04/01/2013 08:20 am ET

Kicking Kickstarter

Now that Kickstarter has hit the awareness of the independent film community with the successful $2 million raise for Veronica Mars, it is time to pause and think through the legal consequences of using Kickstarter for both sides -- contributors and recipients.

But first, we need to make clear what Kickstarter is -- and what it is not -- due to the confusing term "crowd funding" that is used to describe it. There are two types of crowd funding; one kind, of Kickstarter ilk, is basically a donation model, referred to here as donation crowd funding to distinguish it from investment crowd funding, described below. Under donation crowd funding, wannabe entrepreneurs with bright ideas (for Kickstarter, it is limited to "creative ideas," which basically means the arts) submit the ideas on the website and solicit funding from the public, usually in exchange for some small goodie, like a free copy of whatever the product to be produced is, but the contributors do not receive any equity or ownership in the project. Since donation crowd funding seems more fun than mercenary, it is not regulated -- yet. The other kind of crowd funding is for actual investors that receive equity or a debt interest in the venture -- let's call this investment crowd funding -- and it is subject to extensive regulation. This article focuses only on donation crowd funding.

In the case of Veronica Mars, the producers offered contributors the following goodies, depending on the amount of the payment: (a) a copy of the script, (b) a speaking part in the film (which sold for $10,000), (c) t-shirts, (d) DVDs, and (e) signed posters. And they raised more than their required $2 million though this effort. So, heck, what could go wrong?

The good news for the recipients is that the offerings should not be subject to the federal or state securities laws, because they are not offering any investment opportunity, whether as debt or equity, since the contributors do not receive any economic return. However, if the recipients have not accurately stated the facts regarding their project on the website, or if they do not live up to their promises, they may find themselves the subject all kinds of state and federal laws regulating fraud, including statutes regulating (a) unfair competition, (b) truth in advertising, and (c) mail and wire fraud. So it behooves them to make full disclosure of the material facts, which is similar to the standard under the securities laws.

But one law of particular concern to the Veronica Mars offering is California Labor Code section 450, which prohibits charging anyone a fee as a condition to applying for or accepting employment. The California Department of Labor Standards Enforcement has previously come down like a load of bricks on anyone that charges aspiring actors a fee for auditions or for an acting role. Given that the Veronica Mars offering expressly offered and accepted $10,000 for a speaking role, I would not be surprised if they received an impolite letter from this department.

At some point, they may also get a letter from the IRS informing them that the "donations" are taxable income to them upon receipt, unlike an equity investment or a loan. I suspect that some recipients either overlook this issue or plan to treat the funds as a tax-free "gift." However, a tax-free gift requires that the payment be made out of "detached and disinterested generosity" with no consideration given. For almost all donation crowd funding, there is some consideration offered for the donation, albeit it is often of much lower value than the donation, and this consideration is enough to take the donation out of the tax-free gift category and moves it to the "tax me now" category. This may be acceptable to recipients that can immediately deduct their production costs under IRC section 181 (permitting the deduction of the first $15 million of the cost of producing audio-visual works in the United States), but this section expires at the end of this year, recipients may not qualify for it for a number of reasons, and it does not apply for state tax purposes. For recipients that do not have an offsetting deduction, the tax hit on the contributions will be substantial.

On the flip side of the coin, contributors may attempt to deduct their payments as "charitable donations," given that it seems like it is for a good cause and they don't receive much in return. But charitable donations are only deductible if (a) they are made to a qualified "501(c)(3)" organization, which most recipients are not, and (b) there is no consideration received in exchange, which also is generally not the case. The payment will not be deductible under any other theory, so in most cases the contributors cannot deduct their payments at all.

It is also worth considering how the payments will be treated for purposes of calculating (a) residuals owed to the guilds and (b) participations owed to talent. Presumably, the payments should be treated as gross receipts that are included in calculating residuals and participations owed after the film is made, and the payments should probably be allocated to whatever goodie the contributor received (for example, the payments would be treated as DVD gross receipts if the contributor received a DVD).

These are certainly not insurmountable obstacles, and surely not enough to stop all the fun, but both sides should at least look before they leap and consider the consequences.