Crowdfunding Campaigns: Tax and Legal Issues

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1 ATTORNEY NAME Title, PracticeArea address Crowdfunding Campaigns: Tax and Legal Issues T. Joshua Wu Partner Clark Hill Strasburger OUTLINE What is crowdfunding? How businesses raise funding Traditional funding strategies Alternative funding strategies Crowdfunding policy issues Special issues with equity crowdfunding Income tax issues for crowdfunding Includable in income Allowable expenses Gifts and donations 1 2 1

2 What is crowdfunding? Merriam-Webster the practice of obtaining needed funding (as for a new business) by soliciting contributions from a large number of people especially from the online community Facts about crowdfunding 375 = number of crowdfunding platforms in North America 16.2 billion = total crowdfunding volume worldwide 2.65 billion = total funding volume of reward crowdfunding million = crowdfunding commitments in the U.S. retail sector *Statista.com Growth of Initiated Offerings SEC study for Scott Bauguess (Feb. 28, 2017)

3 Types of Crowdfunding Offerings Crowdfunding Offerings by Issuer Location SEC study for Scott Bauguess (Feb. 28, 2017). 5 SEC study for Scott Bauguess (Feb. 28, 2017). 6 3

4 How Businesses Raise Funding Traditional funding Bank loans Equity investors Debt investors Friends and family Crowdfunding Project crowdfunding Accredited-investor crowdfunding General public crowdfunding (Title III of the JOBS Act) How Businesses Raise Funding Project Crowdfunding Fundraising party solicits money for a project and gives investors something tangible or intangible in return (but not stock or debt) $1.5 billion reportedly pledged to Kickstarter projects, with 7.85 million total backers. Project (Gift) Crowdfunding Investors do not expect anything in return for funds Charitable causes Medical needs for unique cases Honeymoon trips 7 8 4

5 Crowdfunding Policy State blue-sky laws (1900s) Designed to prevent speculative schemes that have no more basis than so many feet of blue sky. Antifraud provision for false statements made in offerings SEC Regulation A (1964) SEC Rule 146 (1970) Limited private offerings exempt from registration with SEC SEC Rule D (1982) Liberalizing exemption for certain private offerings Defined accredited investor JOBS Act How Businesses Raise Funding What is an accredited investor? Certain institutional investors Directors, executive officers, or general partners of the issuing company Sophisticated or wealthy individuals Net worth in excess of $1 million, or Individual income in excess of $200,000, or joint income with spouse in excess of $300,000 in each of last two years and anticipated in current year. Entities where owners meet above criteria

6 How Businesses Raise Funding Crowdfunding by Accredited Investors (Title II) JOBS Act created new exemption for private securities (not registered with SEC) Companies allowed to advertise and promote private offerings so long as: They were not raising more than $1 million over a twelve-month period They allowed only accredited investors to buy securities General public crowdfunding (Title III) JOBS Act authorized businesses to sell securities in their companies using crowdfunding even if investors not accredited SEC rules effective May 2016 General Public Crowdfunding (Title III) Unlimited number of investors Must be made through funding portal (not fundraising company directly) If investor s net worth and annual income are both less than $100,000, she may not invest more than $2,000 or 5% of her net worth or income (whichever is greater) in crowdfunded offerings of securities during rolling 12-month period If net worth exceeds $100,000, she may not invest more than 10% of her net worth or income (whichever is less) in crowdfunded offerings Accredited investors are not capped

7 Business Issues Choosing the legal entity Three types for Title III Regular corporations S corporations H.R. 531 (proposed) Exception to 100 shareholder rule Limited liability companies State of incorporation Franchise taxes on authorized shares Shareholder rights Voting rights Inspection rights Business Issues Types of securities Notes Convertible notes Common stock Preferred stock LLC units/membership interests Classes of securities Convertible preferred stock Voting and nonvoting classes of common stock Stock redemption rights Offering amount

8 Business Issues Special Issues in Equity Crowdfunding Disclosure to investors / funding portals Term sheet Nonbinding summary Pitch deck Disclosure document (SEC Form C) Name, legal status of entity, date of organization, website address. Officers and directors Owners of 20% or more of outstanding voting equity securities Description of business Number of employees Target offering amount Use of funds Etc. 15 Contributions to corporation Section 351(a) provides that [n]o gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation. Rewards Rewards or perks from entity in addition to equity may trigger gain recognition to extent of the FMV of the property received Contribution to partnership Section 721(a) no gain or loss for contribution of property in exchange for interest in partnership 16 8

9 Special Issues in Equity Crowdfunding Worthless investments Section 1244 allows ordinary loss on stock of small business corporation Section 165(a) allows deduction for loss not compensated for by insurance or otherwise Small business stock Section 1202 exclusion of 100% of gain recognized on stock of a qualified small business (QSB) corporation held for more than five years Section 1045 allows investors to roll over gain realized on sale of QSB stock into stock of another QSB corporation Special Issues in Equity Crowdfunding Qualified Small Business Stock the stock was originally issued after August 10, 1993; the taxpayer obtained the shares of stock as the original holder from the corporation; the issuing corporation meets the domestic C corporation requirement; the corporation engages in an active business; and the taxpayer's stock was issued before the corporation's aggregate gross assets exceeded $50 million

10 Income Tax Issues - Reporting Section 6050W requires information reporting for certain payments made in settlement of payment card (e.g., a credit card) and third party network transactions (e.g., PayPal). de minimis rule applies if aggregate payments to the payee by the third party for the calendar year do not exceed $20,000 or if the aggregate number of transactions between the third party and the payee that would otherwise be reportable does not exceed 200 within the calendar year Income Tax Issues - Income Under Code Sec. 61(a), except as otherwise provided by law, gross income includes all income from whatever source derived. A gain constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it. (Commissioner v. Glenshaw Glass Co., (Sup Ct 1955) 47 AFTR 162) Treas. Reg sets out the constructive receipt doctrine

11 Income Tax Issues - Crowdfunding IRS Information Letter No cases or IRS rulings directly address the taxability of contributions to a crowdfunding project. Generally, money received without an offsetting liability, that is neither a capital contribution to an entity in exchange for a capital interest in the entity nor a gift, is includible in income. Crowdfunding revenues generally income if they are not: Loans that must be repaid Capital contributed in exchange for equity Gifts made out of detached generosity and without any quid pro quo Income Tax Issues Trade or Business Section 199A No specific definition of trade or business But specific inclusion for rental or licensing of tangible/intangible property Proposed Regulations point to Section 162(a) and related case law Primary purpose of profit Regular and continuous

12 Income Tax Issues Expenses Deduction for ordinary and necessary expenses incurred in trade or business Common and accepted Helpful and appropriate Taxpayer must show that he engaged in the activity with an actual and honest profit objective. Hobby loss Deductions attributable to an activity not engaged in for profit are generally allowed only to the extent of income from it. See Section 183. Deductions for hobby activities are claimed as itemized deductions on Schedule A, Form Income Tax Issues Hobby Loss Factors to determine if activity engaged in for profit or hobby: Does the time and effort put into the activity indicate an intention to make a profit? Do you depend on income from the activity? If there are losses, are they due to circumstances beyond your control or did they occur in the startup phase of the business? Have you changed methods of operation to improve profitability?

13 Income Tax Issues Hobby Loss Factors (cont.) Do you have the knowledge needed to carry on the activity as a successful business? Have you made a profit in similar activities in the past? Does the activity make a profit in some years? Do you expect to make a profit in the future from the appreciation of assets used in the activity? An activity is presumed for profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses). Income Tax Issues Hobby Loss Multiple activities Based on facts and circumstances Similarity of activities Cases Profit motive Barbour v. Comm r TC Memo Businesslike attitude Eisenman v. Comm r TC Memo Records Rohr v. Comm r TC Memo

14 Income Tax Issues - Crowdfunding Income Tax Issues - Crowdfunding Exception from gross income for gift Comm. v. Duberstein, (S Ct, 1960) 5 AFTR 2d 1626, the value of property acquired by gift is excluded if it: comes from a detached and disinterested generosity; is made out of affection, respect, admiration, charity or like impulses; is not made from any moral or legal duty, nor from the incentive of anticipated benefit of an economic nature; and is not in return for services rendered. Economic or other consideration? Quid pro quo? What about rewards for contributions? Look to donor rules? Deduction by contributor Payments to Section 501(c)(3) public charity Return benefits to donor? Payments to individuals Payments to for-profit business Payments for credit card processing fees and administrative fees Issues with respect to all or nothing fundraising

15 Special Considerations in Real Estate Trend towards private real estate investments over REITs Real estate deals structured through LP or LLC entities allows tax benefits to flow-through to investors Tax benefits of investing in LP or LLC deals limited to institutional investors until crowdfunding. Potential benefits include depreciation, interest expense, and NOLs to offset other passive investments. Crowdfunding & ICOs Crowdfunding intersection with Blockchain What do the investors receive? Commodity Equity Debt Prepaid goods Derivative Contract to acquire tokens

16 Crowdfunding & ICOs SEC Asserts that tokens can be securities Treas. Reg (a)(2): A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. Basis? Are foreign tokens shares in a foreign entity? Crowdfunding & ICOs Contracts for tokens Simple Agreement for Future Token (SAFT) Agreement with accredited investors for right to tokens At official launch of token, holder receives tokens based on set formula Tax treatment as forward contract? Taxable to issuer with zero basis?

17 State Tax Issues Constitutional limitations Commerce Clause Substantial connection (nexus) with the state Fairly apportioned Does not discriminate against interstate commerce Fairly related to the services provided by the taxing state Due Process Some definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax. Miller Brothers Co. v. Maryland, 347 US 340 (1954). State Tax Issues Nexus National Bellas Hess, Inc v. Department of Revenue of Illinois, 386 US 753 (1967) Quill Corp. v. North Dakota, 504 US 298 (1992) Click-through nexus for e-commerce S.D. v. Wayfair (2018) State guidance Virginia 2013 House Bill 1872 noted that crowdfunding is eligible for any income tax credit for which it otherwise qualifies

18 State Tax Issues Washington State Department of Revenue issued guidance requiring project creators who raise more than $12,000 to register with department, obtain a license, and file all appropriate tax returns. Project creator must report donations when project fully funded for excise tax purposes. Project creator must collect sales tax on donations if provides retail services, digital products, or tangible personal property as rewards. QUESTIONS?

19 SPEAKER T. Joshua Wu ( ) LinkedIn 37 19