To Tax or Not to Tax: Understanding Donation-Based Crowdfunding

If you use social media – be it Facebook, Twitter or another website – you’re likely already familiar with the concept of crowdfunding. Let’s say one of your friends volunteers for the local chapter of a nonprofit organization. She’s been tasked with creating her own fundraising campaign on behalf of the organization for one of their annual events. Her goal is to raise $1,000. She kicks off her campaign by posting a link for submitting a monetary donation on her personal Facebook page. You click on the link, and you’re navigated away from Facebook to the organization’s website, where you can make your donation in any amount to ultimately contribute to the overall fundraising goal of the organization. This is one of the more common crowdfunding strategies used on social media channels across the board.

Crowdfunding is defined as “the practice of funding a project or venture by raising money from a large number of people who each contribute a relatively small amount, typically via the Internet” (Oxford Dictionaries). In other words, the creator of the fundraising campaign – either an individual or a business entity – is able to reach out directly to a wider population of potential donors or customers without the assistance of a team of venture capitalists and marketing specialists. If you break this concept down further, you’ll see that there are actually three distinct types of crowdfunding – reward-based crowdfunding, equity-based crowdfunding, and donation-based crowdfunding – the last of which will be the primary focus of this post.

According to the Financial Times, donation-based crowdfunding “enables individuals to directly share their money with causes and projects that they feel strongly about, and thereby empowers others to create impact.” On the contrary, reward-based crowdfunding involves “rewarding” donors with tangible items of monetary value in exchange for their pledge of support. Similarly, equity-based crowdfunding allows donors to invest money in the cause or project in exchange for equity, or shareholding, in the company. Put more plainly, reward-based and equity-based crowdfunding are essentially business transactions, whereas money raised as a result of donation-based crowdfunding is freely and voluntarily given without anything given in return for donors’ contributions.

When considering donation-based crowdfunding, and its relationship to tax planning and preparation, it’s imperative to understand the inherent differences between the three types of crowdfunding. Depending on the type of crowdfunding used, the funds raised as a result are either taxable or nontaxable. This is often where confusion originates, since crowdfunding is a relatively new concept, and the IRS has not been able to provide much guidance on the subject. Although thousands of individuals and businesses alike have successfully used crowdfunding to raise money for a worthy cause, or to build their business, they often don’t consider the overall impact that it has on income taxes.

The Journal of Accountancy states, “While pledges received from donation-based crowdfunding are likely to be considered nontaxable gifts, reward-based crowdfunding is likely to carry income tax ramifications for the project creator.” As previously mentioned, in donation-based crowdfunding, there’s no exchange of products or services. However, in reward-based and equity-based crowdfunding, there is an exchange of goods and/or services; thus, any funds raised are considered taxable income when reporting to the IRS.

One important aspect of all types of crowdfunding is the use of third-party payment processors – for example, WePay.com or PayPal.com – as a tool to process donors’ contributions. Although these payment networks are frequently used, many of them don’t explicitly state on their website whether or not payees are required to file Form 1099-K to report their funds as taxable income, which inevitably adds another layer of confusion. The Journal of Accounting goes on to further explain third-party payment networks, as well as the primary difference between donation-based and other types of crowdfunding:

“Regs. Sec. 1.6050W-1(c)(3) … clarifies that participating payees (those who would receive the Form 1099-K) are persons who are providers of goods and services … This is an important distinction when considering the reporting obligation of payment processors for donation-based crowdfunding websites, as the recipients of donation-based crowdfunding campaigns generally do not provide goods and services.”

Case in point, contributions made to a donation-based crowdfunding campaign are considered charitable gifts, and as such, are not subjected to taxation. Conversely, those made as a result of reward-based crowdfunding are taxable in accordance with income tax regulations. If you’re planning a crowdfunding campaign, it’s important to be an informed taxpayer and take these points into consideration, so you can avoid any discrepancies or mishaps when reporting your taxes.