Crowdsourcing and Taxes

[Burzmali]

I've been following the crowdsourcing wave (kickstarter, indiegogo, etc.) for the last year or so and I've seen more than a few project bemoaning the ravages of the tax man regarding funds collected via crowdsourcing drives.

It would seem to be that receiving revenue in the form of pre-orders is by necessity offset to some extent with the liability of providing the product pre-ordered as well as any swag, as well as consumed by balancing "uncollected wages" accounts and other general bookkeeping. Are these projects just deficient in the CPA department or does this form of funding a project really hold such a disadvantageous tax position?

[webhick]

This could be a cash basis vs accrual basis problem. On cash basis, you claim your income as you receive it (not when you bill for it) and claim your expenses as you pay it (not when you're billed for it). Inventory could be affecting things as well, since whatever you spend on that inventory (parts or the item itself) sits as an asset account on the books until you actually sell it. Then the amount you spent gets shifted to the Cost of Goods Sold expense account, and the income from the sale added to your income account. Pre-orders for a product that doesn't exist yet could pose a problem because there's been no direct output for manufacturing that product.

Or I could have misunderstood the whole situation. In which case, just ignore me.

[Famspear]

I checked, and Wikipedia has had an article on this term ("crowdsourcing") since May 2006. I've never even seen or heard of this term anywhere, until just now in this thread.

Wikipedia defines it this way:

Crowdsourcing is a distributed problem-solving and production model. In the classic use of the term, problems are broadcast to an unknown group of solvers in the form of an open call for solutions. Users—also known as the crowd—submit solutions. Solutions are then owned by the entity that broadcast the problem in the first place—the crowdsourcer. The contributor of the solution is, in some cases, compensated either monetarily, with prizes, or with recognition...

Yada-yada-yada. Hello?

I doubt that the term "crowdsourcing" is old enough to have a "classic use."

In plain English, can someone explain what "crowdsourcing" is? Perhaps by providing an example?

[Famspear]

Answer: Wikipedia itself would be an example of crowdsourcing.

[Famspear]

I've been following the crowdsourcing wave (kickstarter, indiegogo, etc.) for the last year or so and I've seen more than a few project bemoaning the ravages of the tax man regarding funds collected via crowdsourcing drives.

It would seem to be that receiving revenue in the form of pre-orders is by necessity offset to some extent with the liability of providing the product pre-ordered as well as any swag, as well as consumed by balancing "uncollected wages" accounts and other general bookkeeping. Are these projects just deficient in the CPA department or does this form of funding a project really hold such a disadvantageous tax position?

Can you give a specific example?

By the way, you have certainly identified a fundamental concept, although I would rephrase it this way:

.....receiving funds [not "revenue"] in the form of pre-orders is by necessity offset to some extent with the liability of providing the product pre-ordered....

If you haven't provided the product or service yet, you haven't yet received "revenue." You've received only "the money" -- the "funds." Even a cash method taxpayer should be able to record this transaction as a debit to cash and a credit to liability. There is no revenue event at this point.

There are tax law exceptions to this rule, though. For example, if an employee receives compensation from his employer in December 2011, in advance of the rendering of those services in January 2012 (admittedly an unusual situation), the employee is still generally going to have to report the compensation as income on his 2011 return (and it will be reported that way by the employer on the employee's 2011 Form W-2 report).

[The Observer]

Can you give a specific example?

I am not sure if you understand what Burzmali was talking about. A visit to Kickstarter.com will probably make the issue clearer to you.

In my case, a group of people calling themselves Team Ubi wants to develop, build and sell a product called Ubi. Instead of going through the hazardous route that most startup companies go through in trying to attract investment capital to produce a product with the risk that the product doesn't sell, Kickstarter allows Team Ubi to solict levels of donations towards the initial production of product. Different levels of donations provide rewards of varying value, usually including at the higher levels the actual product once it comes into existence. A goal is set in order for the project to be considered funded successfully; if the goal is not met then the project is cancelled and the donors do not have to surrender their money.

[Burzmali]

Can you give a specific example?

I am not sure if you understand what Burzmali was talking about. A visit to Kickstarter.com will probably make the issue clearer to you.

In my case, a group of people calling themselves Team Ubi wants to develop, build and sell a product called Ubi. Instead of going through the hazardous route that most startup companies go through in trying to attract investment capital to produce a product with the risk that the product doesn't sell, Kickstarter allows Team Ubi to solict levels of donations towards the initial production of product. Different levels of donations provide rewards of varying value, usually including at the higher levels the actual product once it comes into existence. A goal is set in order for the project to be considered funded successfully; if the goal is not met then the project is cancelled and the donors do not have to surrender their money.

That's the jist of it, but I'll give the specific example that inspired this thread.
(the kickstarter project is at http://www.kickstarter.com/projects/pri ... 3d-printer)

Brook Drumm wanted to make cheap 3-D printer kits. He figured that he could rework an existing design and provide full kits for around $500. He set the goal for his kickstarter campaign at $25,000, presumably some kind of break even point for the effort invested in the new design. A month later he has raised $830,000, which includes orders for over 1,000 kits plus various other special orders (fully assembled instead of in kit form, etc). After Kickstarter and Amazon take their cuts and pledges fall through, he has probably raised around $750,000. At some point after this, he claims that he got hit with a $330,000 tax bill from the IRS. That seems odd to me. He has taken orders for 1,000 units at a (ballpark) cost of $300 a piece in parts, plus labor to cut, kit and ship them, which he is contractually obligated to deliver. I don't see how his books could show enough income to justify that tax bill.

[Famspear]

......Brook Drumm wanted to make cheap 3-D printer kits. He figured that he could rework an existing design and provide full kits for around $500. He set the goal for his kickstarter campaign at $25,000, presumably some kind of break even point for the effort invested in the new design. A month later he has raised $830,000, which includes orders for over 1,000 kits plus various other special orders (fully assembled instead of in kit form, etc). After Kickstarter and Amazon take their cuts and pledges fall through, he has probably raised around $750,000. At some point after this, he claims that he got hit with a $330,000 tax bill from the IRS. That seems odd to me. He has taken orders for 1,000 units at a (ballpark) cost of $300 a piece in parts, plus labor to cut, kit and ship them, which he is contractually obligated to deliver. I don't see how his books could show enough income to justify that tax bill.

Without more specific information, it's hard to provide an answer without writing an essay.

Even if he actually received the $830,000, then what was the IRS rationale for asserting that he owes $330,000 in federal income tax? If he set the deal up properly, the receipt of the funds would simply have been capital contributed to a new business enterprise. The key phrase is "if he set the deal up properly". For example, did the contributors (and I'll just use the word "contributors" due to lack of a more specific term here) actually receive a legally enforceable property right of some sort in return for contributing the cash -- such as shares of stock or other ownership in the enterprise, or some sort of legal right to be repaid (i.e., did the enterprise have a clear legal obligation to pay the contributors back)? Obviously, those who had actually ordered these kits would presumably have a valid contractual right of some sort. But what about those people (if any) who just intended to be "investors"?

The Internal Revenue Service might have concluded (possibly incorrectly) that he just didn't have a clearly defined, legally enforceable obligation to provide something to his contributors -- so that the receipt of the funds by him was deemed to be income to him. Again, this is all conjecture, in the absence of very specific information about what the IRS position was and what the details of the deal were.

Off topic: Depending on how carefully the deal was or was not structured, he could also have a federal or state securities law problem. Under securities laws, lots of deals that you might not think are covered by the laws are indeed covered by the laws, and often it's up to the person pushing the deal to prove that his deal is somehow exempt.

[The Observer]

For example, did the contributors (and I'll just use the word "contributors" due to lack of a more specific term here) actually receive a legally enforceable property right of some sort in return for contributing the cash -- such as shares of stock or other ownership in the enterprise, or some sort of legal right to be repaid (i.e., did the enterprise have a clear legal obligation to pay the contributors back)? Obviously, those who had actually ordered these kits would presumably have a valid contractual right of some sort. But what about those people (if any) who just intended to be "investors"?

And this may be where the problem is, in terms of whether the IRS understood correctly that the manufacturer in essence only received a capital contribution or if the manufacturer didn't follow the correct steps in setting up this plan. Typically, the only legal or contractual item to come out of these crowdsourcing projects is the actual product itself. If you skim through the various projects, however, there are lower levels of donations that basically only grant "bragging rights" or some small token of appreciaton for pledging a a dollar or two towards the project. And this is may be part of the problem, if the manufacturer hasn't clearly identified how much of the funding is going to result in product going back to the investors.

[Arthur Rubin]

Can you give a specific example?

I am not sure if you understand what Burzmali was talking about. A visit to Kickstarter.com will probably make the issue clearer to you.

In my case, a group of people calling themselves Team Ubi wants to develop, build and sell a product called Ubi. Instead of going through the hazardous route that most startup companies go through in trying to attract investment capital to produce a product with the risk that the product doesn't sell, Kickstarter allows Team Ubi to solict levels of donations towards the initial production of product. Different levels of donations provide rewards of varying value, usually including at the higher levels the actual product once it comes into existence. A goal is set in order for the project to be considered funded successfully; if the goal is not met then the project is cancelled and the donors do not have to surrender their money.

That's the jist of it, but I'll give the specific example that inspired this thread.
(the kickstarter project is at http://www.kickstarter.com/projects/pri ... 3d-printer)

Brook Drumm wanted to make cheap 3-D printer kits. He figured that he could rework an existing design and provide full kits for around $500. He set the goal for his kickstarter campaign at $25,000, presumably some kind of break even point for the effort invested in the new design. A month later he has raised $830,000, which includes orders for over 1,000 kits plus various other special orders (fully assembled instead of in kit form, etc). After Kickstarter and Amazon take their cuts and pledges fall through, he has probably raised around $750,000. At some point after this, he claims that he got hit with a $330,000 tax bill from the IRS. That seems odd to me. He has taken orders for 1,000 units at a (ballpark) cost of $300 a piece in parts, plus labor to cut, kit and ship them, which he is contractually obligated to deliver. I don't see how his books could show enough income to justify that tax bill.

Obviously, if I were his tax preparer, I'd research it carefully, but future "labor", even if contracturally required, might not be allowable. Perhaps he mistakenly filed for his business on a "cash" accounting basis, which is probably not an allowable method.

[Burzmali]

Without more specific information, it's hard to provide an answer without writing an essay.

Sorry about that, these projects tend to be organized by newcomers to the whole "selling things for profit" arena and they tend to not have much of a concrete plan until the pledge amount spirals up and they have an "oh shit" moment.

Even if he actually received the $830,000, then what was the IRS rationale for asserting that he owes $330,000 in federal income tax? If he set the deal up properly, the receipt of the funds would simply have been capital contributed to a new business enterprise. The key phrase is "if he set the deal up properly". For example, did the contributors (and I'll just use the word "contributors" due to lack of a more specific term here) actually receive a legally enforceable property right of some sort in return for contributing the cash -- such as shares of stock or other ownership in the enterprise, or some sort of legal right to be repaid (i.e., did the enterprise have a clear legal obligation to pay the contributors back)? Obviously, those who had actually ordered these kits would presumably have a valid contractual right of some sort. But what about those people (if any) who just intended to be "investors"?

Kickstarter, at least, doesn't allow the creation of "investors" in the sense that any campaign that lets backers own part of the new endeavor are removed. You can't pledge $10k to get 1% of the product's revenue or anything like that. Pledges range from near-gifts (pledge $1 and I'll send you and email saying "Thanks!") to pre-orders (Pledge $20 and you'll get a DRM-free copy of my new FPS TBS MMORPG WTF BBQ as soon as it is finished) to services (Pledge $10,000 and I'll fly to your house and make you dinner for a week). Kickstarter's terms specify that projects are contractually obligated to provide what they promise and if a project fails to deliver, they will supply to the backers the details required to chase them down with a lawsuit, but I have no idea if that would hold up in court.

The Internal Revenue Service might have concluded (possibly incorrectly) that he just didn't have a clearly defined, legally enforceable obligation to provide something to his contributors -- so that the receipt of the funds by him was deemed to be income to him. Again, this is all conjecture, in the absence of very specific information about what the IRS position was and what the details of the deal were.

That's pretty much what I figure as well, but it seems odd that with $330k, he couldn't get a CPA on the job to shore up his defense or at least delay things until he could prove COGS or something.

Off topic: Depending on how carefully the deal was or was not structured, he could also have a federal or state securities law problem. Under securities laws, lots of deals that you might not think are covered by the laws are indeed covered by the laws, and often it's up to the person pushing the deal to prove that his deal is somehow exempt.

California is pretty notorious for that, so had it been the state coming after him, I'd buy it much more easily.

[Famspear]

.....Typically, the only legal or contractual item to come out of these crowdsourcing projects is the actual product itself.....

Yeah, then the promoter could definitely have income tax law problems or securities law problems, or both.

This is a universal, recurring theme.

I'm working a bankruptcy case right now where a small businessman (in this case, a chiropractor) set up an LLC which went into Chapter 7 bankruptcy after a few years. Neither the individual nor his LLC were my clients prior to the bankruptcy (and the individual technically is still not my client). This week, I contacted him to request the financial data for the LLC for the pre-petition (ie, pre-bankruptcy) portion of the year in which the bankruptcy case commenced. Even after having received what I thought was a fairly straight-forward request, he claimed to have no idea what I was talking about, and said he would have to forward my request to his own accountant.

Hey, kids, if you don't know what a basic financial statement is, you probably shouldn't be trying to start your own business. We see this endlessly: Susie makes the best chocolate chip cookies, and she wants to start a cookie business and sell gazillions of 'em. Well, Susie, guess what? There's more to the cookie business than just makin' great-tasting cookies.....

[Burzmali]

Hey, kids, if you don't know what a basic financial statement is, you probably shouldn't be trying to start your own business. We see this endlessly: Susie makes the best chocolate chip cookies, and she wants to start a cookie business and sell gazillions of 'em. Well, Susie, guess what? There's more to the cookie business than just makin' great-tasting cookies.....

The funny thing is that one of the results of all these crowdsourcing projects that spring up, go viral, and ram head long into problems that they aren't set up to handle is that they are still managing to deliver. It may be late and not quite up to the standard they promised, but this type of on-the-job-training is probably a lot more cost efficient than your average business school degree.

[Famspear]

......That's pretty much what I figure as well, but it seems odd that with $330k, he couldn't get a CPA on the job to shore up his defense or at least delay things until he could prove COGS or something....

Yeah, I was thinking that, too. With the level of dollars we're talking about, he should have been able to afford very good legal and accounting help. Whether he actually got good help and followed good advice is another matter.

[Famspear]

Obviously, if I were his tax preparer, I'd research it carefully, but future "labor", even if contracturally required, might not be allowable. Perhaps he mistakenly filed for his business on a "cash" accounting basis, which is probably not an allowable method.

Yep. That's right, because he probably intended to manufacture the product and sell the product as inventory in the ordinary course of business. In this situation, he would generally be required to use the accrual method for federal income tax purposes.

By contrast, a person who provides only (or primarily) a service, such as a medical doctor or a chiropractor, would be able to use the cash receipts and disbursements method for federal income tax purposes.

EDIT: And you're correct on the "labor" point as well; until the cost of the labor was actually incurred, he would not have been able to take a deduction for it (and he would not be able to capitalize the labor cost and include it in inventory, either, until he incurred that cost).

[Burzmali]

It may be late and not quite up to the standard they promised, but this type of on-the-job-training is probably a lot more cost efficient than your average business school degree.

Quick show of hands. Who else flashed to Rodney Dangerfield in the movie Back to School, in the business class explaining about all the costs that go into a business start up.

While business school may teach you certain things, there is also great value to real world experience and those without real world experience who pontificate about how things should be are just sucking up air and time and likely to really screw things up with their "expertise".

Just you wait until someone forms a derivatives market for crowdfunded projects to hedge project completion dates by allowing backers to buy and sell options to buy and sell pledges on a secondary market. Get in on the ground floor and you could be the Gordon Gekko of the crowdsourcing world.

[The Observer]

Quick show of hands. Who else flashed to Rodney Dangerfield in the movie Back to School, in the business class explaining about all the costs that go into a business start up.

No, I flashed to the Underpants Gnomes from South Park:

1.Collect Underpants
2. ?
3.Profit

I, on a regular basis, over the last 25 years, have had to interact with "busines people" who really never had a understanding of basic business finances and principles; they were honestly confused as to why they were in the economic mess they were in. They typically were undercapitalized, had high overhead or operating costs, top heavy with employees, and didn't seem to realize that the product/servce that they were selling was (a) overpriced, (b) becoming obsolete, and/or (c) was inferior to their competitor's product/service.

And these people included educated professional people, including doctors and lawyers. They were certainly skilled at their art or science, but never should have been in charge of adminstering the business.

[Famspear]

While business school may teach you certain things, there is also great value to real world experience and those without real world experience who pontificate about how things should be are just sucking up air and time and likely to really screw things up with their "expertise".

Yes, ideally you want to have both real world experience AND the formal training of business school.

Unfortunately, real world experience, for most people, does not provide the range of knowledge needed to succeed in business -- that's why most people fail in business. Some things in business are just too complex to handle without either having formal training or retaining a professional who has formal training.

Lots of people have real world experience with accounting or bookkeeping, for example. But, if Bob, a 42 year old guy with no college training, has 20 years of experience doing nothing but payroll, receivables, and payables for a small business, and nothing else, he is going to be hard-pressed to handle the preparation of consolidated financial statements for multiple legal entities. For preparing consolidated financial statements, Mary (a 22 year old just out of college with a bachelor's degree in accounting degree and only two months of real world experience in a CPA firm) will nevertheless work circles around Bob.

[Famspear]

......educated professional people, including doctors and lawyers. They were certainly skilled at their art or science, but never should have been in charge of adminstering the business.

Absolutely. I have seen that time and time again. Doctors are some of the worst -- great at being doctors in a narrow sense, but little clue as to how to make the business work.

[Quixote]

The following is all educated speculation.

Given the timing here, no one at the IRS has ever looked at Drumm's return. He raised the $830,000 in 2011. Even if he filed his return by 4/15/2012, rather than filing for an extension, it is way too soon for IRS to have audited his return and made a determination regarding such a complex issue. He received a bill for $330,000 because he filed a return showing $330,000 tax due. He reported the receipts as income when received, but reported few, if any, expenses because he didn't start producing the kits until 2012. In other words, he reported his income on a cash basis.

Why, you ask, did his accountant not set him straight on this? Because he doesn't have an accountant. His tax return was prepared by Turbotax, which is great at adding and subtracting, but isn't going to tell you you're using the wrong accounting method.

End speculation.