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Thinking of Crowdfunding? Make Sure You’re Not Doing Anything Illegal!

Some thoughts from an IRL lawyer.

kickstarter-logo-www-mentorless-com_We are living in an amazing age for content creators and entrepreneurs. The rise of crowdfunding has revolutionized how artists and fans create new and exciting works, and how entrepreneurs can start entrepreneur-ing. But like any new thing, the kinks are still being worked out. The crowdfunding model is so new that a lot of laws and regulations haven’t caught up with it, and so accessible that users may be diving in without fully realizing the costs or rules they have to follow. And of course, despite the best terms of use and cautious users, the system is still open to abuse or misuse. Luckily, there’s some guidance in the laws we have and laws that are being written to help everyone out.

Investing ideas

Perhaps the trickiest area of law when it comes to crowdfunding it just figuring out the status of backers, and what their relationship is to the project. When you sign on as a backer of a project on Kickstarter, what kind of transaction is that anyway? Is it a donation or gift? Is it a purchase of a perk? Or is it an investment? For the sake of sustaining the crowdfunding model, let’s hope it’s not the last one.

In the traditional business model, getting investors in your company is a regular occurrence and investment in start-ups and such is one of the driving forces of economic growth. But when you get money from an investor it’s usually in a big chunk. That transaction sets up a legal relationship between you and your investors, one that is highly regulated. Investors often own part of the business or thing they are investing in, and the people in charge of the thing owe what’s called “fiduciary duties” to the investors – which basically means you have to behave in the most honorable and careful way to protect the investment. There are other even more specific rules for when a company goes public (that is selling stock to anyone that wants it) which involve all sorts of disclosures that must be made to investors and to the government. Most of these laws were meant to protect consumers. Many have their origin in the depression and trying to make sure another stock market crash didn’t happen and people didn’t lose their life savings investing in bad businesses.

So what’s going on when thousands of people invest in a crowdfunding campaign? Well… we sort of don’t know. The law is still catching up, but the good news is that many states are falling on the side of saying crowdfunders are NOT investors. There is a growing movement in state legislatures to clarify what crowdfunding is and to regulate it in a different way from conventional business models. States like Oregon and Minnesota are allowing business to raise capital up to a certain amount and be exempt from regular investment regulations through crowdfung. They have to do this because the federal government has been sitting on regulations and laws for years that would clarify things, but done nothing. Still, these laws vary from state to state and the majority of states still have no applicable laws on point at all.

So, the law is moving forward for crowdfunders, but until it’s uniform we still have some possible issues. Luckily, the main way crowdfunders get around these hurdles and regulations is by considering their backers as customers or donors rather than investors, but this opens a whole other can of worms – taxes.

A taxing problem

Now, it may be tempting to believe that when someone backs you on Kickstarter there are no strings attached, but the IRS hasn’t made up its mind on that. There’s a huge grey area around whether backing funds are non-taxable gifts or taxable income. The IRS hasn’t made any sort of rulings on this and, so far, there is no binding court precedent to guide us either so, the law is really murky. However, it’s could be very hard if you’re using this money for business to justify the heaps of cash you raise on Indiegogo as gifts. The IRS waits like a cheetah to pounce on any money that passes in the open between people as income. Even if backers get nothing in return or the value of a perk is far less than the amount you paid, the taxman may see the money as a way of paying someone to do some labor, which brings us back to income. And, unless you’re legally organized as a non-profit entity that qualifies for a tax exemption, these are not clearly nontaxable donations.

Kickstarter and Indiegogo knows this. Their payment partners will issue you a form called 1099-K to be filed with your taxes. Remember, they also send this form to the IRS, so don’t ignore it. The income they credit to you is the entire gross amount you raised, without their fees (of which there are many) deducted. Again it’s up to you to deduct these as business expenses. However, for Kickstarter and Indiegogo, they only will do this if your project raises more than $20,000 or if it has 200 or more backers. Not getting a 1099-K or other form does not in any way mean that the income from the project is not possibly taxable. So, if you have a small project, you may still need to report the income yourself. And remember guys, paying taxes may be a drag but it’s way more fun than being audited and prosecuted for tax fraud.

Final tips

So, what does that mean for creators? It really means TALK TO AN ACCOUNTANT or other professional. Look at crowdfunding a project as a serious business venture. Don’t just skim over the terms and conditions when you sign up to be a crowdfunder. Check what the laws are in your specific state about crowdfunding, if they exist and make sure you figure taxes and fees into the goal you set for your project.

Remember, nothing here is meant to be legal advice, just information about what the law is and where it’s going. And it looks like it’s going in some very interesting places.

Jessica Mason is a writer and lawyer living in Portland, Oregon. More of her writing can be found at www.fan-girling.com, and follow her on Twitter at @FangirlingJess.

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