Where Crowdfunding Goes, Taxes May Follow

Brandon Harris already has what many start up co-founders covet: Venture capitalists who are interested in funding his fledgling social media site, Dartitup.

Venture capital was once one of the few financing sources for early-stage companies like Dartitup, the “manly-man’s’’ answer to Pinterest, the image-sharing site beloved by women.

But entrepreneurs like Harris now have a growing range of early financing choices rooted in social media, including Kickstarter, an online platform where creative entrepreneurs can appeal for contributions from a global web of supporters.

What’s more, Congress has now offered start ups even wider options — including a “crowdfunding’’ provision allowing them to raise up to $1 million from an unlimited number of investors who would buy ownership shares through a website or other intermediary. This private sale of shares would involve simpler regulatory and disclosure requirements than registering with the Securities and Exchange Commission for an initial public offering of publicly traded shares.

Crowdfunding websites are likely to pop up quickly to connect start ups and investors as soon as the SEC issues regulations to implement the JOBS Act, now awaiting President Obama’s signature.

All this could tempt young entrepreneurs to envision a frictionless, friendly world of virtual finance where money would flow in as easily as “Likes” on Facebook, and stodgy old bricks-and-mortar business constraints wouldn’t apply.

Think again, say seasoned small business advisors mulling the possible consequences of the new financing methods. Raising money from other people quickly propels a young venture into the traditional world of corporate rules, bookkeeping requirements, tax bills and legal questions, said M.J. Bogatin, an attorney for start ups in the San Francisco Bay area. His clients often see themselves primarily as artists or filmmakers, but Bogatin tells them, "It's a business. Look, you've started a new business enterprise.''

And young start ups will be navigating these business issues while regulations for the new crowdfunding methods may leave many questions unanswered, Bogatin said.

For example, the Internal Revenue Service hasn’t published specific guidance on the tax consequences of receiving money through sites like Kickstarter, where some projects have already raised more than $1 million from enthusiastic supporters. Many new entrepreneurs are probably assuming their Kickstarter windfalls are tax-free donations rather than taxable income, Bogatin said.

But Kickstarter itself doesn’t describe the funds as donations. Instead, it calls them “pledges,’’ while informing users they’re responsible for any tax obligations they incur.

Thomas Andres, an Oakland, Calif., accountant, advises his small business clients to report Kickstarter money to the IRS as income. This is particularly wise, Andres said, if the start up offered “rewards’’ to people who chipped in money — a common practice in successful Kickstarter campaigns.

A start up sending “rewards’’ such as T-shirts to contributors can look very much like a traditional business selling goods or services. The Kickstarter revenue, minus expenses, could be taxable profit, Andres said. "I'm sure that's the way IRS would come down on it,'' he said. The IRS declined to comment.

The new “crowdfunding’’ provisions of the JOBS Act just passed by Congress raise even more complex questions for entrepreneurs, say securities experts. Bipartisan supporters in Congress designed the bill to help companies tap investors for the early cash they need to get established and hire workers. The JOBS Act legalizes “crowdfunding’’ sites where, unlike Kickstarter-style platforms, start ups would sell ownership shares to the public.

But raising funds from thousands of investors could create headaches down the road, said Arkansas Securities Commissioner Heath Abshure.

Although the bill eases federal requirements for completing private share offerings, a young company would then be bound by SEC rules protecting the rights of their new stockholders, as well as by certain state laws. Accommodating those shareholder rights can involve new costs, and some loss of the autonomy that entrepreneurs treasure.

“You have new owners. That’s what a shareholder is,’’ Abshure said.

State securities regulators will be scrutinizing start ups that issue shares through crowdfunding, because regulators fear that the relaxed federal rules will permit hordes of scammers to fleece unsophisticated investors. A trade group for those state regulators, the North American Securities Administrators Association, was among the consumer groups and other organizations that opposed many elements of the JOBS Act.

Abshure, a vocal critic of the bill, nevertheless sympathizes with the desire for less burdensome means of raising start-up capital. In his past work as a corporate attorney, he helped small companies sell shares to investors. But he warns that a start up with 1,000 crowdfunding shareholders scattered across the globe may have trouble attracting venture capital when the time comes for a second financing round.

Venture firms will probably seek shares on better terms than the crowdfunding investors received, setting up a possible revolt among original shareholders, Abshure said.

Mark Heesen, president of the National Venture Capital Association, said VCs would help start ups resolve such complications if they see real potential in the company. But if the VC’s interest is only tepid, a passle of crowdfunding shareholders could tip the balance against the VC’s investment, Heesen said.

Thomas Lee Hazen, a securities expert and law professor at the University of North Carolina at Chapel Hill, sees jeopardy for startups who write their own share offering materials and post them on a crowdfunding website without the kind of advice they’d have gotten from the attorneys and investment banks that shepherd traditional IPOs.

Young enterpreneurs are likely to describe their crowdfunding projects with zeal and enthusiasm, Abshure said. But if they omit risks or material information needed by potential investors, they could be vulnerable to state fraud prosecutions, he said.

M.J. Bogatin, the Bay area attorney, reminds his clients that every statement they make on the Internet is forever preserved and broadly visible to federal and state regulators, as well as tax authorities. “It’s anything but private,’’ he said. “Now the very enterprise is public by nature.’’

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