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IRS speaks out on crowdfunding

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in Small Business Tax

Are you hoping to launch a new business venture without risking a fortune? The “modern” way of obtaining working capital is to initiate a crowdfunding effort. But the IRS has been silent on the tax ramifications for recipients—until now.

Alert: The IRS recently issued an information letter on this issue. (IRS Information Letter 2016-0036, 3/30/16) Although the guidance technically applies to only one taxpayer, it provides valuable insights into how the IRS will treat crowdfunding in other situations.

Generally, unless a special exception applies, the IRS says that crowd­funding contributions constitute taxable income to recipients.

Here’s the whole story: In the past, entrepreneurs mainly solicited funding for new business ventures through initial public offerings (IPOs). But crowdfunding can be an easier solution.

Crowdfunding is the process of generating capital through a large pool of investors, with each usually contributing a relatively small amount. It is handled online through portals such as Kickstarter, Fundable and CircleUp.

The IRS examined the law and related regulations for “constructive receipt” of funds in comparable situations. Essentially, if the funds are credited to a taxpayer’s account or are otherwise set apart and made available to the taxpayer if he or she wants to gain access to them, the payments represent taxable income. Conversely, income isn’t constructively received if the taxpayer’s control is subject to substantial limitations or restrictions.

The sticky wicket is that crowdfunding campaigns can take on various forms. For instance, in exchange for putting up cash, a contributor might be awarded an equity interest in the company, qualify for certain products or services or merely receive a minimal gift in-kind. Or, if the venture is aimed at an environmental or altruistic cause, the contributor just gets the satisfaction of helping out without receiving any tangible benefit. Depending on the setup, the contributor may also be entitled to a refund if the venture goes bust.

Faced with these considerations, the IRS determined that the taxation of money received by an entrepreneur is based on the particular “facts and circumstances,” but should generally be treated as taxable income unless one of these three exceptions applies:

  1. There is a loan that must be repaid
  2. A capital contribution is made in exchange for an equity interest in the business entity
  3. A gift is made out of generosity without any quid pro quo. Note: A voluntary transfer without any quid pro quo isn’t necessarily a gift for federal income tax purposes.

Along the same lines, crowdfunding money is generally taxable to the extent it is received for services rendered or if it results from selling property to a supporter.

Tip: The IRS also suggests that recipients can obtain a private letter ruling in a specific case.

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