Startups

The IRS is basically ignoring the equity crowdfunding boom

Startup investment on crowdfunding platforms largely goes untaxed.

Startups

The IRS is basically ignoring the equity crowdfunding boom

Startup investment on crowdfunding platforms largely goes untaxed.
Startups

The IRS is basically ignoring the equity crowdfunding boom

Startup investment on crowdfunding platforms largely goes untaxed.

Back in August, I bought a tiny stake in the alt-right social network Gab.ai: 181 shares, or about .0018 percent.

Gab is a social network that mashes together elements of Facebook, Twitter, and livestreaming apps, but with a far-right twist. It was founded by Silicon Valley entrepreneur Andrew Torba, a Trump supporter who claims to have “helped meme a President into office, cucks” and hopes that Gab will capture influencers who have been banned from mainstream platforms. Given that Torba was ejected from the elite Y Combinator incubator for “speaking in a threatening, harassing way toward other YC founders,” he had limited options when it came to raising funding for the business. He turned to a new investment vehicle called regulation crowdfunding, which allows private companies to raise up to $1.07 million in investment from members of the public. I chose to invest in Gab because it represents the kind of fast-growing, technology-centric startup that typically gets funded through venture capital.

The dream: Gab takes off, Facebook-style, and I become as rich as Peter Thiel. The reality: I will probably never see that $199.10 again.

Macallan Rare Cask

At least I won’t have to pay taxes on it.

I got my Gab shares thanks to a relatively new ruling from the SEC that allows amateur investors to play venture capitalist on a small scale. This new ruling, known as regulation crowdfunding, was recognized by the Securities and Exchange Commission on May 16, 2016. This type of crowdfunding works just like Kickstarter or GoFundMe, except that companies use it to raise money in exchange for stock. In the past, this would have been restricted to elite investors, but the JOBS Act signed by Obama in 2012 dictated that more people should be able to make high-risk, high-reward investments in startups. It took the SEC four years to decide exactly how it would work, and then another year or so before the regulation crowdfunding space started to heat up. In 2016, 79 companies raised $17.9 million, and it’s expected to grow fast. “We aim to revitalize capitalism and keep the American dream alive,” says the website for WeFunder, one of the largest regulation crowdfunding marketplaces.

Regulation crowdfunding may be the amateur investor’s first experience with the world of capital gains.

I wanted to see how this new investment vehicle would work from the inside, so I invested in Gab through the regulation crowdfunding platform StartEngine. The process took 10 minutes, and my stock was emailed to me a few days later in a PDF titled “Gab — Subscription Agreement.” After huddling with a lawyer, I sort of understand my new asset. But I was still curious about one thing. If you believe regulation crowdfunding proponents, this type of deal is on track to fuel a huge sector of the U.S. economy. How is the IRS planning to tax all this stuff? Here is what I found out.

As usual, the IRS is lagging behind. As it turns out, the IRS has not issued any broad guidance related to regulation crowdfunding. The agency has fallen behind when it comes to crowdfunding in general; it has said it will attempt to issue guidance on crowdfunding for medical expenses, a much older type of crowdfunding, by June 30, 2018. A spokesperson for the agency confirmed that regulation crowdfunding is not on the agency’s to do list right now. This isn’t super surprising, since the agency took seven years to figure out how it wanted to tax Bitcoin.

Most regulation crowdfunding transactions are going to go entirely untaxed. There are existing principles that would apply to regulation crowdfunding, said John W. Dickson, a CPA with Henssler Financial. So far, neither Gab nor I have made any money from this transaction, which means we do not yet owe anything in taxes. “You pay taxes when you make money,” Dickson said. “Taxes, as high as they are, are a percentage of what you made. You’re paying taxes on money you earned.”

In other words, I don’t owe anything unless I make money from the investment. If I lose money, I could actually take a tax deduction as a capital loss. It’s all part of how the tax code heavily encourages private investment. So, bullet dodged there.

Nor is Gab required to pay taxes on the $1.07 million it raised from investors like me. Investor money is taxed as income in some countries, but not the U.S. “They aren’t paying taxes on the money they raised,” Dickson said. “For a company like this, it’s just a balance sheet entry. It goes into their net worth. They have no income at this point.”

Well, technically Gab recorded income of $1,554 in 2016, but that’s not enough to be significant for tax purposes. In 2017, the company introduced Gab Pro, a subscription for $5.99 a month, so it’s possible that the company will have material income this year.

Regulation crowdfunding may be the amateur investor’s first experience with the world of capital gains. There is an unlikely scenario in which I would have to pay taxes on my investment in Gab. If Gab becomes wildly successful and it hasn’t diluted my stock down to nothing through subsequent offerings, I could potentially get paid and therefore the IRS would also get paid. If Gab starts issuing dividends, I would report those as income. If I were to sell my shares in Gab and it’s been less than a year since the purchase, the money I made would be taxed ordinary rates according to my income tax bracket. If I were to sell and it’s been over a year, I would get to pay that sweet, sweet long-term capital gains tax rate, which maxes out at just 15 percent.

In other words, regulation crowdfunding is a very good deal for companies, less so for investors and the tax man.

In theory, regulation crowdfunding allows amateur investors to participate in high-risk, high-reward investment. In practice, the investment is actually high-risk, low-reward. If you back a company like Gab because you believe in its mission of becoming Twitter for racists and want to support it, regulation crowdfunding is a great way to do that. But if you are hoping to cash out, the risk is much higher than it is for professional investors. Venture capitalists are choosing from a bigger, more elite pool of companies to invest in, and they have lawyers and accountants to advise them on the real worth of their investment. Furthermore, the potential upside for regulation crowdfunding is also much smaller than it is for venture capital. “I would consider this like gambling, but probably the odds are worse because at least in a deck of cards there’s ... four kings, four queens,” Dickson said, “but in this situation everything is a variable because there is a limited amount of information.”

On the other hand, if you are a company like Gab, regulation crowdfunding is a 360-degree win. “It’s a great situation,” Dickson said. “You take everybody’s money.”

Adventures in equity crowdfunding

181
Number of shares the author purchased in the social network Gab.ai, thanks to new rules that allow anyone to invest in startups
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Adventures in Equity Crowdfunding will continue as I monitor my investment in Gab.ai. Will Gab hit it big? Will regulation crowdfunding revitalize capitalism in America? More updates will happen here.