Crowdfunding: One platform with many tax results
Despite lack of IRS guidance in this emerging area, taxpayers and their advisors should be aware that different tax rules apply to various types of income and donations made through online fundraising
Editor’s note: This article has been reviewed for changes under the 2017 Tax Cuts and Jobs Act (TCJA). The information provided in this article was not affected by the 2017 TCJA. However, note that the JOBS Act of 2012 is now in effect and this article has been updated to reflect changes related to its implementation.
Internet-based crowdfunding -- raising money online for a project, company, or cause – is relatively new. As it’s known today, it dates back only to about 2003, when a website called ArtistShare was launched to allow music fans to help fund their favorite creative artists. Since then, crowdfunding sites have raised billions of dollars worldwide.
How crowdfunding works
The mechanics of crowdfunding are simple. For a business-related project, a site member sets up a campaign seeking money from “backers” to accomplish his or her fundraising goals. If the campaign meets its goals, the backers typically receive the earliest rights to the product or service that they have helped fund, based on their level of investment. On the other hand, if the campaign doesn’t meet its fundraising goals, the backers will receive a refund of their contributions.
But meeting an online fundraising goal and successfully launching a product or service are two different things. Although backers may get their money back if fundraising goals are not met, if the product or service is not successfully launched for any reason, online campaigns are not typically required to refund money to backers.
More recently, crowdfunding websites and campaigns have moved beyond products and services to take on altruistic purposes. Many organizers create campaigns to support specific causes or people who are in need, such as individuals who need help with medical bills. In these campaigns, contributions typically aren’t refunded, even if the goal hasn’t been met.
With a range of purposes, crowdfunding has evolved – and has given rise to unclear issues when it comes to taxation. This is because the tax code treats similar ventures outside the scope of crowdfunding differently. Although the funds may come in through a single platform, the tax implications can be surprising for taxpayers who don’t look into the potential results of their campaigns and/or donations.
The tax consequences of crowdfunding for organizers and backers
So far, the IRS has been silent on how taxpayers should address crowdfunding on tax returns. Without official guidance, the proper tax treatment likely hinges on two factors:
- The campaign organizer’s intent and factual situation, and
- Whether backers receive goods or services in exchange for their contributions
One thing is pretty clear: If the campaign organizer’s intent is to generate funds for a project that would otherwise be considered a trade or business if viewed outside the context of the fundraising website, any funds raised will be treated as taxable business income, under Internal Revenue Code § 61(a). The clearest example is when backers will receive products or services in exchange for their contributions.
Outside the context of online crowdfunding, this is like an individual putting down a deposit on an item before it’s manufactured. The deposit, when paid to a cash-basis business, is taxable upon receipt, and the cost of creating the items can be deducted as cost of goods sold when delivered.
When backers receive the right to purchase an item, the result is less intuitive. For example, an inventor establishes a campaign to fund the manufacturing of a widget he designed. In exchange for backers’ contributions, backers receive the right to purchase the widget from the first production run before anyone else. The campaign funds raised are taxable business income to the inventor. This is true even though the backers didn’t receive a right to the actual product, but, rather, a right to purchase the product first.
IRS information reporting
Crowdfunding websites will often issue a Form 1099-K, Payment Card and Third Party Network Transactions, to the campaign organizer receiving the funds. How taxpayers should report the amounts on this form on their tax returns varies depending on the nature of the payments. Since the IRS implemented the Form 1099-K, the IRS has started sending more notices to taxpayers who received the Form 1099-K, but did not report the income on their returns.
“Life event” fundraising
Campaigns launched on websites such as GoFundMe allow individuals to raise funds to cover the costs of various life events, such as a vacation or medical bills. These campaigns typically have no resemblance to business activities, and donors typically don’t receive anything in exchange for their contributions. Given the nature of these campaigns, the proceeds that organizers receive won’t be taxable income. Under § 102(a), gross income does not include the value of property acquired by gift.
To qualify as a gift, according to the Supreme Court’s ruling in Duberstein, the contribution must proceed from a “detached and disinterested generosity … out of affection, respect, admiration, charity or like impulses.” If the donor received anything in exchange for making the gift, this indicates that the transaction was not a gift.
If the donor didn’t receive anything in exchange for giving the money, the recipient may be able to exclude the income from his or her taxable income because it was a gift. In other words, to be a gift, the donor must give “something for nothing.” These same rules apply when the contribution is between relatives or friends.
For example, an individual establishes a campaign for his ailing relative, but in exchange for the gift, the individual offers and provides accounting services commensurate with the value of the gift. The individual would not be able to exclude the money raised from his income under § 102(a). The income will very likely be classified as trade or business income, despite the original purpose.
On the other hand, if an engaged couple establishes a campaign for attendees of their wedding to contribute to their honeymoon, the income raised would likely be classified as an excludable gift. This is true even though the attendees receive food, drinks, and entertainment while attending the wedding. The difference here is that the guests could attend the wedding regardless of whether they contributed to the honeymoon fund.
It’s important to remember that no matter how charitable the intentions of crowdfunding campaigns may be, contributions for individuals or organizations that aren’t qualified charitable organizations, such as §501(c)(3) entities, will not qualify as deductible charitable contributions, regardless of the circumstances. Taxpayers can deduct charitable contributions only when they’re made to qualified charitable organizations that are not intended to benefit specific/named individuals.
The gift tax limit
Lastly, a contribution to an individual’s crowdfunding campaign that’s a gift and doesn’t qualify for a charitable deduction may be subject to gift tax rules if it exceeds the annual gift tax exclusion limit. If a backer gifts more than that amount to any individual in a given year, the backer may have to file a gift tax return.
Implementation of equity-based crowdfunding legislation
The tax treatment of crowdfunding becomes more complicated as the JOBS Act of 2012 is now effect. The JOBS Act allows small businesses to use crowdfunding platforms to grant to backers partial ownership of the business, rather than just a product or service. With backers now becoming partners or shareholders, tax uncertainties are likely to increase.
Know the rules
When it comes to crowdfunding, taxpayers and their advisors should know the details about any transactions made, and be sure to properly report the income or contribution. Here are three important takeaways:
- Business campaign organizers should properly report crowdfunding income, which should likely be treated as business income, even if it comes through a less-traditional channel.
- Charitable campaign organizers should beware of offering anything in exchange for a “good cause” donation, because they could end up being taxed on that money regardless of the original purpose.
- Donors should remember that their altruistic donations made through crowdfunding platforms often don’t qualify as charitable deductions under the tax code, and that they can deduct contributions made only to a qualified organization.
Lastly, stay tuned for upcoming regulatory changes that could further impact the tax treatment of amounts raised through online crowdfunding.