Are Investments Made Through Crowdfunding Platforms QSBS Eligible? 

Crowdfunding

“Because of this bill, start-ups and small businesses will now have access to a big, new pool of potential investors — namely, the American people.” 

– President Barack Obama during the signing of the JOBS Act, April 5, 2012

The Jumpstart Our Business Startups (JOBS) Act paved the way for crowdfunding in 2012. Since then, there has been extreme growth in the volume of capital raised through this mode of investing, which has given rise to crowdfunding platforms within the startup marketplace. These platforms facilitate companies in raising capital from both accredited and non-accredited investors, who were previously unable to invest in early-stage private companies.  

Now, these various crowdfunding platforms are competing in the startup investment marketplace. These companies are finding a way to connect businesses that need capital with individuals or groups of investors willing to fund their efforts.

How did Crowdfunding Emerge?

This meteoric growth in crowdfunding gained traction in 2012 when the Jumpstart Our Business Startups (JOBS) Act was signed into law during the Obama administration. This legislation was created to stimulate funding to small businesses and push the American economy forward after the 2008 recession. It also allowed founders and entrepreneurs to publicly promote their startup capital raises. During the signing of the JOBS Act, former President Obama spoke highly of America’s rich history of entrepreneurship: 

“One of the great things about America is that we are a nation of doers — not just talkers, but doers.  We think big.  We take risks. And we believe that anyone with a solid plan and a willingness to work hard can turn even the most improbable idea into a successful business. So ours is a legacy of Edisons and Graham Bells, Fords and Boeings, of Googles and of Twitters. This is a country that’s always been on the cutting edge. And the reason is that America has always had the most daring entrepreneurs in the world.”

Not only that, but the former President also looked ahead hopefully at the potential benefits that this legislation could bring about on a national level: 

“And for start-ups and small businesses, this bill is a potential game-changer. Right now, you can only turn to a limited group of investors — including banks and wealthy individuals — to get funding. Laws that are nearly eight decades old make it impossible for others to invest. But a lot has changed in 80 years, and it’s time our laws did as well. Because of this bill, start-ups and small businesses will now have access to a big, new pool of potential investors — namely, the American people. For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”     

The Addition of Regulation CF and Regulation A+

Four years after the JOBS Act was signed, Title III (known as Regulation CF or equity crowdfunding) was enacted, giving private early-stage companies access to raise capital from American taxpayers as a whole. 

The addition of Regulation CF was designed to stimulate the economy and boost the startup ecosystem by lessening the restrictions on how these private startup companies raise capital. Regulation Crowdfunding (CF) permits individuals to invest in securities-based crowdfunding transactions subject to certain investment limits. The rules also limit the amount of money an issuer can raise using the crowdfunding exemption (limit of $1M during any 12-month period, and expands to $5M with amendments to Rule 504 of the Securities Act of 1933), impose disclosure requirements on issuers for certain information about their business and securities offering, and create a regulatory framework for the broker-dealers and funding portals that facilitate the crowdfunding transactions. 

In addition to Regulation CF, another amendment was added to the JOBS Act called Regulation A+. This addition was designed to allow companies to raise more capital but with more legal restrictions than Regulation CF.

Regulation A+ was also enacted to help companies raise additional capital beyond the limitations of Regulation CF, offering in effect a “mini IPO”. The offerings are subject to SEC approval. However, the costs are less than traditional IPOs and the ongoing reporting is less burdensome for the company.

There are two Reg A+ tiers, and both have limits and regulations. Tier I allows a company to raise up to $20 million from accredited and non-accredited investors. Tier II allows a company to raise up to $75 million. Accordingly, if one chooses to raise up to $20 million, they would be allowed to meet the requirements of either Tier 1 or Tier II, depending on their choosing. However, there are limits on the amount an individual can invest, depending upon their net worth.

In comparison, Regulation CF allows for companies to raise a smaller amount of capital but with more relaxed legal regulations and restrictions. While Regulation A+ gives companies the ability to raise significantly more funds but with the addition of greater restrictions and oversight. However, both Regulation CF and A+ open the door to allow everyday taxpayers to invest in the innovative startup ecosystem. 

Redefining Accredited Investors

Prior to Regulation CF, in order for investors to partake and contribute in private equity markets, they must meet requirements that label them as accredited investors. 

Historically, qualifying as an accredited investor was based upon an individual’s overall net worth. Investors needed to meet income or wealth requirements to be considered accredited investors. These stringent financial specifications kept many investors out of the pool for certain tax benefits in the private equity marketplace.  

In 2020, the Security and Exchange Commission (SEC) made changes to the components of this definition to modernize the accredited investor criteria.

The SEC’s new classification (in effect as of December 9th, 2020) of accredited investors expands the definition of an accredited investor to people with demonstrated knowledge of the risks of investing in private companies. In effect, the SEC is saying that wealth should not be the only requirement for defining an individual as an accredited investor. They expounded in a recent statement that there is an “ongoing effort to simplify, harmonize, and improve the exempt offering framework, thereby expanding investment opportunities while maintaining appropriate investor protections and promoting capital formation.”  

Accredited investors include individuals with a net worth of at least $1 million (not counting primary residence value) or a yearly income of at least $200,000 (or an annual income of $300,000 for married couples) for the last two years and expected to be maintained. Accredited investors are also now considered investors who have a level of professional financial knowledge and experience that merits a lesser need for protection. Accredited investors can now also be general partners, executive officers, or a combination of the roles for the issuer of a security. 

The Recent Rise of Crowdfunding

New crowdfunding players have continued to emerge in response to the growth in the investor base and investment opportunities, and their platforms make it easier to connect investors to promising startups that need capital. A few of these popular and quickly growing crowdfunding platforms include Wefunder, SeedInvest, DealMaker, OurCrowd, MicroAquire, MicroVentures, NextSeed, TruCrowd, Indiegogo, StartEngine, and Republic.

To gain a clearer insight into the rise of investing on crowdfunding platforms, it’s necessary to see how far it has come over the last few years.

According to data gathered by KingsCrowd, in 2018, crowdfunding campaigns raised $74 million and began to boom. By the close of 2019, crowdfunding had become a popular and recognizable mode of investing, raising more than $100 million. In 2020, investments on crowdfunding platforms more than doubled from the previous year amidst the global pandemic and financial crisis.

Investments in crowdfunding campaigns in 2021 have more than doubled again, surpassing $500M in investments from the prior year. Predictions estimate that investments made through crowdfunding platforms will soar to as high as $200 billion by the end of 2025. 

How QSBS can Help Drive Investment in Companies that are Crowdfunding?

Complementing the rise in crowdfunding, investors may have the ability to leverage QSBS opportunities for tax-free gains, where eligible.

Qualified Small Businesses Stock (QSBS) aligns nicely with the early stages that companies tend to be in when they’re seeking funds through crowdfunding. Most of these companies have yet to reach the $50 million gross asset threshold. However, given the complexities of QSBS eligibility, a deeper analysis is often warranted to ensure the other QSBS eligibility criteria are met.

See more on the other eligibility criteria for Qualified Small Businesses.

The QSBS exclusion permits stockholders to exclude up to 100% of capital gains from the sales of the qualified stock. This exemption can be up to $10 million or ten times the original investment venture, whichever is more.  

As part of the Build Back Better Act (BBBA), the 100% QSBS exclusion would be limited to taxpayers with an adjusted gross income of over $400,000. This could mean that many non-accredited investors and crowdfunders could remain eligible for the 100% exclusion if their AGI is below this level.

Can Crowdfunding Offer a Solution for Rollovers?

Crowdfunding platforms also offer a unique opportunity to address one of the key hurdles with the QSBS rollover provision per Section 1045—namely that rollovers need to be made within 60 days of a gain.

IRC Section 1045 enables taxpayers with realized gains of otherwise eligible QSBS stock, who have not met the 5-year holding period for the QSBS tax exclusion, to roll their proceeds into other QSBS stock and continue towards meeting the 5-year holding period.

Do you have a QSBS gain you are looking to rollover into other QSBS stock? Provide some additional details here, and we can help you explore potential ways to reinvest your gain and preserve your QSBS tax exemption.

This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.

About QSBS Expert

QSBS Expert was founded by a group of entrepreneurs, investors, accountants and lawyers who came together when trying to navigate a QSBS situation of their own. We quickly realized that the regulations left a lot of open questions and the publicly available information was confusing to sift through…so we thought that others may also benefit from having a “go to” resource for all things QSBS.