What Small Business Owners Need to Know About Crowdfunding and the IRS

In 2012, Palmer Luckey launched a Kickstarter campaign to raise $250,000. His big idea was to make virtual reality headsets for video gaming developers. The campaign crowdfunded $2.4 million, ten times its original goal. Two years later, in 2014, Facebook, now Meta, acquired Oculus VR for a staggering $2.3 billion: what an investment!

While a success story of this size is rare, crowdfunding has boomed for small business owners. With all this in mind, let’s explore crowdfunding and the IRS in depth:

How to raise money through crowdfunding

Over 12 million people are estimated to raise money through crowdfunding platforms.

(You read that right!)

You might've heard about platforms like Kickstarter, Patreon, or GoFundMe on social media. In 2023, these platforms will provide capital to build businesses without the pressure of bank loans or venture capital. They have democratized startup funding and given aspiring entrepreneurs access to resources.

So, what exactly is crowdfunding?

Crowdfunding is an alternative way to get an investment. A fundraiser or entrepreneur can reach out to people and ask them to contribute through online platforms. But before you start thinking about it as a pool of funds you can dip into at any time, you should know that it's not a free ride. The income from crowdfunding is taxable, so avoid running into trouble with the IRS.

Types of crowdfunding to raise capital

Here's a quick look at the types of crowdfunding campaigns and the tax implications of each:

Donation-based crowdfunding

Donation-based crowdfunding is the most common type of crowdfunding. Individuals donate money to an initiative without expecting anything in return. The fundraiser doesn't need to pay the funders back.

These donations are usually tax-exempt. According to the IRS, if people “donate to a crowdfunding campaign out of generosity and without expecting anything in return, the donations are gifts. So, they won't include the gross income of the person for whom the campaign organizer.”

But, funds become taxable income if used for personal purposes.

Equity-based crowdfunding

This crowdfunding campaign generates capital for small businesses or early-stage startups. 

Individuals invest money in return for equity in the company. The individuals may want the fundraiser to pay back its donors later. Since the venture is issuing securities instead of offering a good or service, these funds aren't considered business income.

They’re exempt from business taxes but almost certainly will have to pay capital gains tax.

Note: The Security and Exchange Commission (SEC) regulates Equity-based crowdfunding.

Rewards-based crowdfunding

Small businesses, startups, and nonprofits commonly use this crowdfunding campaign. This crowdfunding campaign uses a tier-based donation system. The fundraiser will provide backers with a reward, such as a service or new product, in exchange for a fixed amount.

According to the IRS, if the funds come with "any moral or legal duty" or "the incentive of anticipated benefit of an economic nature,"  it's not a gift. In such cases, it's considered income, and the IRS will expect you to pay taxes on it.

Are crowdfunding donations tax deductible?

The short answer is no. Crowdfunding donations are generally not tax-deductible for the individuals making the contributions.

Tax deductions apply to charitable donations made to qualified NGOs. Crowdfunding campaigns often involve individuals supporting businesses or personal projects which don't fall under the same category.

So, in donation-based crowdfunding, individuals contribute without expecting anything in return. The recipient's taxable income treats these funds like gifts. But, just because the donations are not taxable doesn't mean the donors can claim them as tax deductions.

Receipt of a form 1099-K for payments made from crowdfunding funds

A Form 1099-K's issued by crowdfunding platforms when your total gross payments surpass $20,000 and 200 transactions in a calendar year. 

When you receive a Form 1099-K, you must report this on your tax return, even if they're raised through donation-based crowdfunding and deemed tax-exempt. The Form 1099-K is for informational purposes and to ensure the IRS knows the transactions.

How can crowdfunding creators decide how much money to report on a tax return?

Creators should report the total funds when reporting crowdfunding income on a tax return. Some types of crowdfunding income may be tax-exempt (such as donation-based crowdfunding). It's still important to disclose the total amount raised for transparency and compliance purposes.

Here are some steps to help creators determine how much money to report on their tax returns:

Keep accurate records

Maintain thorough records of all funds received, including documentation from your crowdfunding platform, to help ensure you have an accurate account of the total amount raised.

Differentiate between taxable and nontaxable income

Some crowdfunding income, like donation-based crowdfunding, may be considered tax-exempt. But, reporting taxable income on other types of crowdfunding is necessary.

Review crowdfunding terms and conditions

Familiarize yourself with the terms and conditions of the crowdfunding platform you used. The platforms usually guide the treatment of funds for tax purposes.

Seek professional advice

Consult with a tax professional who can provide advice based on your issue. They'll tell you the proper treatment of your crowdfunding income and ensure accurate reporting on your tax return.

Report your crowdfunding income to follow tax regulations and avoid issues with the IRS. When in doubt, consulting with a professional is always a wise decision.

“Money received through a crowdfunding campaign may be taxable; taxpayers should understand their obligations and the benefits of good record keeping.” – Internal Revenue Service.

Small business owners need to understand the legal and tax implications of crowdfunding. Not all that glitters is gold, but with the help of a professional, you can be on good terms with the IRS. Learning about the IRS regulations in your jurisdiction ensures crowdfunding platforms stick around to bring your dreams to life.