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  • Writer's pictureAmie K

Crowdfunding Gone Wrong

Crowdfunding and crowd surfing - two things that can be fun and fruitful if done right, and also two things that can be painful and punishing when it goes wrong.

Crowdfunding 101

Crowdfunding can be great for entrepreneurs who need capital for their business venture. It raises money and awareness in a relatively easy way with the use of internet platforms designed to bring small business owners and consumers or investors together.

A benefit is crowdfunding proceeds don't have to be in exchange for debt or equity, like other financing options. Rewards-based crowdfunding is often used by startups to raise money by promising early access to products or services of the budding business.

What Not To Do

A Texas-based small business recently found out what not to do the hard way when the Federal Trade Commission's (FTC) Bureau of Consumer Protections stepped in to investigate improper use of funds raised via Kickstarter and Indiegogo. The FTC brought charges against the owner and his LLC after he allegedly misused over $800,000 raised via the crowdfunding platforms, paying for personal expenses and Bitcoin rather than producing a product.

Hundreds of consumers alleged promises were not fulfilled after giving money to the startup, with some claiming the defendant used threats in attempt to quiet their criticism. In addition, the defendant shut down the company without returning funds or responding to contributors requests.

In its complaint, the FTC found the defendant had "not used the funds primarily for development, production, completion and distribution and have yet to provide a single completed product to any consumer who contributed to the campaigns."

The defendant and the FTC have come to a settlement agreement where he may never use crowdfunding again and has agreed to a judgement of nearly $800,000. Despite not using funds to develop or produce a product, the supposed hi-tech backpack maker is insolvent, so the monetary settlement is suspended due to his inability to pay. However, if it's found the defendant misrepresented assets, the entire amount will become due.

How's Crowdfunding Taxed?

A good question. Having the FTC on your back will be enough; treating crowdfunding proceeds correctly for tax purposes is important.

Is it a gift? A gift for tax purposes is of detached and disinterested generosity, transferred where full consideration is not received in return. Generally, funds given on a crowdfunding platform have some expectation of return whether in the form of equity, rewards, or product. It's not likely these funds are gifts but if they are, the giver may need to file a gift tax return if it's greater than the annual gift tax exclusion.

And it's not a charitable donation when the recipient isn't a qualifying nonprofit organization either. Most businesses using crowdfunding platforms like Kickstarter are for-profit, though plenty of nonprofit crowdfunding donation-based platforms also exist.

Is it taxable income? Most likely yes, if the investor gets no equity. Generally, funds raised are going to be considered taxable to the recipient even though they are not sales in a traditional fashion. Timing of recognizing income can get more complicated depending on whether the business is cash or accrual basis for tax purposes and the crowdfunding platform's rules on how and when money is transferred. Also don't forget a business (who is actually trying to be one) will have legitimate expenses to offset this income, so be sure to capture those as well.

I'm curious to know how the defendant reported his crowdfunding proceeds for tax purposes and exactly how he is insolvent if he didn't spend the money on his alleged business. In other words, I would think the IRS might also soon be asking..."Where's the money, Lebowski?"

Amie K

Material shared is for general information purposes only and not to be considered tax advice. Please contact your tax and business advisers for how this may apply to your unique situation!

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