Nobody is against free money, right? So crowd funding can seem like a panacea for a wide range of problems. And everybody is doing it. Just write a good story that explains why people should send you a few bucks, then sit back and wait for the money to roll in.
What could be easier? While I’m not against the idea of crowd funding, and I have made contributions to a range of crowd-funding projects, I often think that people leap into the idea of crowd-funding with very little thought. For instance, did you know that there are two different kinds of crowd funding, with very different legal and tax issues for businesses?
There are “traditional” crowd funding sites like Indie Go Go, Go Fund Me, RocketHub and Kickstarter where businesses, not-for-profit groups, and individuals try to raise money for all sorts of projects. Donors give them a small amount of money in exchange for a small premium. Each project has a fundraising goal, and if it doesn’t meet its goal, no money changes hands. Anybody can participate in a traditional crowd funding site as a donor or fund raiser.
Now there are also securities-backed crowd funding sites and services, where businesses offer equity in the company in exchange for investment capital from qualified investors. These new securities-backed crowd funding sites were made possible under the JOBS Act, and many of the rules and regulations surrounding them are still unclear because the Securities and Exchange Commission hasn’t yet published its final set of guidelines. Participation in securities-backed crowd funding sites is limited to certain kinds of businesses and investors who meet minimum qualifications.
Regardless of which kind of site you’re participating in, however, there may be some fairly serious issues associated that most people don’t even think about. If you’re a business owner or entrepreneur, here are three that seem worth considering before you post your request for funds on a crowd funding website:
- Intellectual property considerations
- Use of funds and escrow considerations
- Accounting & compliance considerations
If you’re an individual, here are three potential issues for you to consider:
- Insurance and public assistance considerations
- Tax issues
- Privacy and safety concerns
If you’re an investor or donor, here are three potential issues to consider:
- Privacy and safety concerns
- Tax issues
For Entrepreneurs: Crowd Funding & Intellectual Property
Charles L. Mauro, a well-known expert on patent and intellectual property issues, wrote a long and well-researched article on his blog about this issue. Mauro points out that much of patent and IP law rests on the concept of “FITF” (first inventor to file). Many of the notices on crowd-funding websites seem to reference raising seed money to develop an idea that is in its very early stages. What, Mauro asks, is to stop an unscrupulous patent troll or anyone else with bad intentions from scraping the best ideas from crowd-funding sites and filing provisional patents that could be used to keep inventors from owning their ideas outright?
Having worked around Silicon Valley for several decades, I have had lots of experience with the impact that secure intellectual property rights have on a start-up company’s valuation (and therefore on how much money it can raise). If you have rock-solid IP protection, your start-up is worth at least 20% more than if your ideas haven’t yet secured that protection. So does sharing the information about your idea on a crowd-funding site hurt your valuation? Mauro says it can.
But Mauro says that the biggest risk in floating an early-stage idea on a crowd funding site isn’t someone stealing your idea, or reducing the value of your idea, it’s inadvertently infringing on someone else’s IP. Here’s an excerpt from his article:
“Possibly the greatest risk to your potential success is not people stealing your ideas, but something entirely different. Your most significant risk is likely to be violation of the intellectual property of individuals and companies who have already patented your concepts and will not be happy to see you tossing about their IP. Unless you employ some level of prior art search, you are essentially putting yourself in the way of very serious oncoming traffic. Traffic in this case means all manner of rough play by lawyers who are retained by those whose IP you may have infringed.”
Prior art search means conducting the kind of (usually expensive) legal research that goes into establishing whether your idea is really new — or whether someone else has already patented some portion of it. If you raise money on a crowd funding website for an idea that is based on someone else’s intellectual property, you could wind up being liable for far more in damages than you raised on the site. Even if you wind up winning, it’s likely to be an expensive battle that costs more than you raise, so taking the time to do the homework first makes sense.
For Entrepreneurs: Use of Funds and Escrow Issues
In 2013, the Securities & Exchange Commission issued rules for securities-based crowd funding under the JOBS Act. For the first time, it allowed businesses to raise money by selling shares directly to individual investors who meet certain criteria. That, of course, is different than the kind of crowd funding site where companies or individuals simply offer “incentives” of one kind or another in exchange for raising money, right?
Yes and no. Yes, the crowd funding sites have different rules than the crowd funding referenced in the federal JOBS Act. The biggest difference is that anybody can participate in a crowd funding website, while only qualified investors who meet specific criteria can purchase stock in start-ups under the JOBS Act.
But some of the rules in the JOBS act may apply to businesses who use crowd funding sites. For instance, a number of states have created their own rules for businesses who use crowd funding to raise capital. The final federal rules for crowd funding are still being revised, but regulators are concerned enough about “pump and dump” scams that it seems clear that there will soon be nationwide rules that match state rules on things like use of funds and escrow.
A pump and dump scam is a con where a shady entrepreneur exposes his ideas to as many potential investors as possible, gets them to pony up their credit cards, and when he reaches his goal, takes their money and dumps the project. It’s been around for decades, and there are still sketchy stockbrokers out there pushing high-risk investments through cold-calling methods to drive up the price of a penny stock, then dumped the stock at a higher value and ran for the next idea.
With the advent of crowd funding, the con artists repackaged the old scam in a new “help save the…” (world, sick child, old lady facing eviction — you name the cause). One of the reasons the SEC has cited for the delay in its final rules on securities-based crowd funding is the need to protect investors from “pump and dump” schemes.
Use of funds means that money raised through crowd funding can only be used for the stated purpose. So if you say you’re raising money to enter your film in festivals and showcases, you may not be able to use the money to pay yourself a salary — or pay your actors or editors.
Escrow means that you can’t spend any of the money until certain conditions are met. Most public crowd-funding sites have a built in escrow provision: if you don’t reach your goal, nobody’s credit card is charged, and you wind up with no money.
What it means to a business using crowd funding to raise money is that the legal and accounting rules for crowd funding still aren’t set in stone. What is permissible today may not be permissible next month — and any attempt to use the money for something other than the intended purpose, or to use it without following the still unclear escrow rules in many states could wind up being costly in the long run.
For Entrepreneurs: Accounting & Compliance Issues
As noted in the section on escrow and use of funds, the rules for accounting for money raised through crowd funding and the compliance issues around crowd funding remain uncertain. Ask three CPAs whether money raised through crowd funding is capital or income, and you are likely to get three different answers.
Some states have specific rules on how money raised from crowd funding is taxed. Some don’t. And the IRS is waiting on the SEC’s final regulations to “clarify” that money raised through the direct sale of stock in a securities-backed crowd funding plan is capital, not income. (This matters to both investors and the companies receiving the money, of course.)
The compliance questions are even murkier. Some groups like FINRA, which regulates financial and insurance companies (including brokers and agents) have issued their rules for crowd-funding programs, and others have not.
What does it mean? That depending on where your business is located, and what kind of business you run, there may be rules and regulations you have to follow before you can use securities-backed crowd funding or “traditional” crowd funding — and nobody is 100% sure of that those rules are.
For Individuals: Insurance and Public Assistance
There are dozens of sites where families and individuals can “raise funds for loved ones in need.” The range of personal causes is infinite, and many of the stories told on these sites are truly heart-wrenching. My Facebook newsfeed seems to have three or four of these crowd funding pleas every week.
People want to raise money for medical bills (for a human or a dog), fund a child’s dream (summer camp, a trip to a leadership camp, scholarships), help someone recover from a disaster (a fire, tornado or hurricane), or solve problems caused by ill health, age, or long-term unemployment (save-my-house pleas, help me fight my insurance company, etc.). One thing I suspect that few of the people posting their stories on crowd funding websites realizes is that by asking for help paying for medical bills, they could be helping an insurance company’s bottom line instead of their own.
That’s because a lot of insurance policies come with adjustment clauses that make the insurance company liable for a lower percentage of the total cost if a third party (like a crowd funding site, trust, or donation site) is responsible for part of the bill, too. So if you have $100,000 in medical bills, and you raise $10,000 on a crowd funding site to help pay those medical bills, you could find yourself facing even higher bills if your insurance company deducts the money you raised from its portion of the bill. (This is not legal in all states, but it is a possibility in many.)
More importantly, if you are receiving any kind of public assistance such as Medicaid, SSI, food stamps, or help from a county hospital system, the money you raise from crowd funding is probably reportable as income that could make you ineligible for assistance, or reduce the amount of assistance you can receive.
Does this mean you shouldn’t use a crowd-funding service to raise money in the event of a disaster? No, it simply means that you have to make it clear in your posting WHAT the money is for. Instead of raising money to pay medical bills, raise money to cover “family expenses” for travel, lost time at work, and other needs. That’s what a benefactor did for the families of the circus performers injured in the Ringling Brothers show in Rhode Island this summer: she put together a crowd-funded site that helped pay the travel and living expenses of family members who stayed in Rhode Island with the injured performers.
Also, if you are receiving public assistance, make sure that you know the impact that raising money can have on your benefits. If you raise $5,000 but lose $10,000 in benefits, it’s not a good deal — but if you raise $10,000 and lose $2,000 in benefits, then it’s a very good deal.
For Individuals: Tax Issues
Money raised through crowd-funding sites that is paid directly to an individual is most likely taxable income. That means that if it’s over $600, you’ll owe federal income taxes on the money, and may also owe state income taxes depending on where you live. Money raised through crowd funding is “ordinary income” UNLESS you specify in your crowd funding posting that it is for business purposes. Then it may be self-employment income — which is taxed at a higher rate than ordinary income.
You may be able to offset the taxes on the money you raise if the money was spent on tax deductible items, such as rebuilding after a fire or other disaster, medical bills, or child care. That, of course, requires filing a “long form” tax return that itemizes deductions — and this year’s medical bills are only deductible if they are more than 10% of your adjusted gross income.
Many crowd funding websites report the income against the social security number of the person who sets up the funding project — so if you are raising money for a not-for-profit organization or for someone else, make sure that the site has the correct tax ID so that you don’t wind up paying taxes on money you never received.
For Individuals: Privacy and Safety
Personal privacy and safety issues are issues that can’t be stressed enough when it comes to crowd funding. Let’s start with the question of privacy. Say that you’re in dire need of help with bills this year — and four years from now, you’ve paid off your bills, and you’re up for a prestigious job. Will the first Google results for your name still reference your old crowd-funding plea? Will that hurt your job search?
That’s the most common privacy issue that comes with crowd funding: a search engine result that lasts far longer than the situation that led you to crowd funding in the first place. But there are other kinds of privacy and safety issues, too.
Let’s consider the problems faced by a woman named Nancy, whose crowd funding plea wound up on my Facebook page a month or so ago. Her long-time partner had died, without leaving a will. Since Nancy had been caring for her partner, she hadn’t been working, and the couple was behind on the mortgage when the death occurred — and, coming home from the funeral, Nancy found that a water leak had caused significant structural damage that wasn’t covered by homeowner’s insurance.
Helpful friends shared Nancy’s story on social media, adding details like where they met Nancy, how wonderful she and her partner had been, and the name of the bank that was pressuring her for back mortgage payments on a house that wasn’t habitable. Someone wouldn’t have to be Sherlock Holmes to very quickly pinpoint where Nancy lived from the information supplied by these helpful friends. And just how many recently widowed women would really like for all their personal details to be broadcast to strangers as part of a fund-raising effort?
I don’t think any of Nancy’s well-meaning friends thought about the possibility of endangering her with what they posted, but that’s exactly what happened. Nancy didn’t do herself any favors during the process of trying to raise the money she needed for household repairs, either. She sent a series of updates to donors that included photos of the home repairs in progress (and inadvertently, her license plate and street address), the name of contractors she was working with (easy to spot their trucks once you knew the neighborhood, even if she hadn’t already given away her own address), and even a mention of the kennel where her dogs were being cared for during the repairs, along with her habit of visiting them every afternoon around 3 p.m. (thus providing a specific location where she could be spotted and tracked).
So before you start a campaign, stop and think about what information you are willing to give away in order to raise the money, and what safety measures you can put into place to protect yourself and your family while you do it. Some information — home address, descriptions of cars, photos of car license plates, cell phone numbers, the name of the school a child attends — should never be posted online.
Three Crowd Funding Issues for Donors or Investors
Like the businesses and individuals who turn to crowd funding sites for cash, donors or investors need to take time to think through some issues before they provide credit card details. The three major issues for those providing the cash are:
- Privacy and safety concerns
- Tax issues
Privacy and safety concerns cover questions like who processes the donor’s credit card information, who has access to their personally identifying data, and how secure the transaction is. For example, my husband was looking for an unusual present for my birthday a couple of years ago, so he decided to make a donation to a film about magician and skeptic James Randi, who has worked tirelessly to expose scam artists who pose as mediums and psychics.
When it comes to donating to worthy causes, remember that donations made on the crowd funding sites are generally not tax deductible. I have seen instances where friends could have made a tax-deductible donation to an organization — or a contribution to the same organization through a crowd-funding site. You have to decide for yourself if your donation is large enough to make a difference on your taxes. For me, a donation has to be more than $250 for it to matter. What’s your threshold for contributions that don’t deliver a tax write-off?
Also, remember that no matter how worthy an individual’s sad tale sounds, donations made to help someone pay medical bills, repair storm damage, or send a kid to college are not tax deductible for the donor — while contributions to recognized charities might accomplish the same purpose while delivering a tax deduction as well.
Last, but not least, crowd funding sites are filled with scams. It’s sad, but true. The websites can’t check out every claim made by every fund raiser. So the dog injured by a callous human who is in dire need of vet care might not exist — or might have already succumbed to injuries, and the sick child who wants to see Disney World before time runs out might be very surprised to hear that she is sick.
Whether the fund raiser is an individual or a charity, it’s up to donors to determine for themselves whether their money is going where they want it to go — and how much they are willing to donate without knowing for certain who will benefit from it. Many legitimate charities use crowd funding sites, and I feel sure that most of the businesses and individual who seek help there will use the money for its intended purposes.
But there are always some thieves and con artists out there who make everyone else look bad. So take the time to decide how much you’re willing to risk, and whether or not there are independent sources of information that will help you make a wise choice.
The first information source is Google. One of my Facebook friends is a proud graduate of the University of Oklahoma, and recently posted a plea from a family who said that their home was destroyed in a Mother’s Day tornado in a small Oklahoma town. As it happened, I’d been in Oklahoma two days before the “storm”, and had driven through the town mentioned in the posting. It was bright and sunshiny with nary a storm cloud in sight. Of course, tornados can sweep across the prairies in minutes.
So I checked news sites, and none of them mentioned a tornado in that part of the state in the past year. In fact, there hasn’t been a tornado on the ground in that particular town in over 20 years. My home in Texas is less than 100 miles from the Oklahoma border, and it’s unlikely tha a tornado could have been on the ground causing significant damage without making news in my part of Texas.
My friend was just trying to help — but the person who posted that plea knew that most people would simply donate a few dollars without checking the facts. Don’t help scammers line their pockets. In fact, they reached their goal of raising $5,000 — and the donors have no way of knowing that the whole thing was a scam. Do your homework before you click “donate”.