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Crowdfunding and Taxes: What You Should Know

04/08/2015 12:50 pm ET | Updated Jun 08, 2015

If you're thinking about jumpstarting your own cause, an innovative new product or a future small business, you'll need capital -- or access to it.

For many, the answer has been crowdfunding, a fast-growing, web-based system of raising funds from individuals around the world. It's an industry less than a decade old that allows artists, activists and a growing number of entrepreneurs to connect with financial support far outside the conventional lending system. Currently, Kickstarter, Indiegogo and RocketHub are leading the industry. Estimates vary widely, but research organization Massolution put 2013 global crowdfunding revenue at $5.1 billion.

Here's how crowdfunding works. Through sites like the ones mentioned above, campaigners seeking a sum of money to get a project off the ground create a pitch that educates potential funders -- or "backers," as they're often called -- on their project, its funding goal and the reward backers will receive for taking part. If interested, backers use their credit card to make a pledge. If the campaign meets its goal and deadline, the crowdfunding site activates all the card-based pledges and the campaign is funded.

Many crowdfunding efforts today are artistic or cause-based, but that is expected to change in the near future. Implementing the crowdfunding provisions of 2012's Jumpstart Our Business Startups (JOBS) Act, the U.S. Securities and Exchange Commission is putting final touches on regulations allowing ordinary investors to participate in equity crowdfunding for the first time. This would mean that business owners could raise money via the web in exchange for a piece of ownership in their company.

Because the process of crowdfunding is relatively easy compared to other means of obtaining capital, some might neglect to research potentially unfavorable tax, financial or legal implications from their campaign. Potential crowdfunding campaigners might want to make a preliminary call to a qualified tax adviser, financial planner or an attorney before launching any online fundraising effort.

No matter how the crowdfunding industry evolves in the future, even the most modest artistic and cause-based campaigns should consider how to build the most tax-efficient effort. It comes down to a central question: will your campaign's proceeds be deemed non-taxable gifts or taxable income?

In crowdfunding, campaigners typically offer a "reward" that is typically well below the value of what the backer gives. Some campaigns go with an online thank-you, t-shirts, hats or an exclusive first run of their product or service. Rewards are typically offered on a tiered basis, meaning backers will be offered something cooler and more valuable for higher contributions.

Many experts believe the whole crowdfunding tax landscape needs more clarification, possibly through a test case in the federal court system. That is why both campaigners and backers might consider getting advance tax, financial or legal advice that directly addresses their personal circumstances. Another important reason to seek advice; many states have their own tax laws that may affect funding campaigns.

Back to the non-taxable gift vs. taxable income issue. The IRS says a gift in general is "any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money's worth) is not received in return." One example of a non-taxable gift is what's commonly known as the annual exclusion. In 2015, an individual can offer a non-taxable gift of up to $14,000 in 2015; spouses can give a combined $28,000.

Taxable income issues can be significantly more complex. Campaigners should be aware that crowdfunding sites often use financial intermediaries to keep track of all backer transactions, including tax-reporting issues. As an example, if a campaign reports over 200 separate transactions worth more than $20,000, the intermediary generally has to issue an IRS form 1099-K. Even if a crowdfunding campaign raises considerably less than that amount, it doesn't guarantee there won't be tax issues later.

All of these factors make qualified and individualized tax, legal and business advice valuable. Consider adding the following to your list of questions if you do:

How can crowdfunding proceeds affect the campaigner's current tax status? Individuals, companies and nonprofits have different tax issues and financial precedents that could blunt the effectiveness of any fundraising campaign. Again, it is wise to do tax and implementation planning for a crowdfunding campaign before launch so all potential issues can be addressed.

What tax issues might affect the beneficiaries? Crowdfunding a person's unpaid medical bills may have significantly different tax ramifications than crowdfunding one's own independent film project. It is not enough to consider the tax ramifications for the campaign; if there are separate beneficiaries, their tax issues may dictate a different approach to raising funds.

Should a business or nonprofit entity be formed in advance? Sometimes fundraising plans spawn bigger questions about the long-term goals of the individual, group or enterprise. If appropriate, participants could seek guidance to form an actual business or nonprofit entity. Discussing structural issues in advance will not only help with tax issues, but also lead to better strategies for fundraising and long-term mission.

Is it wise to become a backer? Most crowdfunding supporters give such small amounts that tax issues don't really surface. But backers who want to offer more substantial support should speak with financial advisors about whether there are more efficient ways to lend support.

Bottom line: Before you consider crowdfunding a cause, project or business, it's important to do individual research and consider speaking with qualified financial advisors. This exciting, fast-growing alternate funding system may have unexpected tax consequences for individuals, groups and backers.

Jason Alderman directs Visa's financial education programs. To follow Practical Money Skills on Twitter: www.twitter.com/PracticalMoney

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