California: When is crowd-sourced funding taxable income?

Crowdsourcing is the practice of engaging a crowd, often through the use of social media, for a common goal, like raising money.

Crowdsourcing was made possible, in part, by the 2012 Jumpstart Our Business Startups Act (JOBS Act), which eases regulations that would restrict crowd engagement activities meant to raise startup capital. For example, one section of the JOBS Act directs the Securities and Exchange Commission (SEC) to revise rules that prohibit certain general solicitation or advertising activities when the purchaser is an accredited investor. Another provision exempts certain people from having to register with the SEC as broker-dealers.

A March 2015 Wall Street Journal blog tells the story of former NBA star Yao Ming, who plans to raise $3 million via Crowdfunder. His Napa Valley company, Yao Family Wines, intends to use the money for a Napa Valley visitor center and a Shanghai tasting room. In return for an investment of as little as $5,000, the company promised that investors would receive “100% of all distributions out of free cash flow generated by the winery until they receive their investment back plus a 2% preferred return annualized. Thereafter they will receive 25% of all distributions out of free cash flow. Finally investors will receive 25% of any returns if the company gets acquired or has an IPO.”

With over $8 million in wine sales, Yao Family Wines describes itself as the biggest seller of high-end California wines in China by value.

One question that invariably arises with operations like this is whether the funds are taxable income. The California Franchise Tax Board (CFTB) recently issued practitioner guidance on that question, ultimately concluding that in most cases amounts raised are includable as taxable income unless specifically exempted by law. However, it should be noted that the answer depends on the facts and circumstances of each case, like how the funds will be used, and what the donor receives in return for his funding commitment.

The CFTB suggests that “when in doubt about whether or not some of your income is taxable, do not guess!”

According to The New York Times, many inexperienced entrepreneurs are “tripped up by the taxman.” This is so because in many states, sellers are subject to sales tax on anything they sell to an in-state buyer, but the type of goods triggering a filing obligation varies. And particularly relevant to crowdfunds is when an entrepreneur offers something intangible to attract funding, like an e-chat; some states tax these intangibles in the same way that they tax tangible goods.