If you’re using Kickstarter to fund a project, you’re probably wondering if you have to pay taxes on the remaining money raised your first year. Michael Guenther, a California CPA specializing in tech startups, recently published an article outlining a method that can be used to prevent being taxed on that money. I’ve used that method with three of my clients, and it’s a solid way to avoid having to pay money in taxes that you’ll need the following year in order to complete the remainder of the project. Here’s an explanation of how that method works. 

The Method

The method is to make a special election or elections using IRS form 3115. Your ability to use this method depends on whether you are a cash or accrual basis taxpayer, whether the advance payment is for goods or services, and if for goods, whether the taxpayer keeps inventory accounting records for tax purposes. These elections allow you to defer recognition of the payment for tax purposes until the year it is actually earned (with a probable maximum of two years) by delivering on the product(s) that the funds were paying for.

The Example

So let’s say a game company receives $400,000 to produce and supply to backers twelve different, but related, products. The company receives the full $400,000 as soon as the project is funded in 2013. In 2013 they work really hard, spend $300,000 of the funds on production costs, and produce and send to customers eight of the twelve products. In 2014, they finish, produce, and ship the remaining four products for a cost of $80,000.

Normally, at the end of 2013 they would owe tax on $100,000 ($400,000 revenue – $300,000 of expenses).  The IRS and state tax authorities will happily walk away with 30% or more of that, leaving them with only $70,000 to carry to 2014 for finish making the other four games.  Not a pretty picture since they need $80,000 to even complete the products.

If they jump through the right hoops and file the correct forms, it would work more like this: $400,000 is received, but only $266,666 (8/12 – I’m really over-simplifying this part) is “earned” by the end of 2013. With the right elections, that’s all they report for revenue on the 2013 tax return.  The remainder is put into a balance sheet account called “Advance Payments” or “Deferred Revenue.” It’s critical that this be fully disclosed on the return and a special schedule attached. Amazon payment is going to issue a 1099-K for the full $400,000 for 2013, so that’s what the IRS will be looking for, and there had better be a good explanation why it’s not there. So, for 2013 they show a net LOSS on taxes of $33,334 (266,000 revenue -$300,000 expenses). That loss can be carried forward, again with the right election, to the next year, 2014. So, 2014 shows a net taxable income of $20,000 ($133,334 revenue deferred from 2013 – $80,000 expenses – $33,334 loss carry forward).  In the end, the project still profits and owes taxes on the $20,000 it made, but without the IRS getting to take an extra bite out of the middle.

I’ve done this for three clients so far, and in every case it had to be handled slightly differently to be done correctly. I advise anyone attempting this to get help from a qualified professional. Do not try this at home!