Do you owe federal income tax on what you raised?
The general rule is that all income is subject to income tax.
There are, however, two exceptions to this general rule that may apply to crowdfunded revenue.
Contributions to Capital of a Corporation
Section 118 of the Internal Revenue Code provides that the gross income of a corporation does not include any “contribution to the capital” of the corporation.
So if you did your crowdfunding campaign as a corporation, this exemption could apply. What is the definition of a contribution to capital? The following is the IRS’s test for what constitutes a non-taxable contribution to capital under Section 118:
- The contribution must become a permanent part of the transferee’s working capital structure;
- The contribution may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee;
- The contribution must be bargained for;
- The asset transferred must foreseeably result in a benefit to the transferee in an amount that is commensurate with its value; and
- The asset ordinarily, if not always, will be employed in or contribute to the production of additional income, and its value will be assured in that respect.
There are many cases and revenue rulings interpreting this test.
In Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950), the Supreme Court held that contributions by community groups to induce a shoe company to locate its factory operations in the community qualified as non-taxable contributions to capital. The Court based its conclusion on the fact that the motivation of the contributors was to benefit the community at large and the contributors did not anticipate any direct benefit from their contributions.
In a 2008 Private Letter Ruling, the IRS stated that payments made by a city to a corporation (called Corp A in the ruling) to underground overhead electrical could be treated as a non-taxable contribution to capital.
The IRS used the following reasoning: “First, the undergrounded electrical lines and related equipment will become a permanent part of Corp A’s working capital. Second, the payments are not compensation for services because, after the payments are made, Corp A will not be required to provide any services it is not providing at the present time. The undergrounding is not necessary other than as part of City’s undergrounding program to improve community aesthetics and public safety. Third, the payments are a bargained-for exchange, because Corp A and City bargained at arms-length on the location and cost of the undergrounding of the lines and related equipment. Fourth, the payments foreseeably will result in a benefit to Corp A commensurate with their value because they will be used as part of Corp A’s electrical distribution system over which it provides electricity for sale to its customers. Fifth, the undergrounded electrical lines and related equipment will be used by Corp A in its trade or business to produce income.”
It is risky to rely on Section 118 to exclude crowdfunded proceeds from taxable income. The IRS has identified the use of Section 118 as a common area for abuse and likely scrutiny.
Another, Probably Better, Option
Section 102 of the Internal Revenue Code excludes gifts from taxable income. Crowdfunded revenue is almost certainly a gift, especially if no perks are offered in return.
Janelle Orsi, in her article How to (Legally) Open a Gift (Economy) offers the following guidance on the IRS’ definition of a gift:
- Gifts arise from generosity: “A gift […] proceeds from a detached and disinterested generosity, out of affection, respect, admiration, charity, or like impulses.”
- Gifts don’t come from a moral or legal obligation: “If a payment proceeds primarily from the constraining force of any moral or legal duty, […], it is not a gift.”
- Gifts are not given with an anticipation of return: “If a payment proceeds […] from the incentive of an anticipated benefit of an economic nature, it is not a gift.”
- Gifts are not given as a payment for something: “Payment made in return for services rendered is not a gift.”
- The intention of the giver is what matters: “In determining whether a transfer of property is a gift, […] the controlling factor is the intention with which the transfer […] has been made.”
As this article makes clear, there is nothing clear about the taxation of crowdfunded money! Proceed with caution and speak with your tax advisor.