It seems that you can’t read about startup funding these days without hearing about someone’s wildly successful crowdfunding campaign. There’s also no shortage of cautionary tales either; just read the press around HealBe.
To be clear, I am talking about crowdsourced or peer-to-peer funding offered by sites like Indiegogo and KickStarter, not equity crowdfunding, which though technically legal since 2012, is still awaiting a legal framework for implementation.
Crowdsourced funding enables startups or individuals to raise small amounts to fund anything from an upcoming project launch to medical bills, to product research. The contributions don’t result in equity positions but usually are recognized in some way, say via t-shirts, products, or name recognition.
Benefits of Crowdfunding
Raising funds in this way has several benefits:
- The obvious one is no-strings-attached funding: i.e., no dilution of ownership, board oversight, or mandatory financial reporting requirements to the contributors.
- Importantly, it also gives startups great visibility into existing/potential customer needs and the chance to gain valuable feedback to help test their potential market and fine-tune product and service offerings.
- The attention garnered from a wildly successful campaign might get you press mentions and attention from more traditional funding sources, e.g. investors or even, as in the case of Oculus, acquirers.
- It’s a good way to test proof of concept. If people are investing in your product/service early and often, it shows there is a demand for what you’re offering.
Accounting Treatment for Crowdsourced Funds:
- Using accrual accounting, you should report crowdsourced funds in the same period in which you earned them.
- Under cash basis accounting, you would report them when they are received.
Another accounting issue that arises is around when to recognize the income, associated expenses, and cost of goods sold (for example, credit card processing fees). I wrote a post recently on revenue recognition standards and how to apply them that’s worth reviewing.
As always, you should never mix business and personal funds. Crowdsourced funds for your business should be deposited into your business account and never commingled with your personal funds.
Crowdfunding: Tax Considerations
While the IRS has yet to opine formally, here are some things you need to know:
The IRS defines income in its Publication 334. It defines gifts as “Any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.”
When it comes to taxes, depending on how you structure your campaign, contributions from crowdfunding might be considered to be gifts but funds offered in exchange for your product or for some other material consideration will likely be classified as income resulting from sales and should be reported on Form 1099-K.
If you’re promising contributors your product once it’s launched, that’ll count as advance purchases, aka income from sales. To the extent the IRS considers contributions to be income, you are allowed to offset your related business expenses, including those of starting up, against the income. Either way, you should scrupulously record every contribution and tally it versus the associated costs.
You should also carefully consider the potential that you will incur sales tax liability. While some states, such as Washington, have issued guidance on their tax treatment of crowdsourced funds most have not, so the picture is murky.
You can see it gets pretty complicated. Consulting an accounting and/or tax professional is the best way make sure you’re properly tracking, categorizing, and planning for potential tax liabilities for any funds you raise through crowdfunding.
Have you used crowdfunding to raise financing? Tell us about your experience in the comments section below or contact Early Growth Financial Services for a free 30-minute financial consultation.
Sirk Roh is COO for Early Growth Financial Services. He’s an accomplished finance executive focused on leading early-stage companies through strategic financial decisions. Sirk’s areas of expertise include debt and equity financings, planning/budgeting, financial analysis, cash flow management, high growth management, and cost reductions/rightsizing.