MemorandumTM

Reproduced with permission from Tax Management Memorandum, Vol. 60 No. 14, 07/08/2019. Copy- right ஽ 2019 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

Third party failure, including exchange shut- Tax Treatment of down, ICO failure, crypto investment company Loss Due to bankruptcy; Exchange Shutdown or Investment scams, including ICO scams, crypto high-yield investment scams, crypto Ponzi scheme. Investment Scams

* Casualty and theft losses can be reported on Form By Sharon Yip, CPA, MST, MBA 4684 for individual taxpayers. Losses due to an inves- tor’s own mistake or accident are not deductible. Per- sonal casualty losses and theft losses are deductible INTRODUCTION only to the extent they’re attributable to a federally Many people got into cryptocurrency investment declared disaster under the Tax Cuts and Jobs Act because of its high profit potential, especially in 2017 (TCJA) (Pub. L. No. 115-97), effective Jan. 1, 2018, 2 when the crypto market took off and was having a big through December 31, 2025. However, losses due to bull run.1 Some people even became millionaires due exchange shutdown and investment scams seem to be to their crypto investment. However, the cryptocur- a gray area. There is no specific official guidance re- rency market is also extremely volatile and highly garding tax treatment for such losses. In addition, risky. For example, the market crash in 2018 caused there is no clear consensus in the tax professional many people to lose a significant amount of money in community regarding the proper tax treatment of cryptocurrency (aka ‘‘coin’’). In addition to unpredict- these losses. Currently, the two most common posi- able market conditions, there are also some risks that tions being taken by tax practitioners are: (1) treat the are unique to the crypto market. The biggest risk is losses as non-deductible personal casualty losses; and probably the loss of cryptocurrency not due to market (2) treat the losses as investment losses and deduct condition but due to four typical situations that are ex- them on Form 8949. perienced by many crypto investors: The purpose of this article is to provide a technical Self-committed mistakes/accidents, including lost analysis of the tax treatment of losses suffered by in- wallet access, coin sent to a wrong address, lost dividual taxpayers due to exchange shutdown or password to online crypto account; crypto investment scams, as well as to express the au- Theft loss, including stolen wallet, hacked online thor’s view of a reasonable conclusion. wallet or exchange account, stolen crypto account password; EXCHANGE SHUTDOWN Exchange shutdown has been in the news over the past several years. The earliest and most well-known * Sharon Yip is the founder and owner of Crypto Tax Advisors, LLC, a firm specializing in cryptocurrency taxation. In addition to one is the Mt. Gox shutdown. Mt. Gox was a Japa- serving crypto tax clients, Sharon is also an expert coach to other nese exchange launched in July 2010. By 2013 tax professionals, the author of ‘‘A Quick Start Guide to Crypto- and into 2014 it was handling over 70% of all bitcoin currency Taxation for Tax Practitioners’’ eBook, and the creator of (BTC) transactions worldwide, as the largest bitcoin the ‘‘Mastering Cryptocurrency Taxation – The Fundamentals’’ intermediary and the world’s leading bitcoin ex- online course. change.3 In February 2014, Mt. Gox suspended trad- 1 Bitcoin (BTC) price increased by close to 2,000% during 2017, from under $1,000 on Jan. 1, 2017, to $20,089 (highest ing, closed its website and exchange service, and filed price of the day per Coinmarketcap.com) on Dec. 17, 2017. Even though the BTC price dropped to $12,755 (low of the day on Dec. 31, 2017, per Coinmarketcap.com) at the end of the year, the over- 2 See IRS Publication 5307. all price increase for 2017 was still more than 1,200%! 3 Paul Vigna 5 Things About Mt. Gox’s Crisis, Wall. St. J. (Feb. for bankruptcy protection from creditors. It openly ad- • Section B is used to figure casualty or theft gains mitted that it had lost a total of 850,000 BTC.4 As a and losses for property that is used in a trade or result, Mt. Gox customers lost millions of dollars. business or for income-producing purposes; and Since the Mt. Gox shutdown, there have been quite a few crypto exchange shutdowns, including Italian • Section C is used to figure a theft loss deduction crypto exchange BitGrail, Ukrainian crypto exchange from a Ponzi-type investment scheme if a tax- Liqui, Hong Kong based crypto exchange Gatecoin, payer qualifies to use Rev. Proc. 2009-20, as and New Zealand based crypto exchange Cryptopia.5 modified by Rev. Proc. 2011-58, and chooses to Most of the exchange shutdowns were caused by follow the procedures in the guidance. significant loss of coins due to hacking, which subse- quently led to the exchanges filing for bankruptcy. We would argue that cryptocurrency is an income- Unlike in a stock investment where the investors can producing property in the hands of a crypto investor, at least recover up to $250,000 of Securities Investor as the goal of an investor is usually to earn income Protection Corp.-insured value when a brokerage firm through price appreciation in cryptocurrency. There- goes bankrupt, crypto investors in most cases lose all fore, casualty loss of cryptocurrency falls into the cat- of their coins after an exchange shutdown and can’t egory of loss for property that is for income- recover anything. Some people argue that an invest- producing purposes, and the loss should be reported ment loss deduction can’t be claimed after an ex- on Section B of Form 4684. Unlike for personal casu- change shutdown because the underlying coin does alty loss, there is no requirement for casualty loss re- not become worthless as a result. For example, if an lated to income-producing property to be subject to investor loses some BTC due to an exchange shut- down, the investor lost the coin but the BTC itself did federally declared disaster requirement. Instead, such not lose any value. For that reason, some people be- casualty loss can be deducted on Form 1040, Sched- ule A, line 16 (vs. Schedule A, line 15, for personal lieve that losing cryptocurrency due to exchange shut- 7 down is considered a personal casualty loss, which is casualty losses). usually not deductible under the TCJA. Bankrupt Financial Institution Personal Casualty Loss Deduction Deduction Are losses due to exchange shutdown really a non- Some people may ask—because almost all the ex- deductible personal casualty loss? Let us examine that change shutdowns resulted from or were related to a question from different perspectives. bankruptcy filed by the exchange—can we follow the Cryptocurrency is classified as property for tax pur- 6 rule for deducting losses on deposits in insolvent or poses according to Notice 2014-21. The character of bankrupt financial institutions? Like financial institu- gain and loss on disposal of a property depends on the tions, cryptocurrency exchanges act as a custodian of nature of the asset in the hands of the taxpayer. An in- crypto investors’ coins. If people can deduct the de- vestment property is considered a capital asset, and posit they lost due to bankruptcy of their financial in- gains and losses on disposal of investment property are classified as capital gains/losses. stitution, we believe crypto investors can also deduct the coins they lost due to bankruptcy of their ex- Similarly, the type of casualty loss depends on the nature of the property in the hands of the taxpayer. change. There are three sections in Form 4684 Casualties and Under the TCJA, taxpayers can no longer claim a Thefts: loss on a deposit in an insolvent or bankrupt financial institution as a personal casualty or theft loss. Instead, • Section A is used to figure casualty or theft gains 8 and losses for property that isn’t used in a trade there are two ways to deduct such a loss: or business or for income-producing purposes; • As a casualty loss to the extent the loss doesn’t exceed the taxpayer’s personal casualty gains (i.e., no net casualty loss deduction); 5, 2014). 4 Jon Southurst, Mt. Gox Files for Bankruptcy, Claims $63.6 • As a nonbusiness bad debt. Million Debt, Coindesk (Feb. 28, 2014). 5 Josiah Wilmoth, ‘Hacked’ Crypto Exchange BitGrail Shuts If you choose to report the loss as a casualty loss to Down 3 Hours After Re-launch, CCN (Feb. 5, 2018); Helen Partz, Ukrainian Crypto Exchange Liqui Shuts Down, Cites Lack of Li- offset your personal casualty gains from other items, quidity, Cointelegraph (Jan. 29, 2019); Diana Aguilar, Gatecoin you should report it on Form 4684. If you choose to Crypto Exchange to Shut Down on Court’s Orders, Coindesk (Mar. 15, 2019); Daniel Palmer, Collapsed Crypto Exchange Cryptopia Owes Creditors $2.7 Million: Liquidators, Coindesk 7 See IRS 2018 Instructions for Schedule A (Form 1040) p.A- (May 31, 2019). 12. 6 See Notice 2014-21, Q&A-1. 8 See IRS Publication 547, p.5.

Tax Management Memorandum 2 ஽ 2019 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. ISSN 0148-8295 report the loss as a nonbusiness bad debt, you can re- came almost worthless.12 Another type of crypto in- port it on Form 8949 and Form 1040, Schedule D.9 vestment scam is the so-called ‘‘Bitcoin multiplier’’ or By applying the same rule, we would argue that ‘‘crypto high-yield investment program.’’ The most crypto investors can deduct coins they lost due to ex- famous example is USI-Tech,13 a company that change shutdown either as a casualty loss to offset claimed to develop the world’s first automated trading their personal casualty gain (if any) on Form 4684 or platform for Bitcoin. USI-Tech started to sell BTC as a capital loss on Form 8949 and Schedule D of packages in May 2017, promising a 1% daily return. their personal tax return. In January 2018, USI-Tech stopped BTC payouts to its customers in the United States and Canada. Many people consequently lost large amounts of money. Capital Loss Deduction ICO scammers usually attract investors by giving Under §1234A, gain or loss attributable to the can- them an impression that their ICO project has great cellation, lapse, expiration, or other termination of a business potential and the ICO token will increase in right or obligation (other than a securities futures con- value and produce a high return. If the investors truly tract) with respect to property that is a capital asset in believe that the ICO is a legitimately good invest- the hands of the taxpayer shall be treated as gain or ment, they should be entitled to a capital loss deduc- loss from the sale of a capital asset.10 When crypto tion if the ICO token they purchased became worth- investors store their coins in an exchange, they retain less. Such tax treatment is consistent with that for in- the complete right to their coins. When the exchange vestment in a stock that became worthless, regardless is shut down, the investors lose the right to get back of whether it’s due to business failure or fraudulent their coins. Cryptocurrency is considered a capital as- activities committed by management. set in the hands of a crypto investor. Therefore, we The kind of scams committed by , can argue that the loss of cryptocurrency due to ex- Davor Coin, and USI-Tech are different than a typical change shutdown should be treated as loss from the ICO scam—they are more sophisticated, can last lon- sale of a capital asset under §1234A, and conse- ger, and collect more money. These scams result in a quently, the investor can deduct his/her loss on Form ‘‘Ponzi scheme’’ theft loss. Investors who suffer such 8949 and Schedule D as a capital loss. loss can choose to follow the procedures in Rev. Proc. 2009-20, as modified by Rev. Proc. 2011-58, if they CRYPTO INVESTMENT SCAMS qualify to use the revenue procedures. To qualify for a deduction under Rev. Proc. 2009-20, a taxpayer Another significant risk experienced by crypto in- must be a qualified investor and must have suffered a vestors is investment scams. Many people invested in qualified loss. There are several requirements for a a cryptocurrency (ICO), espe- qualified loss, such as the lead figure(s) in the scheme cially in 2017 when the crypto market was going up were charged by indictment or the subject of a state and up. Unfortunately, most of the ICOs turned out to or federal criminal complaint alleging the commission be scams. In most cases, the ICO token never got of a crime described in Rev. Proc. 2009-20, and either listed on an exchange for trade. Instead, the project the complaint alleged an admission by the lead fig- was abandoned, and the token became worthless ure(s) or the execution of an affidavit by that person shortly after the ICO was over. According to an on- admitting the crime, or a receiver or trustee was ap- line report, the total amount of money scammed from pointed with respect to the arrangement of assets or ICO investors exceeded $687 million just from the 11 the arrangement was frozen. top ten ICO scams in 2017. Taxpayers who qualify and choose to follow the In addition to ICO scams, there are other crypto- procedures in Rev. Proc. 2009-20, as modified by Rev. related investment scams. For example, BitConnect Proc. 2011-58, should report the loss they suffered and Davor Coin were two cryptocurrency companies due to a Ponzi-scheme in Section C of Form 4684. that each set up their own crypto lending programs The result will flow to Form 4684, Section B, line 28 and attracted many investors in 2017. In early 2018, and eventually be reported on Form 1040, Schedule BitConnect, followed by Davor Coin, shut down their A, line 16. lending programs, and soon after, the two coins be-

12 Fitz Tepper, Bitconnect, which has been accused of running 9 Id. Table 1, p.6. a Ponzi scheme, shuts down, TechCrunch (2018); Nathaniell, 10 All section references are to the Internal Revenue Code of Davor Coin: Pulling an Exit Scam in the Style of Bitcoin, One 1986, as amended (Code), or the Treasury regulations thereunder, More Cup of Coffee (Feb. 13, 2018). unless otherwise indicated. 13 See Delton Rhodes, How USI Tech Pulled Off One of the 11 Finance Monthly, The 10 Biggest ICO Scams Swindled Largest Crypto Scams, Coin Central (Nov. 26, 2018), for a de- $687.4 Million (Oct. 2, 2018). scription of USI-Tech’s activities and timeline of events.

Tax Management Memorandum ஽ 2019 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 3 ISSN 0148-8295 Most of the crypto Ponzi-scheme victims do not • Deduct as personal casualty loss to the extent of qualify to follow procedures in Rev. Proc. 2009-20 personal casual gain on Form 4684, Section A. because the lead figures in the schemes were never Deduct as non-business bad debt on Form 8949 charged by indictment, they never admitted their • and Schedule D (Form 1040). crime, and the assets scammed from investors were never frozen by authorities. If a taxpayer does not • Deduct as capital loss under §1234A on Form qualify to use the procedures in Rev. Proc. 2009-20, 8949 and Schedule D. as modified by Rev. Proc. 2011-58, or if they don’t choose to follow the procedures, they can report their loss on Form 4684, Section B.14 Crypto Investment Scams Alternatively, we can argue that BitConnect and Davor Coin victims are entitled to a capital loss de- • Deduct as capital loss according to worthless in- duction due to fact that the coins became virtually vestment treatment on Form 8949 and Schedule worthless. However, as long as the coin is still listed D. on an exchange for trade, a taxpayer needs to sell his/ • Deduct as Ponzi-scheme theft loss on Form 4684, her coin or officially abandon it in order to take a Section C and eventually on Form 1040, Sched- capital loss deduction. ule A, line 16. Unlike investment in BitConnect and Davor Coin, USI-Tech investors purchased BTC packages with • Deduct as casualty loss for income-producing Bitcoin. They were supposed to be paid in BTC as property on Form 4684, Section B, and eventually well. The USI-Tech shutdown took away the inves- on Form 1040, Schedule A, line 16. tors’ access right to their BTC in their USI-Tech ac- • Deduct as capital loss under §1234A on Form count. We believe that an argument can be made for 8949 and Schedule D. those investors to deduct their losses as a capital loss under §1234A, same as for investors who lost their coins due to exchange shutdown. The above analysis and conclusions are based on author’s understanding of federal tax law and IRS OPTIONS FOR DEDUCTIONS guidance as well as their application to losses suffered As discussed in the above analysis, there are sev- by individual taxpayers due to exchange shutdown or eral options a taxpayer can consider for taking a de- crypto investment scams. There is currently no spe- duction for coins lost due to exchange shutdown or cific official guidance regarding the deduction of such crypto investment scams. Following is a summary of losses. Documentation of investment records and the options: proof of facts must be obtained in order to substanti- ate a deduction. In addition, we recommend that a dis- Exchange Shutdown closure be filed with the tax return for any uncertain • Deduct as casualty loss for income-producing tax position you decide to take. Recently, the IRS has property on Form 4684, Section B, and eventually announced that it will issue new tax guidance regard- on Form 1040, Schedule A, line 16. ing cryptocurrency. Hopefully, the issues discussed in this article will be covered by the new IRS guidance, and we don’t need to continue to struggle with what 14 See Form 4684 instructions, p.7. tax position to take.

Tax Management Memorandum 4 ஽ 2019 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. ISSN 0148-8295