Federal Tax Issues Associated with ‘Crowdfunding’

Source: AccountingWEB

December 16, 2015

By Thomas M. Long, Thomson Reuters Checkpoint

​"Crowdfunding,” which generally refers to the practice of gathering online contributions for a project from a large group of financial backers, began primarily as a way for artists and other creative types to raise funds for their endeavors, and it has now become a popular way to raise capital in a broad range of fields. 
Although crowdfunding has been around for a number of years, the tax treatment of the contributions is not always clear, and the IRS has yet to directly rule on the subject.

Crowdfunding is a way, typically on the Internet, for individuals and entities to tap into communal funding for a wide variety of projects – from community development to supporting artists and software innovation. Initially, crowdfunding was largely used by musicians, filmmakers, and other creative types to raise small sums of money for projects that likely wouldn’t make money. But, while still a relatively new way to raise funds, its impact is growing – in some cases, becoming an alternative to venture capital.

While crowdfunding allows an entrepreneur to obtain proceeds for a specific project, what those giving the money get varies considerably depending on how the program is structured. Sometimes those contributing to a crowdfund get absolutely nothing in return except the personal satisfaction of helping launch a cause or participate in creating an innovation they believe in. Often those contributing or pledging to a campaign are offered “rewards,” such as cups with a logo, T-shirts, tickets to an event, or CDs. Or they might receive the right to have their contribution repaid with interest if the campaign is financially successful. Or they might receive an equity interest in the endeavor (i.e., a piece of the business). 

The following are a number of federal tax questions that may arise for both the contributor and the recipient.

Are contributions reported to the IRS? The first question that might be asked is whether the IRS tracks such crowdfunding payments. Code Section 6050W requires information reporting for certain payments made in settlement of payment card (e.g., a credit card) and third-party network transactions (e.g., PayPal). Thus, any payment settlement entity making payment to a participating payee in settlement of reportable payment transactions (generally, any payment card transaction and any third-party network transaction) must make a return for each calendar year to be filed with the IRS, and furnish a statement to the participating payee (Form 1099-K, Payment Card and Third-Party Network Transactions) that sets out the gross amount of the reportable payment transactions, as well as the name, address, and taxpayer identification number of the participating payees. 

However, a de minimis rule exempts a third party from reporting of third-party network transactions of any participating payee if the aggregate payments to the payee by the third party for the calendar year do not exceed $20,000, or if the aggregate number of transactions between the third party and the payee that would otherwise be reportable does not exceed 200 within the calendar year.

Are the contributions income to the recipient? Code Section 61(a)(1) defines gross income as “all income from whatever source derived.” This definition is construed broadly and extends to all accessions to wealth over which the taxpayer has complete control. As the US Supreme Court explained in Commissioner v. Glenshaw Glass Co., a gain “constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it.”

Thus, any receipt of funds or property by a taxpayer – such as crowdfunding contributions – is presumed to be gross income unless the taxpayer can demonstrate that the income fits into one of the narrowly construed exclusions provided by law. One of those exceptions is where the amount received was a gift.

Are amounts received by the recipient a nontaxable gift? Under Code Section 102, the value of property acquired by gift is excluded from the recipient’s gross income. Under the Supreme Court’s well-known holding in Commissioner v. Duberstein, the value of property acquired by gift is excluded if it:

  • Comes from a detached and disinterested generosity.
  • Is made out of affection, respect, admiration, charity, or like impulses.
  • Is not made from any moral or legal duty, nor from the incentive of anticipated benefit of an economic nature.
  • Is not in return for services rendered.

Recipients may exclude payments they receive under Section 102 if they meet the Duberstein standard. Thus, on one side of the spectrum are payments made without the donor receiving an economic or other consideration, while on the other are payments from ordinary business or commercial transactions. Accordingly, if there is a quid pro quo in which the donor receives a tangible economic benefit in return for his contribution, then there isn’t a gift.

Are amounts given subject to the gift tax? If the contribution is determined to be a gift, the tax treatment depends on a number of factors, including the amount of the contribution, the relationship between the contributor and recipient, and the total amount of gifts made that year to the recipient.

Code Section 2501 provides that the federal gift tax is a tax imposed on an annual basis on all gratuitous transfers of property made during life. The donor’s tax liability on the gift depends upon the value of the “taxable gift.” (Code Section 2512) The taxable gift is determined by reducing the gross value of the gift by the available deductions and exclusions. For calendar year 2015, an annual exclusion of $14,000 is available for gifts to each donee. (Code Section 2503)

Can expenses in a crowdfunded project be deducted? Under Code Section 162(a), a deduction is allowed for all “ordinary and necessary expenses” paid or incurred during the tax year in carrying on any trade or business. To be deductible under this provision, a taxpayer must show that he engaged in the activity with an actual and honest profit objective. (Hulter v. Commissioner) A net operating loss – the excess of business deductions (computed with certain modifications) over gross income in a particular tax year – may be used to reduce the taxable income for another year. It may be carried back to earlier years and yield tax refunds. If not exhausted in earlier years (or if the taxpayer elects not to use the carryback), it may be carried forward to later years and reduce the tax for those years. (Code Section 172)

Thus, another preliminary question to be addressed is whether the crowdfunding project is a “trade or business” carried on with an expectation of profit, or whether it is an endeavor with no expectation of profit where the payback is other than monetary (e.g., “vanity” publishing). Under the hobby-loss rule, deductions attributable to a “not-for-profit” activity are generally allowed only to the extent of income from it. (Code Section 183)

However, under Code Section 195, “startup” expenditures are not immediately deductible, except that a taxpayer may elect to expense up to $5,000 of these costs (with that amount reduced by the excess of total startup expenditures of more than $50,000 in the tax year in which the trade or business begins); the remainder of the startup expenditures may be amortized (deducted ratably) over a 180-month period.

Startup expenditures are amounts paid or incurred in connection with:

  • Investigating the creation, acquisition, or establishment of an active trade or business (but not costs incurred after a taxpayer decides whether to enter a new business, and which new business it will enter or acquire);
  • Creating an active trade or business; or
  • Any activity engaged in for profit and for the production of income before the day the active trade or business begins, in anticipation of that activity becoming an active trade or business. 

The expenditure must be one that, if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the taxpayer’s new business), would be deductible for the year in which paid or incurred.

Can the contributor claim a charitable deduction for his contribution? Contributions made to an individual – such as typical crowdfunding contributions – generally don’t qualify for a charitable deduction. Specifically, such a contribution would be unlikely to satisfy one or more of the following requirements in the tax code for charitable deductions: the identity of the donee, purpose of the contribution, or lack of inurement to an individual.

However, if the recipient is a qualified 501(c)(3) charitable organization, a contribution to a crowdfunding effort sponsored by that organization may be deductible if the requirements for a charitable contribution deduction are met. 

Thomas M. Long is managing editor for the Federal Tax News Group with Thomson Reuters Checkpoint within the Tax & Accounting business of Thomson Reuters.