I just raised $100k through crowdfunding! Wait . . . do I owe taxes?

Part I - Rewards-Based Crowdfunding

Let's say you've got a great idea for a business startup, and to raise capital, you've decided to join the rapidly growing crowdfunding community. But deciding which type of crowdfunding is right for your startup can be overwhelming. Should you use rewards-based funding? Or is equity crowdfunding a better fit for your business?

And next, once you raise funds, how is the money taxed? Part I of this blog examines rewards-based crowdfunding: what is it and how is it taxed? With rewards-based crowdfunding (e.g., Kickstarter, Indiegogo), donors can preorder the products you'll be making, or sometimes they just want to donate with no strings attached to see your idea come to life. The important part here is that they do not become investors in your business, and they are not giving you a loan. Some sites, such as Crowdrise, only allow fundraising for charities and non-profit causes.

Taxing Rewards-Based Crowdfunding First of all, neither the IRS nor courts have provided guidance on exactly how crowdfunding should be taxed. That said, certain elements of crowdfunding are similar to other transactions, the tax consequences of which are well understood. Under the Internal Revenue Code, "gross income" means all income from whatever source derived. So in general, funds raised through rewards-based crowdfunding constitute income. It is possible, however, that some funds you raise will be considered gifts, which are not subject to income tax.

To be a gift under relevant case law, it must proceed from detached and disinterested generosity and be given out of affection, respect, admiration, charity or like impulses. Duberstein v. Commissioner, 363 U.S. 278 (1960). This is a factual question about the intent of the donor that must be made on a case-by-case basis. For instance, if your best friend gives money to your business through a crowdfunding site like Kickstarter, just because he wants to see you succeed, the money is more likely to be a gift.

But if a stranger donated money to you because she likes the products you'll be producing (and you're going to send her one once they're made!), the donation is probably not a gift. Even if the funds you raise are considered income, you may be able to offset some portion of that income with your ordinary and necessary business expenses accounted for in the same tax year. For those expenses to be deductible, you must be carrying on a trade or business.

For example, crowdfunding to paint a large mural in your neighborhood for the purpose of beautifying the area and bringing the community together would not constitute carrying on a trade or business (this person might be better off forming a Section 501(c)(3) nonprofit). To illustrate, let's say your business will be making and selling kids dinosaur t-shirts, and every donor will get one t-shirt once they are made. Most of the funds you raise will constitute income, but you'll likely be able to offset some of that income with the costs of producing the t-shirts and the cost of the goods you've given (pre-sold) to the donors.

An additional murky tax issue here is whether you may owe sales tax on the t-shirts given to donors: was their donation a payment for the t-shirt, at least in some part? The safe answer is yes, their donation was, at least in part, for pre-ordering your product, and therefore constituted a sale.

In sum, crowdfunding sites have created many exciting opportunities for startup companies (and nonprofits!) to raise money. Just make sure that you get your startup off on the right foot and know your tax and other reporting obligations. If you are interested in learning more about equity-based crowdfunding, stay tuned for Part II! 

The material in this blog is not intended, nor should it be construed or relied upon, as legal advice. Please consult with an attorney if specific legal information is needed.