Crowdfunding from Both Sides

Crowdfunding is the practice of raising small amounts of money from a large number of people to fund specific projects or ventures. These activities can be personal, charitable, or business-related. According to Forbes, crowdfunding worldwide in 2013 was more than $5.1 billion. There are three popular types of crowdfunding:

• Donations (“charity crowdfunding”) to help individuals or charitable organizations
• Loans (“debt-based crowdfunding”)
• Investments (“equity crowdfunding”)

There are a growing number of other types of crowdfunding, such as supporting expensive litigation in exchange for a share of any recovery.

Tax impact of giving

If you donate funds to help an individual or a project (e.g., an independent film or civic activity) through such platforms as Kickstarter (for creative projects and not personal needs), IndieGoGo (for artistic or technology projects), and GoFundMe (for just about anything), you do not receive any charitable contribution deduction; neither the recipient not the crowdfunding platform is an IRS-approved tax-free organization. You are giving money because you want to support the individual or the project and usually do not receive anything (or anything of significant value) in return.

Exception: Causes.com lets you give money to charitable organizations, such as the Sierra Club and World Wildlife Fund. Donations here may be tax deductible. Similarly, HEALfundr’s Needy Meds component, where you can give money for medicine and not to a specific individual, is a tax-exempt organization; receipts are provided to donors for tax deduction purposes. Usual substantiation rules apply to these donations and you must itemize to take any write-off.

The fees charged to donors by crowdfunding sites are also not deductible. These “processing fees” typically range from 3% to 5% of donations, but can be higher.

Tax impact of receiving donations

The tax impact of receiving donations through a crowdfunding site is not settled yet. Recipients can argue that the donations are gifts because the people making the donations have no expectation of anything in return. This argument works well for those receiving funds for personal purposes, such as paying medical expenses or doing community service projects. The IRS has not yet challenged this tax-free treatment by recipients who use the funds for personal purposes.

If the funds are used for business purposes, the argument becomes less convincing. Under tax law, “income from whatever source derived” is taxable unless there is a specific rule exempting or limiting it. Again, the IRS has yet to make any comments on crowdfunding.

Tax impact of lending

If you lend money through a crowdfunding platform such as LendingClub.com or Prosper.com, you receive interest (e.g., rates currently range from 6.68% to 29.99% on LendingClub), depending on the credit worthiness of the borrower. Any amount of interest is taxable, whether or not you receive a Form 1099-INT. The nature of the borrower (e.g., an individual or a business) does not impact the tax treatment for the lender.

Equity crowdfunding

The JOBS Act in 2012 directed the Securities and Exchange Commissions (SEC) to change the rules to allow small companies to raise money up to a set amount through an online platform without the massive and costly registration needed to “go public.” In effect, individuals who invest funds through an approved website receive an ownership interest in the company.

At present, equity crowdfunding is limited to accredited investors. These are individuals who meet income or net worth standards set by the SEC. This means an individual having income of at least $200,000 per year or a net worth over $1 million (excluding a primary residence). This definition is currently under review by the SEC and could be changed.

There are a number of platforms that can issue stock, including CrowdCube, EquityNet, SeedInvest, Seedrs. Some sites allow individuals to make investments in specific companies; others offer an investment a pool of companies (think mutual funds), which lowers the risk to investors through diversity.

Investments through equity crowdfunding are treated for tax purposes like any other investment. When investors sell their shares, they report gain or loss on the transaction.

Note: Regulations governing investments by unaccredited investors have yet to be issued. They had been anticipated in 2014, but were not issued then; there is no target date.

Conclusion

The Internet has enabled large-scale fund raising for a variety of purposes. Before you participate in any crowdfunding, understand how it works, what the risks are, and whether there are any tax consequences to you.