Finance Paper 2

CrowdFunding.pdf

Home >Business & Finance homework help >Finance Paper 2

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JANUARY 2017

A Review of Federal Income Tax Issues Associated with Crowdfunding by Mark Lee Levine, PhD, JD, LLM, CLU, ChFC Libbi Levine Segev, JD, LLM

Vol. 71, No. 1 | pp. 91-96

ABSTRACT

The term “crowdfunding” has been used in

many settings, from programs like Kickstart-

er in which people contribute funds to indi-

viduals starting new businesses to situations

that involve crowds of people investing in an

idea or company with the expectation and

hope of generating huge value. The variance

in the meaning of crowdfunding creates con-

fusion that extends into the area of crowd-

funding activity’s income tax ramifications.

This review examines the tax concerns con-

nected with crowdfunding, illustrating the

importance of financial service profession-

als’ awareness of crowdfunding concerns.

Introduction: Financial Advisors and Crowdfunding

he scope of this article is limited to an ex- amination of federal income tax issues con- nected with crowdfunding. Why is this

issue of the tax treatment of crowdfunding important to financial advisors? Advisors face investment issues that can involve alternative investment decisions that may cover a group of people investing together. Such investments may be classified under various laws as crowdfunding. Thus, advisors must be familiar with the implications of advising their clients in arrange- ments that constitute crowdfunding and the applica- ble laws, tax or otherwise, that relate. Interestingly, it is difficult to quantify the amount of crowdfunding that is taking place, because there is confusion as to which activities the term “crowd- funding” actually encompasses. This review provides an analysis of crowdfunding—what it means, when it is used, its legal implications—and the federal in- come tax issues for parties involved in crowdfunding. It also differentiates among the many uses of the term crowdfunding as it relates to investments, gifts, etc. and explores how the party making a payment (i.e., the payer) of any monies to a crowdfunding recipient (the payee) might treat such payments under the U.S. federal income tax code. To examine these questions, it is necessary to know how the term crowdfunding is employed; that

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JANUARY 2017

A Review of Federal Income Tax Issues Associated with Crowdfunding Mark Lee Levine and Libbi Levine Segev

the tax implications of crowdfunding as it relates to se- curities, it is important to see how and when the term crowdfunding arises in settings involving securities. The securities in question under this investigation are those under the federal securities law, found in large part in the Securities Act of 1933 and related authorities.3 Mark Lee Levine and Phil Feigin have observed four distinct areas in which the label crowdfunding is employed:4

1) Nonsecurity: General Parlance; 2) Security: Crowdfunding and Regulation D; 3) Security: Crowdfunding and Portal Offerings;

and 4) Security: Crowdfunding under Regulation A. Before looking at the tax implications of these four areas, it is first necessary to establish some groundwork as to (1) when there is a security and (2) how the con- cept of crowdfunding can arise with securities under the Securities Act of 1933 and related materials. The term crowdfunding was reviewed in a book that was recently written by Levine and Feigin titled, Real Es- tate Securities: Syndicating Real Estate. Levine and Feigin illustrate at least four uses of the term crowdfunding.

Nonsecurity: General Parlance Crowdfunding can describe a setting where there is no investment intent by the party contributing to the crowdfunding venture. Rather, there is a desire to support a given idea. For example, if X designed a Magic Belt that contains different buttons, allow- ing the wearer to access e-mails, home safety devic- es, phone calls, etc., many may desire to own this product. However, to reach the marketplace with the product, X needs funding. To gain capital, there are many approaches X might take. X could try to sell in- terests in a new company X could form. The interests might be stock, sold as securities under the Securities Act of 1933. But assume that X simply wants to get moving. X does not want to have others owning his company. Thus, X asks members of the general pub- lic to support his idea by sending $100 each. X states that anyone who sends the $100 will receive his grat-

is, what does this term mean, especially as it relates to investments and securities?

Overview of Crowdfunding There has been a great deal of discussion, via talk shows, news shows, articles, and other media, on the topic of crowdfunding. As is the case with many sub- jects, these programs and articles often fail to define how they are using the term. Advisors need to recog- nize the lack of precision that is often present with the label of crowdfunding. The following definitions cover what is often meant by crowdfunding when using the term broad- ly. Problematically, they are not sufficiently refined to be of much help in technical areas, such as federal securities law. Investopedia states that crowdfunding is, “The use of small amounts of capital from a large number of individuals to finance a new business venture.”1

Clearly, this is only one use of the term, but many other situations employ the term in this sense, espe- cially in recent years. Crowdfunding is explained in Wikipedia as, “The practice of funding a project or venture by rais- ing monetary contributions from a large number of people.”2 The commonality between these defini- tions is a large number of contributors. Of course, one can question the meaning of the term large; similarly, what constitutes a small contribution? As seen in these examples, crowdfunding is often used casually to refer to a number of people contributing monies toward a given goal. The focus on crowdfunding more recently has been the result of a number of entities seeking funds from members of the general public, which has raised concerns about how the crowdfunding activity is sub- ject to government regulation on the state and federal levels. Such inquiry encourages the question, “Why are government authorities involved?” The answer to this issue is noted in part below as to crowdfunding related to securities. Because this article focuses on the narrow issue of

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JANUARY 2017

A Review of Federal Income Tax Issues Associated with Crowdfunding Mark Lee Levine and Libbi Levine Segev

SEC to regulate it by requiring registration of this type of security or to have the issuer (X in the example) show that there is an exemption from such registration. On the federal level, one exemption from this kind of registration can be found in the SEC’s Regulation D, Rule 506(c), which provides that if the issuer can meet all of the re- quirements under the rule, this type of crowdfunding can be exempt from the need to register the transaction.5

Security: Crowdfunding and Portal Offerings Another use of the term crowdfunding is found in Section 4(6) of the Securities Act of 1933. This activity is another use of the term crowdfunding when dealing with a group of buyers that has been attracted to the venture via advertising undertaken by X, such as adver- tising via the Internet and portal offerings to investors. The SEC issued final rules in May 2016, con- sistent with the authority and direction it was giv- en by Congress, to allow crowdfunding via sales of securities on the Web. There are many restrictions on how this type of crowdfunding is allowed to take place as an exemption from registration of securities under the Securities Act of 1933. For this article, the details of this type of crowdfunding via the Web are not important; the key is that crowdfunding through advertising on the Web can take place.6

Security: Crowdfunding under Regulation A Under the JOBS Act of 2012, Congress amended part of the Securities Act of 1933, cited earlier.7 Un- der this change, advertising for investors in a crowd- funding enterprise is allowed on a broad scale, subject to meeting the rules under what is labeled as Regu- lation A. (Some writers refer to this as “A+” in an at- tempt to distinguish the resulting Regulation A after the JOBS Act changed it from the Regulation A that existed under the prior rules.) However, for purposes of this article, the key is that Congress and the SEC now allow one to advertise to the public, under given conditions, to attract a “crowd” of qualified investors. Thus, the term “crowdfunding” is also used in con- nection with Regulation A (and A+) offerings.

itude and the right to buy one of these Magic Belts, when they come on the market, at half the retail price offered to the public. One question in this setting is whether the given request, or offer, by X is a security within the mean- ing of the Securities Act of 1933. It if is a security, this means X must comply with many regulations under both the federal Securities and Exchange Commis- sion (SEC) and state securities offices. This example illustrates one use of the term when encouraging others to contribute to a venture. Again, keep in mind that this crowdfunding activity did not qualify as a security when X merely asked people to contribute $100 to support his goal of de- veloping the Magic Belt.

Security: Crowdfunding and Regulation D The term crowdfunding can also encompass an act that includes the sale of a security under the Securities Act of 1933. Once again, crowdfunding includes a setting where people invest together as a crowd. If the investor pays monies to the issuer of interests in the investment group, such as in a part- nership or limited liability company (LLC), this ac- tivity can be held to be a security when the issuer or manager controls the activity that is a common enterprise by the issuer and the investors to make a profit through the efforts of the issuer/manager. To illustrate using X with the Magic Belt again: If X advertised to have investors invest money (not make a gift, as was the case discussed above) in Magic Belt LLC, directed and managed by X, with the hope of gaining a profit in this common enterprise, such arrangement is probably a security under federal and state laws. As such, this matter would be regulated by the SEC and the applicable state commissions deal- ing with securities. The nature of the regulation is beyond the scope of this examination. However, this scenario illustrates crowdfunding activity that falls within regulatory laws on the federal and state levels. Use of the term crowdfunding in this way has be- come prevalent enough to warrant Congress and the

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JANUARY 2017

A Review of Federal Income Tax Issues Associated with Crowdfunding Mark Lee Levine and Libbi Levine Segev

der IRC Sec. 61(a) would apply. The rule states: “Ex- cept as otherwise provided in this subtitle, gross income means all income from whatever source derived.”11

This issue is, of course, important to X. If X re- ceives payments for his Magic Belt totaling, say, $5 million, X might be subject to tax on the $5 million. IRC Sec. 61(a) states that unless X can show some other relevant authority that the $5 million is not tax- able income, it is taxable. X could cite IRC Sec. 102, which states: “Gross income does not include the value of property ac- quired by gift.” Thus, X would be arguing that since the parties paying him are not becoming owners by virtue of the payments they make, and since they are not obligated to pay X any money, they are making a gift. They are making a payment because of their generosity, not because of any obligation to pay X. There has been very little activity by the IRS on this issue, though it did issue Information Letter 2016- 0036. That letter discussed the above type of setting and the law under IRC Sec. 61(a), among other rules. The letter referred to Revenue Procedure 2016-1 (2016-1 IRB 1) and IRC Sec. 61 as to when receipt of payments constitutes income. As to crowdfunding, the letter states: Crowdfunding revenues generally are includible

in income if they are not 1) loans that must be repaid, 2) capital contributed to an entity in ex- change for an equity interest in the entity, or 3) gifts made out of detached generosity and with- out any “quid pro quo.”

Thus, it appears the IRS is saying that the recip- ient of these payments must, generally, take them in to income. However, the IRS also stated in this letter: “The facts and circumstances of a particular situation must be considered to determine whether the money received in that situation is income.” An additional and confusing comment in the letter stated, “However, a voluntary transfer without a ‘quid pro quo’ is not necessarily a gift for federal income tax purposes.” Clearly the statements by the IRS are not clear as

Other Settings Employing Crowdfunding Clearly there are other situations that can also involve crowdfunding or group investing publicized via advertising. For example, most states also permit some forms of sales solely to investors in their state. Normally such offerings are not made under the ju- risdiction of the federal government and thus are reg- ulated only by the state in which the sale takes place. This is often labeled an intrastate offering. Thus, crowdfunding exists on the state level, too. There are other uses of the term crowdfunding; however the above discussion should be sufficient to illustrate that it is employed in many settings and possesses no uniform definition across settings. This lack of uniformity in turn causes much confusion.

Overview of Crowdfunding and Taxation Having established many uses of the label of crowdfunding, the balance of this paper attends to the tax considerations for the issuer and the inves- tor when a group of individuals makes payments to someone such as X from the example (an issuer). Sections of the Internal Revenue Code (the Code) address how the issuer treats these payments, as well as how contributors treat those payments for federal income tax purposes. The relevant Code sec- tions and issues are discussed below. As mentioned at the inception of this article, the discussion is focused on federal income tax issues.8

Case One: Nonsecurity—General Parlance Crowdfunding is the term employed, as discussed above, when there is action taken such as in a Kick- starter setting.9 Certainly there are many other compa- nies that are similar in operation to that of Kickstarter. See, for example, GoFundMe and similar groups.10

Code Section (IRC Sec.) 61 relates to the issue of how the recipient of the monies, X in the earlier exam- ple, is to treat funds received. Does X treat the money he receives as a gift? Is it subject to federal income tax? This matter has not been addressed very clearly, even though some argue that a general rule found un-

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JANUARY 2017

A Review of Federal Income Tax Issues Associated with Crowdfunding Mark Lee Levine and Libbi Levine Segev

earlier does not directly affect this federal income tax issue. For X, the treatment for federal tax purposes in this Regulation D setting, however, is not income. That is, X is not receiving the money as a payment to himself; rather, the money is invested by the payers in the form of stock or an interest in a partnership, LLC, or any other entity X uses to raise funds. But, again, at this time there is not income to X from the payments made by the investors to X. As for the investors, they have no current deduc- tion when they pay monies to X. The amount they invest would be their basis for tax purposes. For ex- ample, if one invested $10,000 with X, the investor would have an adjusted basis (cost) of the $10,000. There would be no tax deduction for the investor at that time for the $10,000.

Case Three: Security— Crowdfunding and Portal Offerings Although fundraising through the crowdfund- ing approach might be undertaken by Web or portal offerings to investors, the net result for X’s federal in- come tax position should be the same as was outlined above in Case Two. Of course, those buying an interest with X in this type of offering would be capitalizing their invest- ment. That is, as with Case Two, they do not take a deduction for monies invested with X via the portal, but rather treat the monies invested as their adjusted basis (cost). Thus, for the investor, this treatment is the same as described in Case Two, above.

Case Four: Security— Crowdfunding under Regulation A The federal income tax treatment in this setting for X (the issuer) and for the investors, is the same outlined above in Case Two and Case Three, since X’s intent is to gain investment monies, and the investors’ intent is to enter a venture to attempt to produce a gain. Thus, X does not have income from the payments received from the investors, and the investors have no current deduction as a result of their payment made to X.

to this issue. It did note in the letter: “Thus, the in- come tax consequences to a taxpayer of a crowdfund- ing effort depend on all the facts and circumstances surrounding that effort.” With one more attempt to be helpful, the letter stated that the issuer, as a taxpayer, may request a private letter ruling from the In-

ternal Revenue Service that applies the law to the taxpayer’s particular facts and circumstanc- es. The procedure for obtaining a private letter ruling is set forth in Rev. Proc. 2016-1, 2016-1 I.R.B. 1. You may obtain a copy of Rev. Proc. 2016-1 on the Service’s website, www.irs.gov.

It appears reasonable to argue that there is no taxable income in this setting. However, again, X could request a private letter ruling to be more com- fortable with the position that X would take. Other writers have discussed this issue as to taxable income on the receipt of crowdfunding payments.12 See, for example, Kickstarter’s guide, “Kickstarter and Taxes: A Guide for Your Accountant.”13

As to the tax treatment of the parties making the payments to X, it is doubtful that they would have any deduction. They are not entering a business transaction as an investor. Rather, they are arguably making a gift to X, showing support for X’s idea of the Magic Belt. IRC Sec. 162 allows for ordinary and necessary business expenses. However, the parties paying the mon- ies to X are not in any business related to the Magic Belt. They are simply supporting, by gift so it appears, the activities of X to bring the Magic Belt to the market.14

The payers of the payments could not claim a charitable deduction, since the payee is not, under federal tax law, a qualified charitable recipient. (For more on this issue, see IRC Sec. 170.)

Case Two: Security— Crowdfunding and Regulation D The regulations described above regarding crowdfunding in a Kickstarter-type setting apply in part to a Regulation D offering. The exemption from registering a security under Regulation D discussed

JOURNAL OF FINANCIAL SERVICE PROFESSIONALS | JANUARY 2017

A Review of Federal Income Tax Issues Associated with Crowdfunding Mark Lee Levine and Libbi Levine Segev

Libbi Levine Segev, JD, LLM, is a licensed real estate broker with Levine Ltd. Realtors and a practicing attorney with the law firm of Levine Segev LLC. Libbi’s legal practice focuses on real estate acquisitions and sales, leasing matters, devel- opment and finance transactions, evictions, foreclosures, property tax assessments and appeals, business planning and formation, and estate and charitable planning. Libbi earned her Bachelor of Arts from Brandeis University, both her Juris Doctor and Master of Science in real estate and construction management from the University of Denver, and an LLM from New York University. Libbi is an assistant professor in the Daniels College at the University of Denver. She can be reached at [email protected].

(1) “Crowdfunding,” Investopedia; accessed at: www.investopedia. com/terms/c/crowdfunding.asp. (2) “Crowdfunding,” Wikipedia; accessed at: https://en.wikipedia. org/wiki/Crowdfunding. (3) Securities Act of 1933, 15 U.S.C. § 77 (1933). (4) Mark Lee Levine and Phil Feigin, Real Estate Securities: Syndi- cating Real Estate (New York: CreateSpace Independent Publishing Platform, Scotts Valley, California: 2015). (5) See ibid. for more details on Rule 506(c). (6) For more details on this activity see Section 4 of the Securities Act of 1933, endnote 3; and Levine and Feigin (2015), endnote 4. Once again, this type of sale of securities also employs the term crowdfunding. (7) JOBS Act of 2012, 15 U.S.C. § 78a, (2012). (8) However, there are other taxes to consider, such as sales and use taxes. Consider the following authorities as to sales and use tax issues: Justin Gruba et al., “Tax Clinic: Crowdfunding Contributions and State Sales and Use Taxes,” The Tax Adviser, June 1, 2015; accessed at: www.thetaxadviser.com/issues/2015/jun/tax-clinic-08.html. (9) For more on Kickstarter, which is simply an early player in the activ- ity of seeking financial supporters for an idea, see www.kickstarter.com. (10) GoFundMe; accessed at: www.gofundme.com. (11) IRC Sec. 61(a). (12) Cheryl Metrejean and Britton McKay, “Crowdfunding and Income Taxes,” Journal of Accountancy, Oct. 1, 2015; accessed at: www.journalofaccountancy.com/issues/2015/oct/crowdfunding- and-income-taxes.html. (13) “Kickstarter and Taxes: A Guide for Your Accountant,” Kick- starter.com; accessed at: www.kickstarter.com/help/taxes. (14) For more on this point and the related tax issues raised, see Mark Lee Levine and Libbi Segev, Chapter 13, “Real Estate Transactions: Tax Planning and Consequences,” (Thomson Reuters: Eagan, MN, 2016).

Summary of Taxation In summary, where X receives monies from in- dividuals who are not receiving an interest in the X product/company, X may have current taxable in- come. Of course X may argue that there is not taxable income as the payments to X were gifts. If, on the oth- er hand, the payments to X are for an investment with X, then X does not have current income to be taxed. If the investors simply wanted to help X and do not expect any return of their payment to X, as in Case One, there is no deduction for them. They have made a gift to X. If on the other hand, the investors are seeking an investment (and a return on the investment), they do not deduct, at the time of payment, their payment to X. They need to see if later they are either returned their investment and a profit or whether they lose all or part of their investment. Regardless of the outcome, their payments to X are not deductible at the inception.

Conclusion There appears to be a wide variety of activity in the marketplace that is labeled as crowdfunding. This crowdfunding may consist of voluntary payments made to an entrepreneur by individuals who wish to help and who do not expect a return of the monies they paid. It also occurs in other settings, some of which in- volve the sale of securities, in which the payments are made with the intent to try to gain a profit. The federal income tax treatment of the parties making those pay- ments and of those receiving the payments is affected by the intent of the parties in making the payments. n

Mark Lee Levine, PhD, JD, LLM, CLU, ChFC, has been a Col- orado real estate, tax, and business attorney; real estate broker; investor; and professor for over 45 years. Mark’s expertise has made him a prime expert witness in the ar- eas of real estate, tax, business, and brokerage law on a lo- cal and national level. Mark is a full professor at the Burns School of Real Estate and Construction Management at the University of Denver. Mark is extensively published, having written 52 books and over 300 articles in numerous fields. He can be reached at [email protected].

Copyright of Journal of Financial Service Professionals is the property of Society of Financial Service Professionals and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use.