Article Bloomberg Law

The Conundrum of Distressed Cryptocurrency Exchange Taxation

The uncertainties of crypto taxation are magnified because of recent distress in crypto markets over the past several months. Kirkland & Ellis LLP’s Anthony Sexton highlights some key issues.  

Cryptocurrency taxation is subject to tremendous uncertainties. Those uncertainties are magnified because of the distress faced by certain crypto that has been brought on by the severe decline in crypto markets over the past several months. This article can’t come close to covering all the relevant issues, but it highlights a few key ones.

The first question is fundamental: When a customer deposits crypto with an exchange, does the customer continue to own the crypto, or does the exchange own the crypto? The answer, from both a tax and non-tax perspective, is that it depends. Some crypto platforms have terms that expressly provide that the platform is merely acting as a custodian or agent and that customers retain ownership of their coins.

In this case, tax ownership remains with the customer, and tax issues are relatively straightforward. Other platforms provide the ability to sell, rehypothecate, and otherwise act as the owners of deposited crypto. Platforms like this are better seen as shifting tax ownership from the customer to the exchange, with the customer receiving a contractual right to the return of the crypto. That treatment raises many fundamental and unanswered questions.

Is the initial deposit and subsequent withdrawal of crypto to and from the platform a taxable event? A basic principle of tax law is that exchanging one asset for a different asset gives rise to a taxable event even if no cash is involved. That might lead to the surprising conclusion that deposits and withdrawals are taxable because the customer has exchanged the crypto for a mere contractual right to the return of the crypto.

There is a good position that in-kind deposits and withdrawals are not taxable by analogy to other areas of tax law. But the answer is not certain, mostly because crypto exchanges reserve the right not to support crypto received in connection with so-called hard forks and airdrops, which cause additional crypto to be distributed to existing holders of crypto in respect of that crypto.

On-platform sales and exchanges of crypto should be taxable from the customer’s perspective even if they don’t own the actual crypto, because the kind of property they hold has meaningfully changed. Should they be taxable to the exchange itself? They shouldn’t—because there has been no change in the exchange’s financial position beyond fees earned on the exchange. There are various ways to get to that conclusion but no clear authority to support any of them.

What about staking rewards, airdrops, and hard forks with respect to deposited crypto? One of the very few pieces of formal IRS crypto guidance, Notice 2014-21, provides that proof-of-work mining rewards of additional crypto are immediately taxable, and most practitioners believe that guidance also applies to staking rewards. That outcome is hotly disputed, and there is ongoing litigation on the matter in Jarrett v. United States, but it remains the IRS’ position.

Revenue Ruling 2019-24 further provides that the receipt of new crypto is immediately income equal to the value of the new crypto, but only once the taxpayer is “able to exercise dominion and control over the cryptocurrency.” From a policy perspective, this is the wrong outcome—a holder’s existing tax basis should be bifurcated between the original and new crypto, not unlike a pro rata stock dividend.

Setting aside the flaws in the underlying guidance, applying that guidance is less clear when an exchange and not the customer owns the underlying crypto. The exchange should not have taxable income unless an airdropped or hard forked currency has value, but the exchange keeps those coins for itself rather than adding them to customer balances. Customers should have income if the customers would have had income had they held the coins directly, assuming the platform supports the crypto and the customer is able to withdraw it if the customer chooses to. But following a theme, there is no clear authority.

Can a customer of distressed exchanges take a loss before resolution of their claims? Typically not, because retail customers can only take full “bad debt” deductions, and that kind of deduction can only be claimed once recovery amounts are known. Given the volatility in the crypto markets and other factors, a customer ultimately could have a gain rather than a loss if a customer’s ultimate recovery exceeds the tax basis in their deposited crypto—even if they don’t receive a full recovery on the deposit. To the extent customers receive a purely in-kind recovery, there are supportable positions that such recovery is non-taxable, and that is the right policy answer. Unfortunately, even that outcome is not entirely clear, especially if customers receive a mix of in-kind recovery and other property (different crypto, cash, stock, etc.) or customers are migrated to a separate acquiring platform.

What if an exchange must rebalance its holdings to equalize customer distributions or transfer crypto to an acquirer? These transactions would be taxable to the exchange. Given the lack of certainty in the area, there is a risk that the exchange could have a significant tax liability—clearly the wrong result. That tax liability would come in front of, and reduce, the platform’s ability to make distributions to customers.

While there are reporting methods that mitigate this problem, their application to crypto exchanges is unclear. Similarly, there is a risk that exchanges could have income equal to the difference between the amount owed to customers and the amount returned to them, which could reduce the customers’ recovery even more.

Ultimately, the following principles should guide these issues: Customers should not have tax to the extent they are receiving in-kind recoveries in whatever form that takes, whether on the existing platform or a different one. Exchanges should not have tax liability when they have economically not had any increase in wealth, especially because any such tax would, in distressed contexts, hurt customers. As discussed above, there are ways to get to that rational result, but they are far from clean. Hopefully, the IRS, the Treasury Department, or both will provide clarity that considers the unfortunate circumstances faced by these platforms and their customers. If not, tax uncertainty will be layered onto the economic uncertainty customers in this area already face.

This article originally appeared online in the October 21, 2022 edition of Bloomberg Law. Further duplication without permission is prohibited.