Equity crowdfunding allows anyone to invest in early-stage startups. Often the minimums are only about $100. To participate in equity crowdfunding, you will sign up for a site like Republic, SeedInvest, Netcapital or StartEngine. You can then browse the investment profiles, which include details about the products or services, the market opportunity, the team, the IP (intellectual property), the competitive environment and so on.
But of course, there are some drawbacks.
For example, crowdfunding taxes can get complicated. After all, unlike a typical stock you would buy on a stock exchange, an investment in a private deal includes contracts, shareholder agreements and various investment structures.
So, what are the main things you need to know about crowdfunding taxes? Well, first of all, there are capital gains and losses. Let’s take an example: Suppose you buy shares in Startup Corp for $10,000. And after a few years, the value of your holding rises to $30,000. In this case, you have a capital gain of $20,000 ($30,000 minimums $10,000), assuming you sell your shares.
Then what is the tax you pay on this? It depends on your holding period. If it is a year or less, then you will have a short-term gain and the taxes will be the same as for your ordinary income (such as your wages). However, if the holding period is more than a year, then you get preferential capital gains rates. This means that the maximum is only 20%.
Now there may be another tax benefit, depending on the type of security you own. “One interesting strategy for investors is the Qualified Small Business Stock designation where a gain of up to 10 times your investment is tax-free,” said Paul Miller, who is a CPA and managing partner at Miller & Company LLP. “Although, there are qualification requirements for this treatment that would still apply in a crowdfunding raise if structured properly to comply with the tax code.”
Something else: You can place your crowdfunding shares in an IRA, which can provide tax deferral. But you will need to setup a self-directed plan.
“Some of the largest providers in the space, such as RocketDollar and AltoIRA, even have partnerships and integrations with some of the larger equity crowdfunding portals,” said Brian Belley, who is the founder of Crowdwise.org and VentureWallet.
OK then, what if Startup Corp has lots of problems and you wind up selling your shares for $5,000? What can you do?
The IRS allows you to detect up to $3,000 in capital losses against your ordinary income for the year. You can then use the remaining losses to offset any capital gains. Moreover, if you still have losses left, you can carry these forward to future tax years.
Convertible Notes and Crowdfunding Taxes
When it comes to crowdfunding campaigns, you may not necessarily receive shares when you make an investment. Instead, you will get a debt instrument called a convertible security. As a result, when there is a certain trigger event – like another funding, acquisition or IPO – the note will be converted into equity. Usually this is at a discount to the valuation of the transaction, say 20%.
Convertible notes are attractive to companies since they generally require less paperwork than a traditional equity financing. They are also more favorable with limited liability companies (LLC).
To understand why, it’s important to know that this type of corporate form allows for the pass-through of gains and earnings to the shareholders. The result is that they will receive schedule K-1s every year and may even have to pay some taxes.
“However, since convertible note holders don’t have equity in the company until they convert, this can be one way that investors may avoid the potential issue of receiving schedule K-1 forms,” said Belley.
However, convertible notes have their drawbacks as well. To this end, you may have to pay taxes on interest that you do not receive. This is because a company will usually accumulate these payments and convert them to equity when there is a conversion. Yet the IRS does not take this into account. The agency still thinks you have received income
Thus, when it comes to crowdfunding taxes, it’s a good idea to get a qualified expert who understands the intricacies of these holdings.
Tom Taulli (@ttaulli) is an advisor/board member for startups and author of various books and online courses about technology, including Artificial Intelligence Basics, The Robotic Process Automation Handbook and Learn Python Super Fast. He is also the founder of WebIPO, which was one of the first platforms for public offerings during the 1990s. As of this writing, he did not hold a position in any of the aforementioned securities.
Investing through equity and real estate crowdfunding or asset tokenization requires a high degree of risk tolerance. Despite what individual companies may promise, there’s always the chance of losing a portion, or the entirety, of your investment. These risks include:
1) Greater chance of failure
2) Risk of fraudulent activity
3) Lack of liquidity
4) Economic downturns
5) Dearth of investor education
Read more: Private Investing Risks
