How Crowdfunding Works
Taxpayers interested in crowdfunding need to have a solid understanding of how this fundraising option works in order to grasp the potential tax implications.
Whether you plan to give money to crowdfunding projects as an individual OR you intend to use crowdfunding to find backers for a project your company has coming down the pipeline, your taxes are likely to be impacted.
Crowdfunding is generally done using an online platform that allows the fundraiser to explain the nature of the project or venture, including the amount of money they hope to raise, and the time frame (deadline) for the money-raising campaign. Often, the fundraiser will offer some type of reward to those who contribute (usually termed a backer). The rewards are often really just tokens – a coffee cup or t-shirt with a logo, tickets to an event, a video game – or in some cases an equity interest in the endeavor, or the right to be repaid with interest if the campaign is financially successful. Typically, backers who are interested in participating use their credit card to make a pledge, and if the campaign meets its financial goals within the deadline, the crowdfunding site will process the card-based pledges and fund the campaign.
Types
There three main types of crowdfunding:
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Equity-Based: Equity crowdfunding is the process by which an individual is able to invest in an early-stage company in exchange for shares in that company. This type of crowdfunding is best suited for businesses that are established but in need of capital for expansion. However, this type of fundraiser is subject to Securities Exchange Commission (SEC) regulations discussed below.
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Donation Based: Donor platforms allow money to be raised without any obligations to investors. Contributions to the stated cause are donations or gifts with no strings attached. Common donation-based causes include philanthropy; medical, funeral or living expenses for individuals; and disaster-relief.
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Rewards-Based fundraising is most commonly associated with platforms like Kickstarter and Indiegogo. Through the rewards system, individuals and businesses raise money by offering a product or service in exchange for a campaign contribution.,
SEC Issues
Under the Securities Act of 1933, the offer and sale of securities must be registered unless an exemption from registration is available. Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 added Securities Act Section 4(a)(6) that provides an exemption from registration for certain crowdfunding transactions. The Securities and Exchange Commission (SEC) issued final regulations, effective May 16, 2016, implementing these JOBS Act provisions. These regulations permit companies to offer and sell securities through crowdfunding and create a regulatory framework for the broker-dealers and funding portals that facilitate crowdfunding transactions. The regulations were further amended by the SEC in November 2020. These rules, which have a substantial impact on crowdfunding, include the following provisions:
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Business Ventures Raising Capital - When raising money for business projects, there are two issues to contend with: the taxability of the money raised and the U.S. Securities and Exchange Commission (SEC) regulations that come into play if the contributor is given an ownership interest in the venture.
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No Business Ownership Interest Given - This applies when the fundraiser only provides the contributor nominal gifts, such as products from the business, coffee cups, or T-shirts; the money raised is taxable to the fundraiser.
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Business Ownership Interest Provided - This applies when the fundraiser provides the contributor with partial business ownership in the form of stock or a partnership interest. In this circumstance, the money raised is treated as a capital contribution and is not taxable to the fundraiser. The amount contributed becomes the contributor’s tax basis in the investment. When the fundraiser sells business ownership, the resulting sales must comply with SEC regulations, which generally require any such offering to be registered with the SEC. However, the SEC regulations carve out a special exemption for crowdfunding (https://www.sec.gov/education/smallbusiness/exemptofferings/regcrowdfunding)
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Fundraising Maximum - The maximum amount a business can raise without registering its offering with the SEC is $5 million in a 12-month period. Non-U.S. companies, businesses without business plans, firms that report under the Exchange Act, certain investment companies, and companies that have failed to meet their reporting responsibilities may not participate.
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Contributor Maximum - The SEC also limits the amount investors contribute.The amount an individual can invest through crowdfunding in any 12-month period is limited:
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If the individual’s annual income or net worth is less than $124,000, their equity investment through crowdfunding is limited to the greater of either $2,500 or 5% of the greater of the investor’s annual income or net worth.
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If the individual’s annual income and net worth are at least $124,000, their investment via crowdfunding can be up to 10% of their annual income or net worth, whichever is greater, but not to exceed $124,000.
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The forgoing limits are based on the SEC Updated Investor Bulletin posted on October 14, 2022. (https://www.sec.gov/oiea/investor-alerts-bulletins/ib-crowdfunding) These limits change from time to time. The bulletin also includes examples of limits, included above, are computed as well as instructions for determining net worth.
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For the fundraiser, even if the money raised is income for the business, it will probably net out to zero taxable if it is spent on tax-deductible business expenses.
For details on these regulations, see: https://www.sec.gov - enter crowdfunding in the search box.