Crowdfunding has become an increasingly viable option for startups who need to raise much-needed funds without the help of VCs, angels or banks. To date, more than $680 million has been raised on Kickstarter.
For a young, bootstrapping startup, crowdfunding is often seen as fast money that will help you build out the product or app you and your team have always dreamed about. Whether or not a project ultimately reaches its funding goals, it’s still relatively quick and easy to post your pitch and see what happens.
However, amid all of the hype and excitement surrounding crowdfunding, some of the less glamorous (but extremely important) aspects of running a business often go overlooked — particularly taxes and liability. Let’s look at what you should be concerned with.
Liability Issues With Crowdfunding
When you’re raising money from any source, it’s serious business. And while a Kickstarter project may not entail the mounds of paperwork and contracts associated with commercial lenders, project creators are still entering some kind of contract — in this case, it’s with hundreds or thousands of people.
When crowdfunding turns into a platform for taking pre-orders for a yet-to-be-finished product, there are inevitable risks. We’ve all heard stories about high-profile delivery delays like the Pebble smart watch, but they’re hardly an anomaly. A report by CNN Money found that 84% of the top 50 funded projects on Kickstarter in 2012 shipped late. When excited backers expect the same smooth fulfillment process as ordering a product from a retailer like Amazon, disappointment, frustration and worse will inevitably ensue.
It’s doubtful that anyone actually creates a Kickstarter campaign with the sole intention of weaseling money out of people. However, with any technology or creative project, things don’t always go as planned — and some well-intended projects fold before they’re ever brought to fruition.
For this reason, it makes sense to launch a Kickstarter campaign through a legal business structure, such as a Limited Liability Company (LLC), as opposed to posting it as an individual. An LLC or other structure offers a layer of protection that can essentially shield your own personal assets from that of the business. So, if something should happen to your project or business, the business is liable for it, and not you personally. Make sure your LLC or corporation is officially established and then conduct all business and enter contracts through the LLC or corporation.
In addition to creating a formal business structure, you should also take the following steps:
- Once your LLC or corporation is established, get an Employer Identification Number (EIN) from the IRS. This is essentially a social security number for businesses, and you’ll need it to open your business bank account. You can apply for your business’ EIN online through the IRS site. It’s fast, simple and free.
- Create a business bank account. Once you get an EIN, you can open a bank account for your business. This is going to be important for keeping your business and personal finances separate (thus, helping to shield your personal assets).
Crowdfunding and Taxes
The tax consequences of crowdfunding campaigns can catch project creators off guard. When you raise funds for your business through other sources, it’s considered a contribution to capital and is usually not taxed. However, funds raised on Kickstarter are considered income, and creators are issued a 1099-K (at least when they raise more than $20,000 and have more than 200 transactions).
Project creators can often offset this income with deductible expenses related to their project. However, some people run into trouble when their Kickstarter funds fall in a different tax year than their major expenses. For example, you might need to raise money first, then you can start spending it to build the product. To counter this scenario, some project creators opt to form a C Corporation so they have more flexibility in defining their fiscal year for tax reporting purposes (and therefore, make sure their Kickstarter income and expenses occur within the same reporting year).
If you’re looking to raise more money via crowdfunding than you usually earn, you should turn to a professional tax adviser or accountant for help understanding all the nuances and implications. There’s no sense in trying to navigate the murky and evolving reality of crowdfunding and taxes on your own.
Most importantly, you need to approach any Kickstarter project as a serious funded business, not a side project that’s exempt from normal business rules.
Editor’s note: This was originally written by Nellie Akalp for Mashable.