The concept of “crowdfunding” has becoming a increasingly important way of getting access to funds for certain projects. In fact, a June 2015 post on Forbes (http://www.forbes.com/sites/chancebarnett/2015/06/09/trends-show-crowdfunding-to-surpass-vc-in-2016/#bce560444b52) indicated that crowdfunding is expected to grow to over $34 billion in 2016, surpassing amounts invested by the venture capital industry.
But what is not terribly clear to many is what the tax treatment of a crowdsourcing program should be, especially given the wide variety in structures and conditions involved in such programs. In Information Letter 2016-0036 the IRS, while not giving a hard and fast answer to the question, did indicate what issues should be considered in determining the tax effects.
Given it’s a mainly technology industry driven phenomenon, it’s appropriate to consult the definition found in Wikipedia for the concept:
Crowdfunding (a form of crowdsourcing) is the practice of funding a project or venture by raising monetary contributions from a large number of people, today often performed via internet-mediated registries, but the concept can also be executed through mail-order subscriptions, benefit events, and other methods. Crowdfunding is a form of alternative finance, which has emerged outside of the traditional financial system.
The crowdfunding model is based on three types of actors: the project initiator who proposes the idea and/or project to be funded; individuals or groups who support the idea; and a moderating organization (the "platform") that brings the parties together to launch the idea.
Kickstarter is the best known platform for crowdfunding, but it’s far from the only such platform out there—and some individuals have been known to try it as a “do it yourself” venture.
The IRS was asked about the proper tax treatment of such a program that lead to the information letter in question. The project was described in the letter as follows:
I am responding to your letter of February 15, 2016, requesting an information letter about the income tax consequences of a crowdfunding effort to purchase a company through contributions for which the contributors will receive * * *. You ask whether the recipient has constructive receipt of the contributed funds before the funds are used to purchase the company, because those funds may have to be returned to the contributors.
Unfortunately, as you will note above, the exact nature of what contributor will receive is redacted in the letter. As well, the letter does not go into details about the conditions under which the contributions would be returned, though presumably that would take place if the company is not purchased.
The IRS notes that this letter is for general information only and specifically points out that if the taxpayer wants a specific ruling he/she needs to go through the private letter ruling process.
But the letter does outline the situation as involving two key questions—does the receipt of these refunds represent an amount that would be considered income under IRC §61 and, if it would be, would the funds be considered actually or constructively received given the possibility they might need to be returned to the contributors.
The IRS notes that, generally, crowdfunding money would be income unless it met one of three exclusions:
What that means is that crowdfunding revenues generally are includible in income if they are not 1) loans that must be repaid, 2) capital contributed to an entity in exchange for an equity interest in the entity, or 3) gifts made out of detached generosity and without any "quid pro quo." However, a voluntary transfer without a "quid pro quo" is not necessarily a gift for federal income tax purposes. In addition, crowdfunding revenues must generally be included in income to the extent they are received for services rendered or are gains from the sale of property.
While the commentary stops there, it appears that the payments would have problems meeting any of those three conditions in many cases. A crowdfunding contribution would not appear to be able to meet the definition of a loan simply because the contributor and the taxpayer’s goal is to not have the funds repaid—that is, the amount does not have to be repaid and the parties are entering into the arrangement with the anticipation that won’t be the case.
While it is possible an equity interest could be offered, that opens up a whole set of issues regarding rules on offering investment interests that would generally work against the whole “keep it simple” concept here—and, in reality, such equity interests aren’t generally offered.
As for the third option—as the IRS notes, this simply would not normally meet the definition of a “disinterested” gratuitous gift, even if the contributor does not appear to get specific benefits that would be equivalent to what was given up. As well, in many cases the contributor will get a benefit if the goals are met—and, in this case, it appears that they are either services rendered or the sale of property.
But even if it is income there would not be an issue if the funds are not actually or constructively received by the taxpayer. But there, as the IRS makes clear, the exact facts of the situation will govern the question.
Section 1.451-2 of the Income Tax Regulations sets forth the constructive receipt doctrine and provides that income although not actually reduced to a taxpayer's possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. The regulation further provides that income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions. However, a self-imposed restriction on the availability of income does not legally defer recognition of that income.
For this part of the analysis, the restrictions imposed by the platform on access to funds would appear to be a key component of the equation—if the taxpayer can take those funds and use them without restrictions, then the amount would still be taxable to the taxpayer even if the funds were not actually withdrawn and even though they might need to be repaid. For the latter situation the “claim of right” doctrine would apply.
If the funds are later repaid, then the taxpayer would receive a deduction in the year of repayment or, if the amounts were large enough, could use the credit option found in IRC §1341 for such situations.
But, as the letter concludes “the income tax consequences to a taxpayer of a crowdfunding effort depend on all the facts and circumstances surrounding that effort.”