Friday, September 14, 2012

Tax Treatment

In crowdfunding, it is popular for project organizers to say that they are taking gifts or donations.  The organizers may believe no sales or income taxes are owed in relation to the gifts or donations.

But commonly the projects promise rewards or products (such as a game console in the famous crowdfunding example of Ouya) to the backers who pledge funds.

Recharacterization

A concept in tax law and accounting is known as “recharacterization.”    A tax authority may “recharacterize” a transaction from one tax treatment to another if the facts of the situation warrant it.

Tax-free Donation?
For example, a crowdfunded musical artist may maintain that backers gave him gifts.  But he promised music CDs to his backers.  State and federal tax authorities may recharacterize the transactions as sales of goods.  Their justification would be simple: the backers gave money; he gave products in exchange.  (Furthermore, he was not registered under with the IRS as a 501(c)(3) charity.

Under such a recharacterization, the artist would need to report income (revenue minus expenses) for income tax purposes.  He also may have been required to collect sales taxes in relevant states.

Penalties and Interest

If a state tax authority audits him later, and determines he failed to collect required sales tax, he not only would have to pay the tax.  He may also be liable for penalties and interest.

Often, the collection of sales tax requires registration with the state tax authority before (or soon after) any transactions occur.

Use Tax

In theory, when someone buys something, where sales tax is owed but not collected, they are required to report and pay so-called "use tax."  In the example of the musical artist, his backers would have to report and pay use tax on the value of the CD.  Although use tax is rarely enforced against individuals, states like Pennsylvania are drawing more attention to it.



Attorney Wright is an informal advisor to Yellow Brick, the social marketplace for crowdfunding.

Update 2014:  Detailed Guide on How to Plan for Taxes in Crowdfunding Campaign.