By Peter Jason Riley, CPA

"Rewards-based" crowdfunding is fast becoming a primary funding source for creative individuals. Project runners that have a fan base and a flair for the interactive nature of social media are going to be able to utilize crowdfunding as a major pillar of their professional cash flow. In the early days of crowdfunding, folks often saw this outlet as a one-time shot. They felt that this was a well you could not keep going back to. As crowdfunding has matured, we are seeing artists use this model regularly for projects. They are finding that as long as the fan base is happy with the artist's work, they are more than willing to keep supporting new crowdfunding projects. As we move forward, you are going to see creative people using crowdfunding as the major financial arm of their creative business.

To be or not to be income, that is the question...

The first hurdle with crowdfunding is deciding whether all that cash is taxable income. While there is no definitive guidance from taxing authorities regarding crowdfunding income, there are principles that can be applied in deciding the taxation of crowdfunding income. A majority of rewards-based crowdfunding project receipts will be considered income because there is an exchange for a product or an implied exchange for services. The backer is supporting the project because he or she wants to read the book, hear the music, or see the performance, movie or play. The musician will be giving away signed copies of the CD; the filmmaker will be giving away signed DVD's, film posters, or invites to premier; the author will be giving autographed special edition books; the performer might offer a Skype master class; the writer might offer to read a draft. Receiving that special reward and seeing a project to fruition is the primary motivation of the project backer.

Some professionals argue that there can be the component of a gift in the crowdfunding model. I think they base this (partially) on the example that exists with 501c3 nonprofit organizations. For example, when you give a $100 to PBS and receive a "premium" back (say, a $15 umbrella), only $85 will be considered a tax deductible charitable contribution. Some have argued that this same paradigm exists in the crowdfunding world: if the value of the reward being given is diminutive compared to what the backer is paying, the amount over and above the fair market value of the reward might be considered a gift by the project runner. I think this is erroneous reasoning because, of course, the project runner is generally not a non-profit organization and, again, even if the value of the reward is diminutive or even $0, the backer is still expecting the project runner to do something in return for their backing the project: producing the recording, film, book, play, etc. Under the IRS code, a tax free gift is by its very nature a transaction made out of "detached and disinterested generosity." That is clearly not the core foundation of rewards-based crowdfunding.

The other argument that is sometimes made is that the project backer is making what is called a "non-shareholder" contribution to the project runner. This approach has even less promise than the argument for gifting. Very few rewards-based crowdfunding projects are run by corporations, and even if the project runner was incorporated, it is unlikely that the project backer would meet the five IRS requirements for the non-shareholder contribution.

My feeling as a tax professional is that any project which offers a backer some sort of reward is going to be considered fully taxable income by the Internal Revenue Service, regardless of the value of the reward.

In Art, timing is everything...

One important consideration when starting your project is timing. You always want to match income and expenses in the same tax year. One of the worst mistakes a project runner can make is to collect funds late in the calendar year while not expending the cash until the next year. In that case, the project runner (as a cash basis taxpayer) ends up with all the taxable income in one year and all the expenses in another tax year -- the worst of all the possible outcomes.

Expenses and Deductions and other issues

Once we decide that our rewards-based crowdfunding project is a legit trade or business, either by way of being part of an ongoing creative enterprise or in and of itself, then all we have to do is organize our related expenses for the project. Typically, the project runner is looking to cover a distinct group of expenses: the costs of recording a record, editing a film or publishing a book, for example. Clearly our filmmaker who raises $30K to edit and finish a movie will deduct those costs against the income from the rewards-based crowdfunding project. And one must not forget the costs of the backer rewards! Many a project runner has greatly underestimated the cost and energy required to fulfill the rewards that were offered to backers, and all those costs are also deductible against the project income. These include the costs of companies that are springing up to handle fulfillment for project runners.

As you can discern from this brief discussion of expenses, the entire subject of whether crowdfunding income is taxable is pretty academic for the majority of creative crowdfunding project runners. While I am sure it has happened, I have never personally seen any project runner make a "profit" on their crowdfunding campaign. Most project runners who collect more money from backers than they requested simply expand the project to utilize and expense the additional dollars.

Crowdfunding platforms are only required to issue a 1099-K for projects that gross more than $20K in income and have 200 or more transactions in a calendar year. For projects that gross less, there will be no third party reporting to Internal Revenue Service. The income will be reported gross on Schedule C as income and the commission taken by the crowdfunding site will be listed as an expense.

As rewards-based crowdfunding becomes a key pillar in the income stream of more and more creative individuals, a lot of this information will become second nature; until that time, however, this subject will cause difficulties for some creative artists.