Crowdfunding is a widely used method for individuals to raise funds, whether it be for a charitable purpose, a business, or a specific event. As online crowdfunding campaigns have become more common, questions arise regarding the role that tax law has to play in that phenomenon. For example, when the underlying motivation is primarily donative, questions arise as to whether the transfer is income to the recipient or provides a charitable deduction to the donor.

In this week’s feature article, Prof. Eyal-Cohen examines investment crowdfunding, which involves companies offering common stock, convertible debt, tokens, coins, or other assets to the general public using the internet. The questions that she raises are descriptive (how traditional rules of tax law are to be applied to this relatively new phenomenon), normative (whether Congress should encourage investment crowdfunding by means of tax incentives), and administrative (how to clarify the tax consequences for the participant in various crowdfunding initiatives).

The author begins by describing the tax benefits for investment crowdfunding in the United Kingdom. There, “Enterprise Investment” programs provide relief for a certain portion of qualifying investments. Generally speaking, contributions of capital to a company are exempt from taxation at the entity level only if they are used solely for the purpose of exchanging equity in the firm. There is a research and development credit, which provides tax relief for up to 33 percent of the amount that was spent on activities that meet the criteria. Moreover, there are four specific programs that aim to assist small and medium-sized businesses in luring investments: the Enterprise Investment Scheme (“EIS”), the Seed Enterprise Investment Scheme (“SEIS”) the Social Investment Tax Relief (“SITR”) program, and the Venture Capital Trust (“VCT”). These rules were specifically designed to incentivize the undertaking of risks, under the theory that the spill-over effects of calculated risk-taking benefit the overall economy.

In the United States, neither the federal government nor any state other than Virginia provides tax benefits specifically geared toward investment crowdfunding. Accordingly, the article goes on to scrutinize traditional tax rules as they apply to the financial paradigm of crowdfunding as a means of capital infusion. As the author notes, while such platforms offer a democratized approach to fundraising, they introduce a unique set of challenges. The article considers IRC § 351, which governs the transfer of property to a corporation in exchange for stock; IRC § 1202, which governs Qualified Small Business Stock (QSBS); IRC § 1244, which in certain instances classifies losses on the sale of QSBS as ordinary; and IRC § 1045, which defers tax on capital gain realized on the sale of QSBS. On the state level, over thirty states offer Angel Tax Credits aimed at stimulating investment in fledgling companies or small enterprises. These credits are intended to incentivize angel investors, who are individuals who provide financial support to small enterprises during their early phases of growth. The objective is to cultivate innovation, stimulate economic expansion, and facilitate the creation of new jobs. Local governments provide tax incentives with the goal of promoting more investment in businesses that are creative and have the potential for rapid growth. This, in turn, helps to foster the formation of a strong entrepreneurial environment. Accredited investors also have the opportunity to utilize income tax credits – mostly refundable – to reduce the amount of income tax that they are required to pay on their individual or corporation income. The only tax benefit in the U.S. that specifically targets investment crowdfunding can be found in the Virginia tax system. The qualifying Equity and Subordinated Debt Investments Tax Credit, enacted in 2013, offers an income tax credit of up to $50,000. This benefit is equivalent to 50% of the qualifying investments made via online platforms such as general solicitations, online brokers, or crowdfunding portals.

The article concludes by suggesting that Congress establish safe harbor regulations for crowdfunding investors. This would grant taxpayers peace of mind, knowing that their crowdfunding investments will be eligible for tax benefits such as exempting capital gain, claiming ordinary losses, rolling over their basis to their next qualified investment. Treasury should promulgate regulations that clearly define the criteria for determining whether crowdfunding revenues should be classified as excluded from gross income or reported as taxable income. Finally, the IRS needs to implement unambiguous directives about tax benefits for crowdfunding and provide advance tax assurances by issuing private letter rulings.

It is perhaps a truism that tax law must continuously adapt to a changing economic landscape. Old rules need to be revisited, and innovative responses need to be considered. This article is a timely reminder.