Taxes on Crowdinvesting returns

[Burzmali]

With recent laws relaxing the regulation on offering shares of an enterprise to smaller less savvy investors broadly referred to as "crowdinvesting", I'm wondering what the tax implication of some of these "opportunities" are given that many seem to have rather quirky terms and conditions compared to more traditional investments.

Specifically, I was looking over the documents for fig.co which is in the middle of a crowdfunding/investing drive (https://www.fig.co/campaigns/psychonauts-2/invest). Basically, for every $500 share you buy, you will get $2.50 of every ~$68k the game brings in (though if they sell all 30k shares that are authorized, that would be $75k out for every $68k in, but I guess they are going to make it up in volume?). Now, that makes those payments dividends as far as I know, and probably qualified ones. So you are getting hit for taxes on each dividend, which makes sense, but the terms make the shares non-transferrable so you can't sell the shares.

Basically, if you have $10k in shares and the investment underperforms generating $6k in dividends over a few years before the dividend falls to a trickle, you've paid a fair bit in taxes but I don't think you can't write down the investment and take a loss while dividend checks are still coming in and you can't sell the shares. There is a forced buy back provision in the terms, but it seems odd that you'd have to wait until a 3rd party decides to allow you to take the loss. Is there some other clear way to handle such an investment? The offering company position is that this is new and they have no idea how you should handle it.

[Arthur Rubin]

Restricted shares which produce dividends are not that uncommon, although the restriction being permanent seems unusual. I actually have a few thousand in restricted REIT shares, although they are slowly becoming unrestricted as the REIT has merged into a public corporation. However, they offered an annual buyback window at par value.

Even if the company is good, I think investors may have unexpected tax consequences.

As an aside, my father, at least as of 15 years ago, still had some phantom income from former tax shelters -- first they produced phantom deductions, and now they are producing phantom income.

[BBFlatt]

To the extent the distributions exceed the "earnings and profits" of the corporation, they are not dividends but are considered a return of capital to the extent of basis, and beyond that capital gains.

See IRC sections 301 and 316.

[Burzmali]

Restricted shares which produce dividends are not that uncommon, although the restriction being permanent seems unusual. I actually have a few thousand in restricted REIT shares, although they are slowly becoming unrestricted as the REIT has merged into a public corporation. However, they offered an annual buyback window at par value.

I have some as well, but I got them as a retention measure from the company, hence at zero basis. I'm not in the investment field, but I've seen plenty of different investment structures and those that have a basis that you can't sell or write down seem pretty rare.

[Burzmali]

To the extent the distributions exceed the "earnings and profits" of the corporation, they are not dividends but are considered a return of capital to the extent of basis, and beyond that capital gains.

See IRC sections 301 and 316.

Basically, the company works like this example based on their current campaign:

The Company creates a contract with the Developer to give them $15 million to create a game.
The Company will handle sales and distribution and split the revenue with the Developer per the contract.
The Company will have 180 days to raise the $15 million, with some minimum amount to be raised via crowdfunding/investing.
The Company breaks the $15 million into 30,000 preferred stock shares with a target price of $500 and sells some.
The Company pays the Developer from a combination of their own assets and the money raised.
Years later, the Company begins collecting revenue from sales of the game.
The company pays the devs their share based on the revenue share in the agreement, takes a slice off the top to common stock, and the remainder is charged a service fee and split among holders of the preferred stock.
Unsold shares and the service fee are the Company's earnings and that which is left over after expense is profit and is assumingly retained and/or turned over to their Parent corporation.

Based on that flow, the money paid isn't earnings or profit in any sense that I understand, but they continually refer to the payments as "dividends" so I am at a bit of a loss.

[notorial dissent]

Burzmali, I don't know if I've run in to one of these before, but it definitely set my radar off as I read through it, and in the wrong way. Firstly, I'm not sure the reimbursement structure meets with SEC rules. In fact, while they may be trying to call them dividends I'm not quite sure that is what they would qualify as. I will go with bbflat on his comments on the disbursements, I think they would qualify as capital returns and not dividends. You CANNOT claim to or guarantee a certain profit, and if this isn't exactly that it is too close for comfort. The numbers don't add up either and that is another bad point. I will also say that $500 a share on a start up is, well, just questionable at best. They would appear to be looking to raise $15m, now unless they've discovered some model I'm not familiar with, there will be insiders with large blocks of stock as compensation or whatever. If there aren't I would be concerned, and if there are then they are not being honest about the actual stock issue. Another point. The next thing is that the stock is being issued as 144(restricted) stock, which I find VERY peculiar, and again, I'm not sure how close that flies to the edge. 144 is the rule for insiders, but for offering buyers, I quite honestly can't say I've ever heard that, and it basically means that the stock is worthless from day one since it can't be traded or sold, except to the company. I think I would want to look REAL closely at their SEC filings, and if they are to this point, there should be a whole ream of them by now. I would really want to look at this thing's prospectus and go over it with a fine tooth comb, but I'd also want to see the filings as much or more than anything.

This sounds like it could be a number of things, but nothing I'm familiar or comfortable with, and the first thing that pinged when I read it was ponzi, and I'm still leaning that way.

The final post about how this dog and pony show works explains a lot, none of it encouraging. There is a difference between Preferred and restricted shares, but that also generally means there are common shares, and a lot depends on what the voting rights are to the Preferred. The more of this I hear the less I like it.

[BBFlatt]

I agree with ND, this sets off a lot of alarm bells.

Very interesting how the "preferred" shareholders are last in line after the developer, the common shareholders and the service fee for their take.

[notorial dissent]

It may just be my take on this but it looks to me like the "investors" are giving whoever an interest free loan for as long as they want it with no guarantee of ever getting anything back out of it. There is nothing that says they are actually going to make a profit, let a lone an actual product. I've seen some dodgy new issues in my time, but nothing that quite comes up to this one.

[Burzmali]

I agree with ND, this sets off a lot of alarm bells.

Very interesting how the "preferred" shareholders are last in line after the developer, the common shareholders and the service fee for their take.

Nothing about this has really been tested. The game involved is being created by a development studio headed by one of the board members of fig's parent company and fig's CEO is a former employee of that developer. Their parent is subsidizing the operation up to the point of allowing fig to retain enough shares to inflate the dividend. $2.50 for every $68,376 in adj. gross revenue would mean that they are on the hook for $75k per $68,376 taken in without factoring in the developer's cut and the common stock cut, and the service fee has been reduced to <1% for this campaign. This project is a loss leader to build the brand while funding one of their board member's pet projects.

What seems funny to me is that despite this being a far more risky proposition than the return would suggest, you also seem to be taking a stiff boot from the taxes as well, even if you lose money.