Introducing U.S. equity crowdfunding: Potential risks and tax implications

The SEC’s recent adoption of “regulation crowdfunding” rules has opened the door for small investors to participate in a new type of investing market.¹ Regulation crowdfunding allows eligible companies to raise money under the crowdfunding exemption from the SEC registration rules under the Securities Act of 1933, beginning May 16, 2016.² Eligible companies can offer up to $1 million in each 12-month period, an amount that is adjusted annually for inflation and is currently $1.07 million. Individual investors are also subject to investment limits that vary depending on their income and net worth.³

Now organizations can acquire equity using an innovative fundraising model known as crowdfunding, which is based on the idea that an organization can more easily obtain capital from a “crowd” of small investors than from a few large investors. However, small investors participating in this market may invest without fully understanding the risks and tax implications of their decision. Therefore, it is important for tax advisers to understand how this market works, what risks are present, and how to treat these investments for tax purposes.

Before the SEC formally adopted the equity crowdfunding rules, crowdfunding was popularized by websites that facilitate fundraising for organizations (e.g., Kickstarter.com, Indiegogo.com). To obtain contributions from backers, organizations offer rewards generally proportionate with the size of a contribution. These rewards range anywhere from a small acknowledgment on the company website to a party with the company founders. However, crowdfunding organizations previously could not offer equity in exchange for contributions because of regulatory restrictions on public offerings.

Although these rules existed to protect small investors, the high-profile successes of certain rewards-based crowdfunding projects rankled backers who thought they should share in the success made possible by their support. For example, the virtual reality technology company Oculus Rift received $2.4 million in (nonequity) funding from its Kickstarter campaign and was purchased by Facebook for $2 billion.⁴ Contributors who had initially backed Oculus Rift did not receive any share of the $2 billion acquisition proceeds; by seeking out nonequity investors Oculus Rift avoided SEC registration rules that severely restricted the number of “nonaccredited” investors.⁵

However, the restrictions limiting equity crowdfunding offerings were reduced by the JOBS Act, which added a crowdfunding exemption to the registration requirements under the Securities Act of 1933. Organizations can now offer equity using crowdfunding (up to the limits described above) without complying with the full requirements of the SEC registration process. While organizations must still comply with some guidelines (e.g., an organization must obtain audited financial statements in some cases), these rules’ requirements are substantially less complex than those for a public company offering that must meet the registration requirements of the Securities Act of 1933. This change has led to the rise of equity crowdfunding platforms (e.g., StartEngine.com), which are now accepting investments on behalf of organizations. A number of successful campaigns have already been funded on these equity crowdfunding platforms (e.g., Elio Motors, Hylete, Rayton Solar, etc.), increasing the potential that these investment opportunities will continue to grow in popularity and attract more small investors in the future.

Potential risks

While at first glance it seems that equity crowdfunding is a winning proposition for both investors and entrepreneurs, small investors may not fully grasp the inherent differences between traditional markets and the equity crowdfunding market. Historically, nonaccredited investors could only invest in the traditional stock market, where companies are at a more mature stage of growth than a startup company. In contrast, startup organizations carry a substantial risk of failure, with some studies estimating the failure rate to be as high as 75%.⁶ This increased risk of failure could put equity crowdfunding investors at a high risk of losing their total investment. While the SEC acknowledges the risks inherent to equity crowdfunding, advisers should caution clients who wish to participate in these markets to consider the high risk of loss before making these investments.⁷

Another area of risk for investors is the valuation of the company itself during the offering, which can determine the ownership stake of incoming investors. Traditional public offering valuations are the result of an exhaustive negotiation between knowledgeable potential investors and the offeror, resulting in a final stock price that is generally agreed upon by the parties involved. However, the valuation of equity crowdfunding organizations is more one-sided, as the organization offering the equity determines the price without much input from potential investors. This process could lead to overly optimistic valuations that protect the equity stake of current ownership at the expense of incoming investors. Equity crowdfunding investors could be overpaying for their ownership stake, limiting their rate of return if the organization does well in the future. Advisers should caution clients to carefully review whether the offering is overvalued.

Possible tax implications

As equity crowdfunding is relatively new in the United States, it is unclear how these investments should be treated for tax purposes. Accordingly, equity crowdfunding investors should be aware of the special tax implications, making it important for tax advisers to understand how they should approach an equity crowdfunding discussion with clients. The following section focuses exclusively on the tax implications of equity crowdfunding. For investors, the tax treatment of the initial investment may follow the same general rules as stock purchases under Sec. 351. However, as many equity crowdfunding organizations offer different ownership interests in exchange for investment, practitioners should confirm the exact ownership exchanged in the transaction before assuming it is tax-free under Sec. 351. As long as the qualifications of Sec. 351 are met, the startup or the investor will not recognize any gain or loss upon making the initial investment.

Equity crowdfunding regulations stipulate that investors generally cannot sell their stock within one year of investment.⁸ Despite this limitation, the sale of equity crowdfunding stock will tend to follow the same tax rules that apply to other publicly and privately traded stock. If the stock can be sold, capital gains and losses can be recognized and reported on Schedule D, Capital Gains and Losses, of Form 1040, U.S. Individual Income Tax Return. Any excess net capital losses can be deducted against ordinary income up to $3,000.⁹ However, special tax provisions could be available to a client depending on the type of investment the client made. Because equity crowdfunding organizations tend to be smaller startup companies, their stock could be classified under two different Code sections that provide favorable tax treatment for small business investors.

Sec. 1202: Qualified small business stock

First, preferential treatment of gains on the sale of the stock is available under Sec. 1202 if the stock meets the qualified small business (QSB) stock rules. To be QSB stock, the stock, when issued, must be stock in a C corporation that, at all times after Aug. 10, 1993, and before the date of the stock’s issuance (and immediately after the stock’s issuance), has never had gross assets in excess of $50 million. The individual must have acquired the stock directly or through an underwriter at its initial issuance in exchange for money, property, or services. Additionally, the corporation must have met an active business test and have been a C corporation during substantially all of the period the taxpayer held the stock and must meet de minimis rules regarding purchases of its own stock.

If an investor sells QSB stock at a gain, the investor can either take a full exclusion of the gain or defer the gain entirely. Sec. 1202(a)(4) allows exclusion of 100% of any gain from the sale of QSB stock if it is held for longer than five years. This exclusion is limited to the greater of $10 million, less the eligible QSB stock gain attributable to dispositions of the stock of the corporation taken into account by the taxpayer in prior tax years, or 10 times the basis of the QSB stock issued by the corporation and disposed of by the taxpayer during the tax year.¹⁰

Another option is a deferral of gains available under Sec. 1045 to investors who reinvest the proceeds from the sale of QSB stock held more than six months into certain replacement QSB stock within 60 days of the sale. In this case, Sec. 1045 allows for a deferral of the gain until the sale of the replacement stock (depending on how much of the proceeds from the sale of the QSB stock are invested in the replacement QSB stock). To take advantage of Sec. 1045, the replacement stock must meet the QSB active business test and the taxpayer must elect for Sec. 1045 to apply. The deferral amount cannot exceed the cost of the newly purchased stock.

Example 1: An investor has purchased equity crowdfunding stock for $500 that is designated as QSB stock. After five years, the company is purchased by another company, and all the original investors are bought out. The buyer pays the investor $750 for the stock, so the investor realizes a $250 gain. Under Sec. 1045, if the investor reinvests the proceeds from the sale of the stock in another QSB (it does not have to be a crowdfunding transaction) and elects the application of Sec. 1045, the $250 gain is deferred. If the investor does not reinvest the proceeds, then under Sec. 1202, 100% of the gain, or $250, is excluded from income.

Sec. 1244: Small business corporation stock

Preferential treatment of losses as ordinary could also be available for equity crowdfunding investors under Sec. 1244 if the organization can qualify as a small business corporation (SBC). While many of the requirements for an SBC are similar to a QSB, careful attention must be paid to the differences. To aid the reader, the sidebar “Requirements for QSB and SBC Stock” compares the two Code sections and their distinct requirements.

Sec. 1244 SBC stock is directly issued to an individual or partnership as part of an initial issuance. To qualify, the company must have aggregate capital (i.e., contributed capital and paid-in surplus, including the capital being contributed at issuance of the stock) of less than $1 million at the time of issuance. Additionally, the company must have greater than 50% of gross receipts from other than royalties, rents, dividends, interest, annuities, and gains from sales and trades of stocks or securities during the past five tax years before the loss.¹¹ If a company has not been in existence for five years, it may calculate its gross receipts percentage based on the tax years ending before the year of loss, or if less than one year, the amount of time before the loss.¹² However, if the corporation’s deductions (other than the net operating loss and dividends received deductions) were more than its gross income during the applicable period for the corporation, the 50% test does not apply.

The instructions for Form 4797, Sales of Business Property, recommend keeping adequate records to separate Sec. 1244 stock from any other stock owned in the same corporation. If SBC stock is sold at a loss, Sec. 1244 rules allow the taxpayer to take the loss as an ordinary loss instead of a capital loss, up to $50,000 or $100,000 if married filing jointly.¹³

Example 2: An investor purchases $5,000 of equity crowdfunding stock that can be treated as an SBC. Just over one year later, the company sells to another company, and the investors are bought out. The value of the business has declined, and the investor is given only $1,000 for all of the stock, creating a $4,000 loss. Since the stock was SBC, the entire $4,000 loss would be deductible as an ordinary loss. If the stock were not SBC, only $3,000 would be currently deductible (unless the investor had other capital gains to offset), with the remaining loss carried over to future years.

Loss on worthless securities

Additionally, stock may not need to be sold to take a loss. If the company fails and the stock is deemed worthless, then the stock is deemed sold on the last day of the tax year for a value of $0.¹⁴ To be considered worthless, the stock must have no residual value. Because equity crowdfunding organizations are thinly traded, determining whether a stock is worthless may not be easy. If the equity has any value at all (even 1 cent) or has substantially declined in value (but still not zero), then it is not considered worthless.

Regulations for Sec. 165 provide some characteristics that can help determine whether stock is actually worthless, such as when a corporation is experiencing insolvency, bankruptcy, or liquidation. However, none of these factors alone can prove that the stock is worthless, and care must be taken to ensure that the stock has no value before the worthless stock deduction is taken. Alternatively, the worthless stock deduction can be taken if stockholders abandon their investment by giving up all rights to the stock and receive no consideration for it. If the stock is determined to be worthless, the loss will be treated as either a capital loss or an ordinary loss if the stock qualifies as small business stock under Sec. 1244.

Going forward

Tax advisers should familiarize themselves with the different issues raised by equity crowdfunding as this form of investing becomes more popular. Because many startup companies are prone to failure, investors should be aware of the potential risk of loss in this market. Additionally, the tax treatment of these investments could vary depending on the financial state of the company when the stock was issued. For instance, some equity crowdfunding investments could be treated as QSB stock, potentially changing how gains are treated upon the sale of the investment.

While this discussion only serves as a brief overview of tax rules that could affect these transactions, many exceptions could potentially change the tax treatments outlined in this article. Because equity crowdfunding is still in its infancy, the tax treatment of these transactions could be subject to future IRS action, creating an uncertain environment for practitioners and their clients.  

Footnotes

¹SEC Regulation, RIN 3235-AL37 (10/30/15), available at www.sec.gov.

²Securities Act of 1933, P.L. 73-22, Section 4(a)(6), added by the Jumpstart Our Business Startups (JOBS) Act, P.L. 112-106.

³SEC, “Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers” (rev. April 5, 2017), available at www.sec.gov. Eligible companies must be U.S. companies and cannot already be Exchange Act reporting companies. Certain investment companies also cannot participate, as well as certain bad actors and those who have not complied with the crowdfunding reporting requirements for two years. Finally, the rules prohibit companies that have no business plan or that plan to engage in a merger or acquisition with another company.

⁴Griffith, “Dear Kickstarters: Stop Complaining About Oculus Deal,” Fortune (March 27, 2014), available at fortune.com.

⁵An accredited individual investor is defined by the SEC as either (1) someone with total earnings of $200,000 ($300,000 with a spouse) in each of the two previous years and who reasonably expects the same for the current year or (2) has a net worth of $1 million, excluding the value of the individual’s primary residence (either together with a spouse or alone). Individual investors that do not meet either criterion are considered nonaccredited (SEC Regulation D, 17 C.F.R. §230.500 et seq.).

⁶Gage, “The Venture Capital Street: 3 Out of 4 Start-Ups Fail,” The Wall Street Journal (Sept. 20, 2012), available at www.wsj.com.

⁷SEC Crowdfunding Proposed Rules, RIN 3235-AL37 (10/23/13), available at www.sec.gov.

⁸SEC, Updated Investor Bulletin: Crowdfunding for Investors (rev. May 10, 2017), available at www.sec.gov.

⁹Sec. 1211(b).

¹⁰Sec. 1202(b).

¹¹Sec. 1244(c).

¹²Sec. 1244(c)(2)(A).

¹³Sec. 1244(b).

¹⁴Sec. 165(g).