward reward-based crowdfunding campaigns. That is because the principals of such activities are not operating as a corporation.

If that is the case, and there is no reward provided to the donor, there are applicable standards for that money to be considered a nonshareholder donation. Based upon previous decisions from the Supreme Court in similar matters, this criterion includes the following components:

  • The money must be considered a permanent addition to the working capital of the party receiving the contribution.
  • It can’t be considered compensation in exchange for a product or service.
  • The donation must provide a benefit that is commensurate with the value of the contribution.
  • The donation is to be used for generating further income.
  • The contribution must be negotiated for prior to donation.

Most crowdfunding campaign donations could meet most of these standards, but for the last one. That likely won’t apply in the case of a crowdfunding campaign. That’s because the funds received do not go through any sort of bargaining process. Many of these crowdfunding websites do not provide the necessary information between the two parties involved in a donation to meet that requirement.

Crowdfunding has grown exponentially since it first became feasible to raise small amounts of money from large groups of people back in 2009. This form of funding is only getting more popular. There still exists too little in the way of tax guidelines from the federal government. Some facets of reporting this income and how to do it are unclear and there are no hard and fast answers on the horizon either.

At the very least, money that is received through these methods is left to be determined for tax eligibility through the way the money was raised and the value of any rewards or products that are distributed as a result. When stronger mandates are passed the way of doing business with this form of capital could change.

Campaign creators may be viewed as operating a small business or trade. Thus, it brings with it certain issues with the accounting practices that are conducted by these operators. Expenses related to startups could also be reconsidered under these situations.

That is in addition to the timing of the campaigns themselves. It is to prevent their creators from encountering cash flow problems when it comes time to manufacture and deliver the product that was crowdfunded. There is still much work to do in defining how to tax this income.

Right now the rules governing crowdfunding are far less complicated than those that govern saving for retirement. Thus, comprehending them is a bit easier by comparison.

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