For young companies, crowdfunding can seem like easy money that will let them build the business they’ve always dreamed about. So far, more than 53,000+ projects have been funded on Kickstarter to a tune of $916M.
Compared to applying for other funding sources, it’s relatively quick and simple to post a pitch on a crowdfunding site like Kickstarter and see what happens. But this faster pace often means that people looking for funds are less likely to consider some important aspects of running a business. In particular, there are liability and tax issues to consider:
While you may not be dealing with the same amount of contracts and paperwork as you would with a traditional lender, raising money on Kickstarter is still serious business. You may not be dealing with a banker or VC firm, but with crowdfunding, you’re actually dealing with tens, hundreds, or thousands of investors.
A lot of the time, crowdfunding seems like a platform where startups take pre-orders from customers for a not-yet-finished product. And that dynamic always carries risks. For example, CNN Money reported that 84% of the top 50 funded projects on Kickstarter in 2012 shipped late. More than 75% of hardware projects on Kickstarter fail. When backers are excited to get their product, any delays will disappoint, frustrate, and possibly worse.
Obviously, no one starts a crowdfunding campaign to fail or weasel people out of money. However, any time you’re making something (whether it’s a tech product or something creative), you can’t always plan how things will work out. And, unfortunately, not every project will make it.
So, what does that mean for you? If you want to launch on Kickstarter or other crowdfunding site, you should take the following steps before you post your project.
- Form a legal business structure, like an LLC or corporation. This will give you a layer of protection that can help shield your personal property/assets/finances from your business. And if something happens to your project, it means that the business is liable, not you personally. Remember, you need to have the LLC or corporation officially established before starting the crowdfunding process and all contracts and forms should be done through the LLC and corp (and not signed by you as an individual)
- Get an EIN (Employer Identification Number) after your LLC/corporation is formed. If you’re not familiar with an EIN, it’s essentially a social security number for your business and you’ll need it to open your business’ bank account.
- Open a business bank account: Once you have an EIN, your LLC/corporation can open its own bank account. This is going to be an important step to making sure your personal and business finances stay separate.
The tax implications of crowdfunding can catch people off guard if they don’t do a little homework beforehand. When people raise money through traditional sources, those funds are considered “contribution to capital.” That means they’re usually not taxed. However, whenever you raise money on Kickstarter, those funds are considered income. You’ll most likely be issued a 1099-K (you can read more about taxes on Kickstarter here: http://www.kickstarter.com/help/taxes).
If you bring in a lot of income from crowdfunding, you’ll most likely want to offset it with deductible expenses. And most likely, if you’re starting/finishing your project, you will have expenses. The problem occurs when your Kickstarter funds fall in a different tax year than your expenses. For example, let’s say you receive your Kickstarter funds in November, but then you don’t actually dive into the project and start spending until January of the following year.
To address this issue, you have two options. One, you can strategically schedule when you’re going to raise/receive funds and when you’ll be incurring the bulk of your expenses. Or two, you could opt for a C Corporation structure, which gives you more flexibility to define your fiscal year for tax reporting (i.e., maybe your fiscal year is April to April). In this case, you should probably turn to a professional tax advisor or accountant to really understand all the implications.
The bottom line is that you need to approach Kickstarter or any other kind of crowdfunding just as a traditionally funded business. It’s not a side project or hobby. All normal business rules apply.
This post originally appeared on Small Business Trends