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10 Business Law and Tax Law Steps to Improve the Chance of Crowdfunding Success
by Will Lewis on 06/05/13 08:53:00 pm   Expert Blogs   Featured Blogs

The following blog post, unless otherwise noted, was written by a member of Gamasutra’s community.
The thoughts and opinions expressed are those of the writer and not Gamasutra or its parent company.

 

Motorcycle

Imagine the following. You're just out of college or you've just quit your job as a game developer for a big company. You and two of your friends have a great idea for a video game, and you want to finance development of your game via a crowdfunding website such as Kickstarter or Indiegogo. You pull your savings and get a few loans from your parents, totaling $100k. You spend $100k on the initial design of your game and shooting an intriguing trailer. You would like to raise an additional $400k to pay for music licenses, hiring an artist, web hosting, digital distribution, and other costs. You launch your campaign on November 17, 2012 so that it will close a week before Christmas, allowing cool uncles to buy it for their nephews and to allow 18-35 year olds to treat themselves to a nice Christmas gift. You plan on a September 2013 release of the game to allow reviews to drive holiday purchases of your game in 2013. When the Kickstarter closes on December 17, you have raised $1 million. After Kickstarter and Amazon take their cut, you're left with about $920,000 (1M – 1M * .05 [Kickstarter] – 1M * .03 [estimated Amazon Payments rate]. Great news! Right...? Sort of...

The worst case scenario, of course, would be that your project doesn't get funded at all. However, there are serious tax consequences that the imaginary developers in the above situation are going to suffer that could turn this otherwise successful crowdfunding campaign into a nightmare. If 10% of your pledge total is from people in a state where sales of digital goods are taxed, and the average sales tax is 8%, then you might owe about $7,400 in sales tax to your state ($1M * 0.10 - [$1M * 0.10] / 1.08).  If we assume that the developers didn't spend any more on development in 2012, and if we assume that all of the developers are subject to an income tax rate of 45% (35% federal and 10% state), then you are going to collectively owe $365,670 (0.45 * [$912,600 - $100,000]) to the IRS and state tax authorities on April 15, 2013.  Until an amended return is filed in 2013, this leaves about $450k for the remaining development, and a profit of $50k if development costs were on budget. This is not much of a cushion for setbacks. Nor does it result in much immediate profit.

There are ways to postpone immediately paying your taxes, and these developers will have deductions that they can apply to 2012 (called a carryback) that they can file for in 2013. But they will generally not be able to get a return until 2013. Due to timing and tax issues, these imaginary developers may have run into a financial situation that will prevent them from being able to create the game they imagined. And if the game is not as good as they intended come September, then they might suffer weaker reviews and have a harder time generating greater marginal profits from anticipated sales in the ensuing holiday season.

By comparison, if all of the expense was incurred in the same year as income was realized or expense was incurred in earlier years, and development costs stayed on budget, then the total income tax liability for that year would have been $185,670 ([$912,600 - $500,000] * 0.45) (software development so resembles research & development activity that the costs associated with software development may be currently expensed under Rev. Proc. 2000-50). This would result in an after tax profit of about $225k. 

If you've been following the math and logic, then you are probably aware that after filing the amended return in 2013 in the first example, the after tax profit would increase to the same approximately $225k as in the second example. The difference between the two is that, based on the time value of money, the $225k in the second example is worth more than the $225k in the first example because the $175k difference can be invested by the taxpayer in a different project for a year longer in the second example than in the first example.

Games were the top Kickstarter category in 2012 as far as dollars pledged, and video game projects dominate the top Kickstarter  projects. Crowdfunding is, therefore, a great resource for financing your game. In the following guide, I hope to explain the basic legal steps for preparing for crowdfunding, and how to plan for your best after-tax position. There are some great guides on Gamastura for the marketing and business of crowdfunding, and I aim to augment those guides through legal considerations. As you will see, there is not one answer to some the of the more serious legal questions below, and you might find it helpful to engage legal counsel. 

This guide is only designed to apply to crowdfunding on a sales model, such as on Kickstarter, and is not designed to apply to equity crowdfunding.

Before I begin, the IRS requires a disclaimer under Circular 230: any tax advice contained in this article is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or promoting, marketing, or recommending to another party any transaction or matter addressed herein.

0.  Work on Your Product and Your Marketing:  The end goal is to develop a desirable game that results in a profit bonanza. The immediate goal is to raise money to develop the game through innovative marketing. There is a lot of work to do to setup your crowdfunding project, but do not lose sight of your goal. The steps below are largely mechanical, and they should not take precedence over producing fun game play, a good trailer, devising intriguing pledge rewards, and writing good marketing copy.

1.  Form a Legal Entity:  The first step that you should take is to form a legal entity with limited liability such as a C corporation or an LLC. An entity with limited liability is a form of insurance that will shield you and your personal assets from the claims of creditors against your business. Crowdfunding a game opens you up to various types of liability that a corporation or LLC could insulate you from, including liability for not delivering the product you promised or not delivering any product, or violating a third party's intellectual property with your game.

In practice, many companies will use a special purpose vehicle for each game, and that SPV is then owned by the game company. This allows the company to insulate itself from liabilities attached to the game, and allows sophisticated tax planning strategies. This is generally going be outside the scope of independent developers on a tight budget. And you won't generally see a greater marginal return on your investment if you're a smaller developer.

The choice between an LLC and a corporation depends on some tax issues, but all you really need to know for tax purposes is that the after tax position for a small company will generally be worse in a corporation.

Another consideration are management issues and formalities. Operating a corporation requires more formalities than running an LLC, including board of directors' and shareholders' meetings, and if you're going to have trouble following the corporate formalities, then a corporation is not for you. If you fail to follow the corporate formalities, then the courts might pierce the corporate veil in a lawsuit which opens up the shareholders to liability for acts of the corporation.

The big issue in LLC v. corporation is business optics. I'm a big fan of daydreaming, and you need to think about what it is you want out of your game. Do you want to use the game to grow into a publicly traded company? Do you want to grow into a privately-held independent developer? Do you want to make a game, and use that as a piece of your portfolio to help launch a career at a big developer? Do you want venture-backed financing at some point in your future?

If you're going to seek venture-backed financing in the future, then it it could be best to form a Delaware C corporation at the beginning. Venture capital companies generally like to invest in Delaware C corps because that is the standard entity for companies that will go public, and because they are most comfortable with and experienced in negotiating investment terms with Delaware C corps. Be prepared for them to turn you into a Delaware C corp if they give you financing. Several incubators and seed-financing companies have created standard incorporation documents which include standard classes of stock that are designed to make the seed-financing stages go more quickly. Although crowdfunding is, in effect, replacing the seed-financing stage, these standard documents can lower the legal expenses in founding your company.

As a start-up studio with an uncertain future, you might find it easiest to begin with an LLC formed under your state's laws. The management formalities are kept to a minimum. You have a favorable tax position. If everything works out, then you and your fellow developers can treat the LLC as an SPV for the game you developed by transferring your LLC interests to a new corporation that you later form to serve as your development studio. It is much more difficult to dissolve a corporation into an LLC.

Other considerations in forming a company with someone else are buy-sell agreements for LLCs and shareholder agreements for corporations. These govern what happens when another owner wants to leave the company, or when an owner dies or gets a divorce. These are seemingly inconsequential before the company is making any money and everyone is on good terms with each other, but a buy-sell agreement can become invaluable.

It costs about the same to form a corporation or an LLC in any state, approximately $100 in fees to the Secretary of State, and should not take more than 6 weeks. 

2.  Obtain an EIN:  After your company is formed, you should apply for an Employer Identification Number (EIN) from the IRS. An EIN is, essentially, a social security number for your company. An EIN can be obtained immediately after filling out an online form on the IRS website. There is a lot of technical language. The main purpose in obtaining in EIN is so that you can open a business bank account.

3.  Open a Business Bank Account:  An EIN is required to setup a business bank account. Business bank accounts are recommended for two main reasons. First, a business bank account helps to avoid commingling of your personal funds with company funds. Commingling your business funds with your personal funds can be factor against you if someone sues you and is attempting to pierce your shield of limited liability. Second, a business bank account brings greater transparency to your business operations which decreases the chances of disputes with your partners and can give a clear picture of your income and deductions to the IRS. Plus, opening a business bank account is fairly cheap; shop around at your local credit unions.

4.  Setup Your Crowdfunding Account:  As explained in the previous paragraph, keeping your business separate and distinct from your personal life is necessary to both maximize your ability to limit your liability and to minimize the chances of disputes with your partners. A separate crowdfunding account that is distinct to the company that will be developing your game is key to maintaining this separate identity.

5.  Set Fundraising Goals with All Expenses in Mind:  Which crowdfunding platform you use can depend on a lot of different factors, including popularity, culture, features, and cost. All of these can have an impact on how much you raise. But one of these will have a direct, quantifiable impact: costs and fees by the platform and credit card processors.

Which platform you choose to host your crowdfunding campaign on will have a direct impact on your bottom line due to service charges. For example, Kickstarter takes 5% of the total amount that you raise in fees and Amazon takes 3-5% of the amount that you raise as credit card processing fees. By comparison, Indiegogo takes a 4% fee and the credit card processing company takes a 3% fee. When setting your goals, you must account for these fees.

6.  Fill Out Your Form W-9:  If you are using Kickstarter, then you will fill out this form when signing up for Amazon Payments. Other crowdfunding platforms will also have you fill out this form. You are being asked to fill out Form W-9 for two reasons. First, you need to fill out a W-9 so that they can send the proper tax documents to the IRS indicating that you are receiving payments from them. This will allow them to properly classify the payments to you. Second, they are asking you to fill out the W-9 so that they can determine whether you are a US person and whether they must withhold on payments to you.

7.  Kicking off Your Crowdfunding Campaign and Timing Considerations:  As demonstrated in the introductory example, there are serious tax consequences based on when your crowdfunding campaign ends and your funds are disbursed. If you have not spent a lot of money on development already, then you might want to consider ending your crowdfunding campaign early in the year as opposed to late in the year in order to accrue expenses to deduct from your total income. Otherwise, you run the risk of paying more taxes than you owe in the current year, and being forced to wait until the next year for the IRS to return the excess taxed it collected because your development expenses took place in a later year.

8.  Document All of Your Expenses:  It is very important that you specifically document all of your development expenses in order for your return to withstand IRS and state tax authority scrutiny. Additionally, your individual tax positions might make it advantageous for you to characterize your expenses in a way that they can meet the R&D tax credit under IRC 41 instead of a deduction under IRC 174. A post by another user contains interesting information about the R&D tax credit as it applies to video game development. However, the credit is not necessarily more advantageous to you if you're using crowdfunding.

9.  Income Tax Considerations:  Crowdfunding is unique as a consumer product sales platform because it generates substantial income for sellers before a lot of the development costs have been made. In typical software development, the developers would first spend money and then later receive income. They would therefore have expenses to deduct from their income. This would encourage exploring a lot of different tax accounting options, such as expense versus different amortization periods. However, the typical crowdfunding project is going to want to expense everything as soon as possible.

The IRS considers software development to be so similar to research and experimentation costs under IRC section 174, that it allows developers to currently deduct software development expenses, or capitalize and amortize the costs over 3 to 5 years. Since you've received so much income up front, it is generally best to expense and deduct your costs ASAP. 

If you have income in an earlier year and a net operating loss (NOL) in a later year, then you are allowed to carry that loss back for up to two years and file an amended return for that earlier year. This allows you to receive a refund for the tax that you paid in the earlier year. If your NOLs exceed your income in previous years, then you can carryover an NOL for up to twenty years.  What this means is that if you want to maximize your deductions against your income from crowdfunding, then you must have all of your development costs related to the product that you sold in the crowdfunding campaign incurred within two years of your the close of your crowdfunding campaign. 

In simpler terms, to maximize your total after tax profit, you should strive to ensure that you deliver your game to your customers within two years of the close of your crowdfunding campaign to allow you to carryback your development costs to your earlier profits.

10.  Sales Tax Considerations:  Under current state law, about half of the states collect sales taxes on digital download sales and half do not collect sales tax on digital download sales. California, New York, and Florida are large states that do not collect sales tax on digital downloads, and Texas and Illinois are large states that do collect sales tax on digital downloads. See this handy map for the sales tax rules on digital downloads across the US. Under current law, you should assume that roughly 50% of your sales to US persons will be subject to state sales tax, and that you will need to pay that tax. 

The Marketplace Fairness Act would not change this, but changes in state sales tax laws are always subject to change.

Conclusion

There are a lot of things to think about in the list above. Don't let it overwhelm you. You should consult an attorney if you have questions, and, given the cash at play in crowdfunding, you might be able to hire an attorney on a contingency basis. With a little bit of planning you can choose a business entity that will support your dreams going forward, and you can time your crowdfunding to maximize your after tax profits.

William Lewis is a tax and business attorney based in the Silicon Valley. He advises domestic and foreign clients on a range of business, tax, and estate planning matters.  


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