The Downside of Crowdfunding: Filing Taxes

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We all love to hear stories about a great crowdfunding idea. Take the guy who raised more than $70k on Kickstarter for a brand new potato salad. It’s innovative and fresh, inspiring others to test out their own ideas. That’s the upside of crowdfunding.

Here’s the downside of it. These funds are treated as taxable income by the IRS. Indiegogo, GoFundMe, or your preferred crowdfunding site – it doesn’t matter. Uncle Sam is going to take a $21,000 cut out of that potato salad pie. This is why before anyone starts crowdfunding their next great idea, it’s a good idea to start a business.

Why Is It Important To Start a Business?

Unlike personal income, business income has numerous deductions that can help to even out the costs of income. Under a business structure, if someone spends $10,000 to make a new potato salad and they got $10,000 in funding to make that happen, then every cancels itself out. Net income equals zero, which means zero taxes.

When using the accrual method of accounting, this doesn’t even need to happen on the same tax year. With accrual accounting, expenses get counted when services or goods are received. Income counts only when a sale occurs.

For that $10k above, if received under a personal structure, that money is going to get counted as personal income and be taxed. It won’t be taxed under a business structure because almost all expenses as a business are deductible. It pays to keep track of all expenses from Day 1 so that all expenses can be tracked to avoid paying more in taxes than necessary.

What can be deducted as a business expense goes beyond costs and materials. Transportation costs are included in this. Meals could be included at some level. If it costs you something to make money, then that comes off of the business income. It doesn’t get taken off the personal income. That’s the shocking discovery many successful crowdfunders are discovering right now.

There Are Also Tax Complications For Backers

Backers of a crowdfunding campaign also run into sticky tax issues when they try to write off the money used to back a campaign. On sites like Kickstarter and Indiegogo especially, because rewards are being given in return for the donation, it makes it so the amount is not tax-deductible. It is treated instead as a personal expense.

The only exception to this would be if a 501(c)(3) company were fundraising through a crowdfunding site and a direct donation was made. This would be treated as a charitable contribution if nothing were received in return for the donation.

Equity crowdfunding is a little different. If you loan money to a company through crowdfunding and that money doesn’t get paid back, then that is a loss that can be written off. For US backers, however, that’s not technically legal since Title III rules of the JOBS Act have not been approved yet by the SEC. This means there are a lot of blurred lines that are available in the tax code right now from a personal income perspective.

The problem of a non-defined line is this: it is open to personal interpretation. Do you want the IRS looking at your crowdfunding income or donations without a clearly defined rule to determine if you are out of compliance with your taxes? Exactly.

It’s Always a Best Practice To Leave a Paper Trail

It’s unlikely that your finances will be audited this year. That doesn’t mean there isn’t a risk being taken if there isn’t a paper trail involved with crowdfunding investments or money received from a campaign. If an audit does occur, there could be fines and penalties that could kick the $21,000 owed from a $70,000 campaign over the $50k mark easily if it’s been 12-24 months since taxes were due.

If you have any questions about your financial situation, it is best to seek out help from a tax professional. This is especially true if you are taking crowdfunding cash into a personal account instead of a business account. Crowdfunding websites have generated more than $5 billion in the past 12 months for small businesses, so the SEC and the IRS are going to be addressing this cash and what share of it belongs to the government. It’s only a matter of time.

That’s why now is the time to act. If you have a great idea for a crowdfunding campaign, then turn it into a business first. Even as a sole proprietor, you’ll be able to take business deductions even though personal and business income get mingled together.