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Do Play-To-Earn Games Sell Unregistered Securities?

Play-to-earn game developers that sell in-game currency tokens or NFTs to their players may be inadvertently selling unregistered securities. Offering unregistered securities is illegal and the Securities and Exchange Commission (“SEC”) may prosecute developers and obtain injunctions, civil penalties, and orders to refund all investor funds (disgorgement). Further, the investors themselves can sue developers (including as a class action) for securities laws violations, all of which can be financially devastating. Securities laws are a major factor to consider, but there are other applicable laws and regulations that determine whether a play-to-earn game is legal. Accordingly, it is absolutely critical to consult with an attorney specializing in play-to-earn and obtain a legal opinion regarding legal compliance before offering and selling any fungible or non-fungible tokens.

What do securities laws have to do with gaming?

Securities are traditionally associated with stocks and bonds traded on various exchanges. However, “securities” is actually a much broader term and includes virtually anything that a company sells to raise funds, whether to the general public or to a select group of high net worth individuals in a private placement. In the play-to-earn context, either the in-game currency token or the game asset NFT can be considered securities. Crypto/blockchain/NFT regulation is still at the early stages, but the SEC has taken an active enforcement role in pursuing fraud and illegal token offerings in the digital assets market.

Not all tokens or digital assets are securities. The uses a four-prong analysis called the Howey test to determine whether an offering is a security. More precisely, courts apply the Howey test and examine whether something is an “investment contract,” which is a type of security. The United States Supreme Court created the test in SEC v. WJ Howey, 328 U.S. 293 (1946), when it determined that a company selling shares in an orange grove farming operation was actually selling unregistered securities. If a token does not qualify as a security under the Howey test, it is generally considered a “utility token” and may be sold without the constraints of securities laws (but may still be subject to other regulations).

How do securities laws apply to gaming tokens or NFTs?

An “investment contract” has four elements: (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profit; (4) derived from the efforts of others. With digital assets, the SEC generally assumes the first two prongs are met. Most, if not all, play-to-earn tokens involve an investment of money (either fiat currency or cryptocurrency with value) in a common enterprise (i.e. the game project). Thus, whether an offering is an exempt “utility token” or an unregistered security depends on whether the purchasers are led to expect profit derived from the efforts of others. In other words, does the purchased token function as a passive investment that pays dividends?

Of course, this is a very fact-specific inquiry. The SEC’s Strategic Hub for Innovation and Financial Technology (“FinHub”) has a rather complex set of guidelines and guideposts for the analysis, called the “Framework for Investment Contract Analysis of Digital Assets.” The SEC also relies on the DAO Report, which was a 2017 investigation of the Swiss-based DAO Project that explains the SEC’s application of Howey to digital assets.

In general, the determining factor is how the tokens are used. Do players actively use the NFTs they acquire to play the game and earn rewards? For example, an owner must manually enter the racehorse NFTs in Zed.Run (a hugely popular play-to-earn horse racing game) into various races, deciding on the best course type and distance suited to that particular “racehorse.” If the NFTs “wins,” the owner wins a prize, just like in real-life horse racing. Axie Infinity is another example of where players must actively manage their NFTs and “battle” them before earning rewards. Active in-game management likely negates both the third and forth prongs of Howey, as players purchase the tokens for in-game use and any rewards are not from the efforts of others – they come directly from the efforts of the player/owner. The same logic applies to in-game currencies that can be used to acquire in-game assets, pay entry fees, upgrade NFTs, and for other purposes. Simply put, while the in-game currency may certainly fluctuate in value on the secondary market, it is not a passive investment vehicle. It is an active “utility” component of a play-to-earn game.

Do staking and lending features affect the securities analysis under Howey?

As play-to-earn games become more sophisticated, so does the analysis. Many games now offer “staking” – which rewards players with in-game currency for parking their tokens or removing them from circulation for a set period of time. Additionally, NFT renting and lending are becoming more common, where owners let third parties to borrow their NFTs, actively use them within a game, and in return, receive a share of any winnings. The staking and lending mechanisms effectively enable passive income for token owners. Passive income is a hallmark of a security under the Howey test.

Play-to-earn games are a rapidly growing sector of the overall crypto and NFT market. It is critical for developers to ensure legal compliance, not only to protect themselves and their companies from crippling lawsuits, but to also make their product attractive to potential investors. In 2022, a comprehensive legal analysis of the play-to-earn project is a must-have for any pitch deck. Note that even if the token or NFT is not a security under federal law, state level “Blue Sky laws” may apply. Additionally, a token or NFT may be regulated as a commodity or under money transmission laws. In other words, the securities analysis is only part of a full legal evaluation.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2022 Artaev at Law PLLC. All rights reserved.

Stablecoins 101: What Are They, How Are They Taxed, and Can I Use Them In My Business?

Cryptocurrency has significant business utility, especially in international transactions. Companies can exchange funds directly, without wiring fees or banking delays, and easily convert their native currencies into crypto and vice-versa using a mobile phone. However, traditional cryptocurrencies like Bitcoin and Ethereum are extremely volatile and their exchange values can easily fluctuate 10-20% or more in a matter of days or even hours. Market supply and demand forces determine the prices of these most popular cryptocurrencies and their value is particularly sensitive to various external factors. Events like China’s crypto clampdown, significant buys or sells by capital investors, or even Elon Musk’s tweets can crash the market or send the price of crypto soaring. Obviously, price volatility makes businesses and consumers reluctant to adopt these cryptocurrencies for day-to-day transactions. Price volatility translates into purchasing power uncertainty, which in turn devalues the currency.

Stablecoins are cryptocurrencies that try to solve the volatility problem. They do so by pegging their price to the price of another asset (such as the U.S. Dollar or an ounce of gold). For example, the USD Coin (USDC) can be acquired and sold for U.S. Dollars on a 1 to 1 ratio. USDC is actually backed by existing dollar reserves, meaning that each USDC has a real-world dollar counterpart held by regulated financial institutions. USDC reserves are also periodically verified by a third party (but not audited).

There are other stablecoins as well, for example Tether, Binance USD, TrueUSD, DAI, and more. Like USDC, some are tied 1 to 1 to U.S. Dollar reserves. Others are backed by commodities like gold, silver, or oil. The price of a commodity-backed stablecoin is tied to the market price of a commodity unit, like an ounce of gold. There are also stablecoins that attempt stability through overcollateralization using other cryptocurrencies. Finally, there are algorithmic stablecoins that automatically adjust the cryptcurrency’s supply to keep its market price within certain parameters.

Stablecoins are however still cryptocurrency. Even if the stablecoin has a pegged 1 to 1 exchange ratio with the U.S. Dollar, it is not the same as cash. For tax and regulatory purposes, the IRS treats all cryptocurrency as intangible property subject to capital gains tax. They may be subject to separate state-level regulation as well.

Paying for goods and services in stablecoin is a taxable event because the IRS treats it like a sale or exchange of an asset, which is subject to capital gains tax. Technically, if the stablecoin is pegged to the dollar at a 1 to 1 ratio, the capital gain is 0 and there is no tax owed. But the transaction must still be recorded and reported, just like if you were buying and selling a stock at zero net gain/loss. Otherwise, you risk attracting an IRS audit to determine whether you underreprted taxable income. Buying stablecoin for cash and holding it is a non-taxable event.

Receiving stablecoin in exchange for goods and services is a taxable event. It is not much different than receiving payment in fiat currency, which is income subject to tax. The fair market value of the cryptocurrency as of the date of receipt determines its value for income reporting purposes. With stablecoin, it is easy to calculate because of the 1 to 1 ratio. Receiving 500 USDC is the equivalent of receiving $500 cash. However, spending the 500 USDC is not the same as spending $500 cash – rather, the transaction is considered a liquidation of property (subject to capital gains). Again, if the value of the stablecoin is pegged to the dollar, you are not going to have capital gains. But you must still keep records and record the transaction. If you are using a stablecoin that is pegged to an asset like gold, its price will fluctuate and you may record a capital gain or loss.

Converting other cryptocurrencies into stablecoin and vice-versa is also a taxable event. The sale of the crypto is an asset disposition that is subject to capital gains tax even if the transaction is an exchange of one currency to another. Similarly, using stablecoin to purchase other cryptocurrencies is a sale of the stablecoin that must be reported as income, even if the the capital gain is $0.

Stablecoins are still risky and unregulated. Not all stablecoins are created equal and it is a mistake to think that “stablecoin” means there is no risk involved. The LUNA/TERRA debacle is a good example because TERRA was supposedly a “stablecoin” pegged 1 to 1 to the U.S. dollar, yet it was pegged algorithmically (meaning artificially without any actual assets or fiat currencies backing it). An algorithm that no one really understands is not the same backing as fiat in a vault or money market securities or corporate bonds or commodities portfolios. The bottom line is that without a uniform definition of “stablecoin,” users should at a minimum know what “stabilizes” the value of the purported “stablecoin.”

There are other hurdles to using stablecoins in day-to-day business operations. As cryptocurrency, they are still subject to government regulation. For instance, it is illegal under federal labor law to pay workers in anything other than U.S. Dollars. On the international scene, China recently tightened anti-crypto regulations, prohibiting financial institutions from providing crypto exchange services, which presumably includes stablecoins. At the same time, China is rolling out its “digital yuan,” which is a sovereign-backed virtual currency. United States regulators have also expressed interest in the “digital dollar,” in part to improve financial services access to unbanked or underbanked communities. Additionally, all cryptocurrency transactions are still subject to exchange fees imposed by the intermediaries, and there may be delays or additional processing costs associated with converting stablecoin into fiat currency. Widespread adoption by merchants and the public is a must for stablecoins to develop practical utility – but right now, holding a wallet full of stablecoin is not the most practical or liquid solution for most businesses. Nor does a 1 to 1 dollar stablecoin provide any investment upside and in fact periodically loses value due to inflation.

Finally, there are at least 36 different stablecoins available for purchase via most popular exchanges. It is unknown which stablecoin (if any) will enjoy widespread adoption and popularity sufficient to result in real utility for businesses. Further, stablecoins are not truly decentralized because a central entity is holding the collateral, which in turn must be audited or otherwise verified. If a holding entity starts issuing stablecoins that are not actually collateralized, this would cause hyperinflation and essentially render the stablecoin worthless.

Stablecoin certainly holds a lot of promise for business use, but only solves the problem of volatility. Reduced volatility comes at a cost of a centralized authority and reintroduces trust into the cryptocurrency equation. At the same time, sovereign-issued digital currencies are on the horizon and may very well dispel the need for and demand for stablecoin.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Ask the Crypto Tax Lawyer: Is Staking Income Taxable?

Yes, staking income – just like most other types of income – is taxable. However, the question is when? When you receive the staking reward? Or only when you sell or exchange the newly- obtained tokens? Under the first, more conservative approach, the token is actually taxed twice – once as ordinary income at the time of receipt and the second time at the capital gains tax rate when it is sold or exchanged. Under the second, more aggressive approach, the token is not taxed upon receipt and not subject to tax until it is sold or exchanged. The second approach also allows token holders to take advantage of more favorable long-term capital gains tax rates by holding the staking rewards longer than a year.

How is Staking Different From Interest?

What is staking? It is an arrangement to “lock up” or “stake” a portion of an owner’s crypto tokens in a staking pool in return for additional cryptocurrency over time. The return is often expressed as a percentage. This makes staking seem very similar to an interest rate paid on a certificate of deposit or savings account. Indeed, on Coinbase, staking rewards are expressed in terms of an APY (annual percentage yield) and the term “interest earned” is used synonymously with staking. Unlike proof-of-work mining, which validates new transactions through solving complex algorithms, staking is more energy efficient and environmentally-friendly. Staking allows network participants to nominate their coins to be used as validators and to guarantee the legitimacy of new transactions on the blockchain. In return for validating a new block, the owner receives new tokens; if the transactions validated are later found to be illegitimate, the validator may lose tokens through a process called “slashing.”

Although it may seem like interest income, staking income may not be taxed the same way. The IRS has not taken a definitive position on this question even as the deadline to file 2021 taxes approaches. One of the reasons may be because of pending litigation in Jarrett v. IRS. In 2019, Josh and Jessica Jarrett sued the IRS for a refund on taxes paid on staking income, arguing that cryptocurrency received for staking should not be. Recently, the IRS appeared to concede that staking income is not taxable at inception and agreed to issue the Jarretts a refund. However, the taxpayers rejected the IRS’s offer – instead, opting to push the Tax Court to make a definitive ruling on the issue and create binding precedent. In response, the IRS has asked the Tax Court to dismiss the case in light of the plaintiffs having obtained full relief and the absence of a “case or controversy” for the Tax Court to decide.

The Conservative Approach – Staking Rewards Are Taxed Twice

Intuitively, it may seem that income from staking should be treated the same as interest/dividend income from a savings account, which is incurred when the bank pays it out. In the crypto context, the IRS has taken a position since 2014 that with mining, the fair market value of the virtual currency as of the date of receipt is includible in gross income. Arguably, staking income is sufficiently similar to interest earned or mining to be treated the same. Depending on the terms of the staking arrangement or agreement, the cryptocurrency or token contributed is restricted much in the same way that cash in a certificate of deposit is locked in until maturity.

The Aggressive Approach – Staking Rewards Are Only Taxed When Sold or Exchanged

However, the counter-argument (and the taxpayer’s position in the Jarrett case) is that the tokens received as a staking reward have no value until they are sold or exchanged. In that sense, they are like manufactured product that may have value when created, but is not taxed until it is sold. The product has a market value when created, but the IRS does not impose a tax on it at the time of creation.

Further, fiat currency has tangible value when received – an interest payment of $25 has worth and buying power at the time of receipt. It does not need to be sold or exchanged to have value. Conversely, 100 Tezos tokens (at issue in the Jarrett case) have no buying power or value until and unless they are exchanged into fiat, traded for another currency, or used to pay for services. Yes, if you pay for services with cryptocurrency, you are taxed on any difference between the basis and the fair market value of services received. According to the IRS, if you buy 100 Tezos for $1 (a basis of $100) and then exchange those same 100 Tezos for $300 worth of legal services, you just realized a $200 taxable gain. Proponents of the more aggressive Jarrett approach argue that cryptocurrency or tokens received as staking rewards are more analogous to a manufactured product than fiat currency interest or dividends.

The Issue Remains Unsettled

To complicate the issue further, the IRS’s offer to refund the Jarretts’ tax and settle the litigation seems like a tacit endorsement of the second, more aggressive approach. Arguably, the IRS is conceding the issue and admitting staking income is only subject to income tax when sold or exchanged. However, this position is directly at odds with the IRS’s guidance on tokens received from mining. The IRS’s Notice 2014-21 on virtual currency taxation states that “when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.”

While the issue remains unresolved, taxpayers should consult with their legal and financial advisors on the correct approach for them. The conservative approach risks including too much in your gross income. The aggressive approach risks underpayment penalties in the future if the IRS does issue guidance and takes the same position on staking as it has on mining. But in any case, keep an eye on the Jarrett case, as the Tax Court may rule on this very question in the near future.


Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2022 Artaev at Law PLLC. All rights reserved.

Categories
trademarks

Do I need a Metaverse Trademark?

Luxury goods company Gucci recently bought a plot of LAND in the Sandbox Game, an Ethereum-based play-to-earn game. This LAND is a virtual real estate plot (in the form of an NFT or non-fungible token) where Gucci plans to sell in-game clothing and collectibles. As futuristic as this seems, Gucci is not the only major company looking to get into the Web3.0 space. Walmart, McDonalds, Panera, Victoria’s Secret, Nike, and L’Oréal are just a few of the big players that recently filed trademarks specifically to protect their intellectual property in the Metaverse.

Nike has become particularly active. The company created a Nikeland experience in the popular Roblox game world (along with companies like Vans, Chipotle, and Hyundai, which also have staked out territory on Roblox). Nike also recently acquired RTFKT, a studio that specializes in NFT development and in January 2022, Nike announced the formation of Nike Digital Studios to create and deliver Metaverse and blockchain-based user experiences. Additionally, Nike has filed for dozens of trademarks to protect its virtual brand, including the use of its name and logo in online art, virtual goods, video games, and avatars. With a multi-billion dollar company like Nike trademarking dozens of its NFTs, many game developers, NFT collectors, traders, crypto bros, and others wonder whether they, too, should file for trademark protection within the Metaverse for their brand.

Do Gaming Developers Need Trademark Protection?

Absolutely. Games, gaming, and software in general are highly-competitive industries. Unfortunately, there is not much stopping a third party from copying your design and profiting off of it. This can create – not only marketplace confusion – but irreparable damage and dilution of your valuable brand. This can happen to companies big and small. Additionally, if you fail to trademark your game, brand, logo, catchphrase, etc., your competitor can come in, copy your brand, and then accuse you of violating their rights. While it is possible to file for retroactive trademark protection and win eventually, the easiest (and cheapest) protection is filing a trademark right away.

Do I Need to Trademark my NFT?

Yes. It is essential for you to trademark your NFT in order to protect it from copycats. The United States is a first-to-use country, which means your NFT will already have some automatic protections after minting. However, it would be very tough protecting your unregistered “common law” trademark in the worldwide NFT marketplace. Additionally, it would be very difficult to defend an unregistered NFT trademark in any sort of legal dispute should a third party copy your idea. Filing a trademark with the USPTO ensures validity and protection within all fifty states.

Trademarking your NFT creates a brand identity that is uniquely yours. Trademarking a unique slogan, logo, or design can be a valuable marketing tool for you going forward and add tremendous value to your project. After all, intellectual property rights are what you actually own when it comes to non-physical property like NFTs (and software or computer code in general).

Copyright is another important intellectual property right for NFT owners, users, buyers, and sellers. For example, it is critical to ask what rights you are actually buying when purchasing an NFT? Is there an agreement to transfer the copyright? A license? Nothing at all? Lack of clarity in the NFT transfer process can and will lead to litigation, more so as NFTs become more and more widespread.

How Do I Protect my NFT Internationally?

You can protect your NFT internationally, provided that you also apply for international registration during your initial trademark filing. Under the Madrid Protocol (which is an international treaty for the uniform protection and registration of trademarks), a registration through the USPTO can also be registered in other countries with a single application.

What is a benefit of international registration? International registration allows you to use a foreign country’s laws and judicial resources to enforce your mark in that country. A USPTO registration still allows enforcement through a U.S. based court, even if the infringer is in a foreign country. However, even if you prevail, you might not be able to enforce the U.S. court’s judgment abroad. An international trademark registration opens up a number of other enforcement options. If you are interested in international trademark registration, this is something to discuss at your initial consultation.

What Types of Things Should I Trademark?

Here is a non-exhaustive list of items that could potentially qualify for trademark protection:

  • Avatars
  • Logos
  • Game Name or Gaming Development Company’s Name
  • NFTs
  • Virtual Goods (avatar skins, digital art, etc.)
  • Color Schemes
  • Particular Sounds (The coin grab ding from the classic Mario Brothers game comes to mind here.)
  • Slogans

What Cannot be Trademarked?

The United States Patent and Trademark Office (USPTO) has a set of guidelines that lists some of the following reasons for trademark rejection:

  • Likelihood of Confusion – If you create a game called GranD Turismo 7, you could not trademark that name because people could confuse it with Gran Turismo 7, the newest addition to PlayStation’s highest selling video game franchise. Sony owns the trademark to protect against competitors who seek to profit off of its name recognition by creating a similarly named game. Thus, you cannot trademark GranD Turismo 7.
  • Merely Descriptive and/or Intentionally Misleading – For example, you can’t trademark the words “fun and entertaining.” Even though your game is both fun and entertaining, these only describe the game itself and don’t necessarily make your game unique, so you can’t trademark them. Likewise, the USPTO will reject your trademark if it is intentionally misleading. For example, if your game’s name is “Play with Cryptocurrency,” but the game does not play with cryptocurrency, the USPTO reviewer could consider this game name intentionally misleading and deny your trademark.
  • Primarily a Surname – For example, Smith’s Play-to-Earn Game is primarily a last name (and merely descriptive) would not be suitable for a trademark.

How do I file a trademark for my game or NFT?

Whether you’re filing a trademark for an NFT, a digital avatar, a slogan, or your business name, Artaev at Law has the professional expertise to help you do it right. Artaev at Law, together with the specialized trademark attorneys at Mighty Marks, now offers a fixed fee, all-inclusive trademark service. Contact Dan Artaev at dan@artaevatlaw.com for additional information.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional. Any link to or reference to any specific project is not an endorsement of or validation of that project and is for solely informational purposes.

Ask the Crypto Tax Lawyer: What’s New for ’22?

2022 is a marquee year for anyone who took got involved in cryptocurrency during the 2021 market boom. The start of the new year means the start of tax preparation season and many individuals and companies are working to understand the tax treatment and implications of digital asset investments. In 2021, the IRS and the Department of Treasury announced increased efforts to track cryptocurrency transactions and enforce the perceived underpayment of tax in the crypto world. However, the government’s guidance has been limited. There are many uncertainties and questions in this evolving area of law. Read on for a summary of the key issues:

Cryptocurrencies Are Taxed As Property Subject to the Capital Gains Tax.

In the ever-changing world of crypto, one thing has stayed the same (since at least 2014): Cryptocurrency is property subject to the capital gains tax. In its FAQ guidelines, the IRS addresses a number of situations (such a hard forks and airdrops) to explain its position on basis and gain/loss calculation. If you received, sold, exchanged, or otherwise disposed of “any financial interest in any virtual currency,” the IRS requires you to disclose this on the first page of the 1040. If you check “yes,” expect to file a 1040 Schedule D (“Capital Gains and Losses”) and an 8949 supplement.

What does this mean in practice?

  • If you bought cryptocurrency in 2021 for cash and are holding it (or HODLING), there is no transaction subject to capital gains and nothing to report.
  • If you sold cryptocurrency for cash, traded crypto for another crypto, used crypto to buy an NFT, or paid someone for goods or services using crypto, you have a reportable capital gains transaction. The “gain” is the difference between the initial value (basis) and the sale value. If the period between acquisition and sale is less than a year, the short-term rate applies, which treats the gain as ordinary income. If the period is more than a year, the long-term rate applies and is either 0%, 15%, or 20% depending on your annual income level.
  • Exchanging crypto for other crypto (for example, you exchange BTC for ETH) is also subject to capital gains tax. The IRS treats the exchange as if you sold BTC for cash and used that cash to buy ETH. That means that any “gain” you realize on the sale of BTC is reportable and taxable, even if you use 100% of your proceeds to buy another cryptocurrency.
  • If you use crypto to buy an NFT or pay for some other goods or services, the IRS treats the transaction as if you sold the crypto for cash (incurring a capital gain) and then used the cash to buy the NFT or pay for the other goods/services.
  • What if my corporation or LLCs bought, sold, or exchanged virtual currency or digital assets? There is no guidance to suggest that business entities are treated any different. Record and report crypto and other digital asset transactions like you would physical property or assets.
  • Best practice remains to record all of your cryptocurrency transactions in a spreadsheet or accounting software, including the type of asset, the basis price, the date, and any gain/loss (as well as transaction fees). Alternatively, bigger exchanges like Coinbase make reports available to their customers and integrate with several popular crypto tax reporting platforms.

The IRS Has Not Issued Guidance on Taxing NFTs, Utility Tokens, Security Tokens, or Any Other Types of Digital Assets.

What about NFTs? Or utility tokens that you may have bought and sold as part of a play-to-earn game? Or security tokens (STOs) that becoming a corporate financing alternative for high-tech startups? The IRS has not issued guidance or taken a position on any of these particular instruments. In its FAQ, the IRS defines “virtual currency” as follows:

 Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.  Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency.  The IRS uses the term “virtual currency” in these FAQs to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and cryptocurrency.   Regardless of the label applied, if a particular asset has the characteristics of virtual currency, it will be treated as virtual currency for Federal income tax purposes. 

https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions

Although this definition gives some guidance on the IRS’s position, it is still not clear whether NFTs and non-cryptocurrency tokens are “virtual currency.” For instance, NFTs (non-fungible tokens), represent a wide range of things. They can be art or basketball trading cards, but also can be virtual metaverse real estate or video game magical items. Some commentators have suggested that NFTs will be taxed at the 28% “collectibles” tax rate – but that hypothesis presupposes that all NFTs are “collectibles,” which is simply not true for all NFTs. At the same time, the IRS’s definition of “virtual currency” appears to require the asset to be used as a “medium of exchange,” which is also not true of all NFTs. At this time, the NFT tax analysis is best done on a case-by-case basis, with a careful evaluation of what the NFT represents and how the real-world equivalent would be taxed.

Utility tokens are digital tokens that have non-investment uses (or utility) and fall outside of the federal definition of “security.” Play-to-earn video games (like Axie Infinity and its imitators) use native digital tokens for in-game currency and rewards, but the tokens can also be bought and sold on a secondary market. These tokens are more in line with the IRS’s “virtual currency” definition – and while the IRS has not expressly opined that utility tokens are property subject to capital gains tax, they most likely are. In other words, keep records and be prepared to report your sales and exchanges at tax time.

Security tokens (security token offerings are called STOs) are the digital equivalent of traditional corporate financing instruments like SAFE notes or seed round equity. However, the IRS does not consider STOs (or any other tokens) as stock or securities, even if the Securities and Exchange Commission (“SEC”) does. In other words, you sell or buy a security token, you must do so either as a registered security or one that meets an exemption (for example under Regulation A+, D, or S). However, neither the investor nor the selling company gets to claim any sort of tax benefit from the “security” token – because the IRS likely treats it as property and not securities. This means that when you invest in a security token (even one that is registered with the IRS), the tax breaks or advantages that apply to the purchase and sale of stock do not apply.

The Wash Sale Rule Still Does Not Apply to Cryptocurrency, But Might Apply Next Year.

There is a silver lining to the fact that cryptocurrency (or other tokens) are not considered “securities” for the purposes of tax law. The wash sale rule does not apply to crypto and allows for loss harvesting to offset capital gains (and even up to $3,000 of ordinary income.) For example, right now crypto markets are down from their highs and many investors may be showing a loss. If you sell at a loss and buy the asset back immediately, you can claim the “loss” on the sale on your taxes. The wash sale rule – which is applicable to securities – requires a 30 days period before repurchasing the same or substantially the same security.

Congress is aware of and is working on closing this so-called “loophole,” but right now the wash sale rule likely does not apply. It is unclear whether you will be able to claim a loss on 2022 returns if you sell at a loss in 2022, but as of the date of this article, crypto investors can still take advantage of loss harvesting opportunities.

The 2021 Infrastructure Bill Has Not Killed Cryptocurrency.

In the summer and fall of 2021, there was a lot of concern in the cryptocurrency community over certain reporting requirements that Congress wanted to impose on cryptocurrency market participants. Although much of the “hype” was overblown, the main issues were with the new reporting requirements, the definition of “broker,” and how the reporting requirements would affect miners and other participants who are not in the direct sales business.

President Biden signed the Infrastructure Investment and Jobs Act on November 15, 2021, and needless to say, the U.S. cryptocurrency markets are very much alive and functioning. The Act extended the $10,000 cash reporting requirements to “digital assets” transactions, meaning that businesses that receive more than $10,000 in cryptocurrency have to file a Form 8300 with the IRS. The form requires the disclosure of the payor and payee’s name, address, Tax ID, and other information.

The new reporting requirement will not take effect until 2024. By then, expect the IRS and the Treasury Department to develop regulations and provide guidance to market participants, so stay tuned for future developments in this area. It is likely that the scope of the regulations will be limited, as $10,000+ crypto and NFT transactions are much more common than cash transactions, and (unlike cash) also may take place without the parties ever even seeing each other or meeting.

Additional regulation of digital assets in the U.S. is to be expected given their popularity and increasingly prominent role in the economy. However, the U.S. is not about to “outlaw” cryptocurrency, NFTs, token, or any other digital assets. The blockchain tech market is alive and well, but with better defined taxation and regulation may even become more mainstream.

The bottom line is that cryptocurrency markets and derivative digital assets are here to stay. Regulation is constantly evolving and there are many uncertainties for investors and companies working in this emerging market in 2022. Professional legal guidance is always a good idea.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2022 Artaev at Law PLLC. All rights reserved.

What Every Business Owner Must Know About Cryptocurrency Systemic Risk

Whether your business is a full-scale investor in cryptocurrency and blockchain technology or whether you are simply using cryptocurrency to diversify your balance sheet or facilitate international transactions, you are assuming systemic risk. Systemic risk is basically the risk that the “system” in question will fail. The 2008 financial crisis is a recent example of the financial system’s failure due to overleveraged institutions and opaque and risky lending practices. Cryptocurrency and blockchain tech are quickly growing and becoming an integral part of the global financial markets – essentially evolving into another system. For example, sophisticated investors can self-direct their retirement accounts into cryptocurrencies and stake their entire savings on this growing tech.

Risk is part of any business. However, so is effective risk management, which particularly critical in the blockchain/cryptocurrency context, which operates outside of the safeguards and regulatory oversight common to traditional financial institutions. At the same time, existing tax, securities, commodities, and finance regulations still apply to crypto, and compliance is critical to the smooth functioning of your business. At a minimum, any business involved with blockchain tech should involve an experienced business attorney to develop their internal risk management protocols and have a plan for legal compliance, as well as systemic risk.

1. Existing Tax, Securities, and Other Laws Still Apply to Cryptocurrency.

First, and foremost, cryptocurrency is an asset and blockchain enterprises are businesses that are subject to general state and federal laws. While there is no central authority in the United States responsible for policing crypto markets, that does not mean that crypto business operate independent of the law. Government regulators are playing catch-up, and have repeatedly asserted their authority over cryptocurrency and related tech under existing laws. For example, 2020 was the first year that the IRS asked taxpayers about their crypto holdings. Enforcement units are gearing up to address tax evasion and close the multi-million dollar gap between actual income and what is reported to the IRS. The SEC and CFTC are also stepping up enforcement actions to head off fraudulent activity and lack of transparency in certain financial offerings. The Department of Treasury (through FinCen) is also stepping up oversight to enforce existing anti-money laundering frameworks.

The existing regulatory framework is far from perfect and is not well-suited to the unique characteristics of cryptocurrency. For example, why are some ICOs (initial coin offerings) securities, but established coins like Bitcoin and Ethereum are not securities? Capital gains taxes apply to cryptocurrency and stablecoins. But the IRS has not issued any guidance on NFTs. Are they going to be taxed like “property” or like collectibles, art, gold bullion, or something else? Will NFT tax rates depend on what the NFT is supposed to represent?

Stablecoins are a whole separate issue. Recently, a group of Treasury, SEC, and CFTC officials urged Congress to pass legislation to regulate stablecoins. In the “Report on Stablecoins,” the group noted existing SEC and CFTC authority to regulate these markets, but urged reform and legislation that is specific to the new technology.

For investors and innovators, legal compliance is the essential first step. Nothing stifles innovation like an IRS audit or an SEC investigation. Make sure to consult with an experienced attorney for guidance on the latest state of the quickly changing law in this area.

2. Decentralization Does Not Mean Risk-Free or Safe.

Second, the decentralized nature of cryptocurrency and blockchain tech in general lends itself to a false sense of security among investors and businesses. Some crypto advocates consider regulation unnecessary because blockchain tech is “decentralized.” The public ledger system purportedly means total transparency, equity, and fairness. In reality, a decentralized system is not immune from tampering or malfeasance.

For example, blockchain at its core is software that depends on coders and engineers upgrading the “chain,” fixing bugs, and making improvements. Someone somewhere determines forks and chain upgrades. Also, what about miners? What precludes off-chain influence (i.e. bribes) to miners that would impact the whole chains or cause them to verify certain blocks or transactions out of sequence?

Stablecoins are considered “safe” because the tokens are purportedly backed by fiat or equivalent reserves. But there is a lack of transparency between various stablecoins, different liquidity thresholds between reserves (for example, cash vs. money market vs. short term bonds), and variable redemption mechanisms and minimums. Additionally, is your stablecoin of choice based on a public blockchain or a permissioned blockchain? Permissioned blockchains limit access to the blockchain, providing more certainty as to who is responsible for the chain’s operation and integrity. At the same time, they reduce transparency and accountability.

Further, the federal government does not insure stablecoin or cryptocurrency deposits. If you stake cryptocurrency for a return, you are not insured or protected against the coin’s failure, a run, or illiquidity. If you are using a stablecoin to facilitate DeFi transactions, have a plan in case of network problems, chain disruptions, or backing failures. For instance, use several stablecoins to diffuse the risk.

As illustrated by the recent examples of the SQUID token and the Evolved Apes NFT, crypto tech is full of bad actors. The chain itself is not immune from malfeasance. Any business that fully depends on the integrity of the blockchain for its day to day operations must have safeguards. At a minimum, a crypto company must have a robust security system and team dedicated to detecting network health and chain anomalies. Financial hedging that diffuses the risk over multiple chains, cryptocurrencies, and other assets is also critical. Finally, established and documented due diligence protocols to assure investors, regulatory authorities, and lenders are a must.

3. Do Not Take the Internet For Granted.

Third, there is an inherent systemic risk to anything that depends wholly on the operation of the internet. Outages of certain sites or even network-wide service providers are not uncommon. Just recently, Facebook and Instagram were down for almost a full day. Comcast made headlines for its network outages across the United States on November 9, 2021. Directly related to cryptocurrency markets, exchanges like Coinbase have connectivity issues and other disruptions in times of market volatility. This can have direct adverse financial consequences for a business that depends on access to the crypto markets.

Due diligence protocols and internal safeguards are essential in this context. Offline copies of books and ledgers, at least backing up transactions history on a periodic basis. If you are storing crypto, look into offline (hardware) storage options for your code and data. Consider hedging and diversification.

Most important of all, have a plan. Cybercrime and ransomware insurance options are also worth looking into. Crypto and blockchain are existing, but are not without substantial risk. While government regulators are playing catch-up and are urging Congress to pass a risk control framework, legislation is not an instant process. In the meantime, plan for systemic risk as part of your business plan.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Stablecoin Taxation and Securities Regulation: What Every Investor Must Know.

Stablecoins are cryptocurrencies backed by other assets like fiat currency reserves, precious metals, commercial paper, and even portfolios made up of other cryptocurrencies. By pegging their value to another asset, stablecoins attempt to decrease price volatility and achieve a more “stable” price than uncollateralized cryptocurrencies like Bitcoin and Ethereum. As I previously wrote, stablecoins may be particularly useful for international trade and business due to their predictable value and the ability to avoid wire delays and to minimize transaction costs. Stablecoins are also not targets of speculation or artificial price increases due to external events like Elon Musk’s SNL appearances or even China’s clampdown on Bitcoin mining. If the stablecoin is pegged to the value of the dollar, it will still be worth $1 regardless of whether there is a sudden spike in demand or supply.

Other than potential business use, stablecoins are also a popular investment medium. Certain exchanges have offered attractive interest rates on stablecoin holdings, ranging from Coinbase offering 4% on USD Coin (USDC) to double-digit returns on some lesser exchanges and stablecoins. As always, do your due diligence and make sure you know where your money is going before transferring any significant amount of cash. Also, it may be worthwhile to test the liquidity or withdrawal time with smaller deposits before investing any large amounts.

Just like with traditional cryptocurrency, there are two main legal areas that affect stablecoins: tax and securities regulation. Here are the latest “must knows” in each area:

Stablecoins are taxed like property and are subject to capital gains tax. Cryptocurrency is not “currency” as far as the IRS is concerned – rather, for taxation purposes, it is treated like property and subject to capital gains tax. This gets tricky, especially with stablecoins that are pegged 1:1 to the dollar. Buying stablecoins (or any crypto) for dollars is not a taxable event. However, using stablecoins to purchase goods and services is a taxable event that must be reported, even if your capital gains are zero.

For instance, if you buy 1,000 USDC for $1,000, that is not taxable. Then, when you pay a Romanian engineer 1,000 USDC in exchange for a circuit board design, the IRS deems that you have sold the USDC at the market rate in exchange for the engineering services. The difference between your cost basis and your sell price is the capital gain. Where the stablecoin is pegged 1:1 to the dollar, the capital gain will be $0 (your purchase price and sale price are the same). In fact, you may even realize a loss that you can use to offset your income if you paid a transaction fee. Transaction fees are added to your cost basis, so if you paid a $10 transaction fee to buy 1,000 USDC, your cost basis is $1,010 and when you sell for $1,000, you just netted a $10 loss. Also, you can end up with capital gains or losses if you are transacting large amounts of stablecoin – for example if you sell 50,000 USDT (Tether) when it’s price fluctuated slightly to $1.01, you just received a $500 capital gain.

Additionally, if you are earning interest on your USDT holdings, interest is taxable like ordinary income. In other words, buying stablecoin for fiat currency is not taxable, but earning stablecoin through staking is taxable. Just like you pay income tax on interest earned from your savings account, you will incur income tax on cryptocurrency gains. Finally, when you use your earned USDT to buy something or convert to cash or another cryptocurrency, that is a reportable taxable event subject to capital gains tax because for IRS purposes, you just sold property – your cryptocurrency.

Some stablecoins may be regulated like securities. The Securities and Exchange Commission (SEC) enforces U.S. securities laws, which apply to a wide range of publicly-available investment products like stocks, bonds, mutual funds, and investment contracts where investors provide capital in exchange for expected returns. Cryptocurrencies like Bitcoin and Ethereum are not considered securities because they are exchange mediums and in the SEC’s view, are no different than a foreign currency like the Euro or the Japanese Yen. At the same time, the SEC has scrutinized new coin offerings (also called initial coin offerings or ICOs) and concluded that they may constitute investment contracts if there are facts that indicate the buyer is “expecting a profit to be derived from the efforts of others.” See generally SEC v W.J. Howey Co., 328 US 293 (1946) (where the Supreme Court held that shares in a citrus grove operation were investment contracts subject to securities laws because the investors provided capital with the expectation that workers’ efforts in harvesting oranges would yield profits). Certain stablecoins, especially those that seek capitalization through ICOs and promise a percentage return through “staking,” will be considered “investment contracts” required to register with the SEC and provide public information like any other security.

There are also some stablecoins that are backed by securities like corporate and municipal bonds, mutual funds, and other publicly-traded instruments that are themselves regulated by the SEC. There is little doubt that these security-backed stablecoins are considered derivatives because their value is derived from the value of regulated securities. SEC regulation will require stablecoin issuers to disclose additional information about their companies to the public. Already there is some concerning information release ahead of Circle’s (the issuer of USDC) intent to go public – USDC reserves are only61% cash and money market funds, with the rest divided between U.S. and foreign treasury bonds, municipal, and corporate debt. Previously, the 1:1 stablecoin issuers represented that each coin was backed by actual cash reserves, which were regularly audited. Apparently, that is not the precise reality.

Finally, stablecoins are also facing increased regulatory scrutiny from central bank authorities. Federal Reserve officials have expressed their concerns about the effect of stablecoins on the credit markets. Stablecoins also threaten the ability of the Federal Reserve to regulate monetary supply to stimulate the economy and control inflation. For instance, if a coin like USDC gains widespread adoption, a private company like Circle will be able to regulate monetary supply by increasing and decreasing interest rates. Expect to see increased guidance and regulation from the U.S. Treasury and the Federal Reserve in the near future. It would not be surprising to see stablecoin issuers to be treated as banks in certain circumstances.

Want to know more? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Ask the Crypto Tax Lawyer: Offsetting Capital Gains Through Loss Harvesting.

Update: As of November 10, 2021, Congress is in the process of considering legislation to preclude loss-harvesting through cryptocurrency sales. Congress is also considering other amendments to the Tax Code and other laws to address cryptocurrency specifically. As this is a rapidly developing issue, it is critical that you consult with a tax attorney or other professional about your specific situation and the current state of the law before making any transactions or business decisions.

More than half-way through 2021, cryptocurrency remains an extremely popular investment. Although volatile and subject to unpredictable regulation (yes, that means China), the market has experienced substantial growth. Exchanges like Coinbase and integration with PayPal make owning, trading, and speculating in cryptocurrency easy. Sophisticated investors have even added cryptocurrency into their self-directed retirement portfolios, banking on the continued growth and popularity of the decentralized exchange medium.

As I have previously written, the IRS is keeping a close eye on cryptocurrency investors, transactions, and markets, looking to capture taxes on hundreds of millions in underreported or unreported income. In other words, crypto taxes are going to be an issue for many in the coming tax years, especially after the Biden administration’s mandatory $10,000 or more transaction reporting rule goes into effect in 2023. However, with proper planning and strategy, there are ways to reduce your tax liability even if you are planning to liquidate your crypto positions in the near term.

As a basic matter, know that the IRS classifies cryptocurrency as “property,” which means that it is subject to capital gains tax. General capital gains reduction strategies work for cryptocurrency as well as they do for more traditional property like investment real estate, stocks, and bonds. For instance, waiting at least 365 days to sell lets you take advantage of the lower long-term capital gains tax rate. Selling in a lower income year where your overall income puts you in a lower tax bracket is another strategy.

One advanced tax strategy involves taking advantage of the so-called wash sale rule. Or rather, it is taking advantage of the fact that the wash sale rules does not apply to cryptocurrencies (yet). Under Treasury Regulation 26 CFR 1.1091-1, an investor cannot sell “stock or securities” at a loss, use the loss to reduce taxable income, and then immediately repurchase the stock or security. Under the wash sale rule, there is a 30-day waiting period before purchasing the same or substantially the same stock or security – if an investor repurchases the security within the 30-day restricted period, the loss will be added to the cost basis of the repurchased security and reduce capital gains on the sale of the repurchased security, but it will not be treated as an investment loss to reduce general tax basis. In other words, you cannot manufacture losses in a bear market to reduce your taxable income that you receive from other investments, rentals, or wages.

The IRS has been clear that cryptocurrency is treated as “property” for tax purposes. However, whether it is a “stock or security” remains unanswered and both IRS Notice 2014-21 and the recently amended FAQ are silent on the issue. There is no express definition of “stock or securities” for the purposes of the wash sale rule. Looking elsewhere in the Internal Revenue Code, the definitions of stock and securities in various other sections include traditional shares, notes, bonds, and the like. Indeed, in 1988 the United States Tax Court adopted a narrow interpretation of the Code, holding that stock options were not considered “stock or securities.” Gantner v. Commissioner (91 T.C. 713 (1988). Congress responded by amending the wash sale rule to expressly include stock options, but still did not enact a definition of “securities” for the purpose of the rule.

Based on the current Code and Regulations and the lack of IRS guidance on the issue, there is a strong argument that cryptocurrencies are not “stock or securities” for the purposes of the wash sale rule. What this means is that crypto investors can take advantage of loss harvesting to accrue losses and use those losses to offset income. For example, if you buy one Bitcoin for $30,000 and the next day the price drops to $20,000, you can sell the Bitcoin at a loss of $10,000, “harvest” the loss, and repurchase the Bitcoin for $20,000 shortly thereafter. You still own 1 Bitcoin, but now you have accumulated a loss that you can use to offset capital gains income.

If your losses exceed capital gains, you can use up to $3,000 of loss to reduce regular income. Any excess loss can be carried over to future years to offset future gains.

At the same time, the Securities and Exchange Commission (“SEC”), the Commodities Futures Trading Commission (“CFTC”), and certain United States courts have ruled that cryptocurrencies are indeed “securities” within those Commissions’ regulatory scope. This regulatory effort was generally to stem the fraud and abuse through “initial coin offerings” or ICOs that sought to evade strict regulations designed to protect investors. While there is currently no indication that the IRS would consider cryptocurrency as “stocks or securities,” there is precedent for that conclusion from these other agencies and remains possible that the IRS could issue supplemental guidance and interpretations to that effect.

At the time of this writing, the IRS has not issued any such interpretation and savvy investors can consider the loss harvesting strategy if appropriate for their particular situation. As with all cryptocurrency transactions, good record keeping is paramount. It is especially critical to have accurate records to substantiate your losses if you are repurchasing the same crypto. Good and accurate records are the best tool in defending your position to the IRS, should the IRS take a position and disallow your claimed losses.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Ask the Crypto Tax Lawyer: What Are the Tax Implications of Cryptocurrency and NFT Investing?

Important: The information in this article applies to individual investors and LLCs that are taxed as pass-through entities. The rules are different for corporations and LLCs electing to be taxed as a corporation and are not addressed here. This article is for informational and promotional purposes only and, as always, you should consult with a professional about your specific tax situation before taking any action.

2021 is the year of cryptocurrency. Bitcoin and its kin have attracted many institutional investors, smaller individual portfolios, and even some sophisticated self-directed retirement accounts. The accessibility, decentralization, and unlimited upside certainly make cryptocurrency (or crypto) an attractive investment. Or simply a fun way to try to make some extra fun money. Or lose it – the crypto market is extremely volatile and quickly reacts to government action (i.e. China’s ban) and Elon Musk’s tweets or SNL appearances.

Government regulators are watching the crypto markets. The Securities and Exchange Commission (“SEC”) has already applied securities laws to police initial coin offerings and to prosecute Ponzi schemes posing as crypto investments. As early as 2014, the IRS issued guidance (supplemented by a more recent FAQ) classifying cryptocurrency as property for tax purposes. More recently, the Department of Treasury and the IRS have zeroed in on cryptocurrency as a tax revenue source ripe for enforcement. As part of its tax reform plan, the Biden administration announced mandatory reporting of any crypto transaction of $10,000 or more starting in 2023. On May 20, 2021, the Treasury also released a report detailing the plan to close the so-called tax gap, which is the difference between taxed owed and taxes actually paid. In 2019, the gap was $600 million or 15% of all taxes, and is projected to grow to $7 billion in 10 years if left unaddressed. The biggest contributor is unreported income and Treasury and the IRS will be looking very closely at anyone who is trading cryptocurrency in the next few years for any signs of unreported or underreported taxable income.

Why are there taxes on trading crypto and how is crypto even taxed? Despite its name, cryptocurrency is not really currency for tax purposes. It is taxed like property and is subject to capital gains tax. When you purchase crypto with fiat currency (i.e. U.S. Dollars) you do not pay tax on the transaction. Note: States do not consider crypto purchases subject to sales tax – yet. But when you sell crypto, you are taxed on the gain (if any) just like you would be if you sold a stock or investment real estate. The tax rate depends on the length of time you held the asset and other factors related to your income status. Importantly, when you exchange one cryptocurrency for another (for example, you trade Bitcoin for Ethereum) the exchange is taxable. The IRS considers an exchange to be a sale of one asset for cash – income – regardless of what you do with the proceeds. Accordingly, it is critical to keep accurate and clear records of every transaction involving cryptocurrency, regardless of gain or loss. Interestingly, while the IRS considers cryptocurrency “property,” it does not consider it “securities” and therefore investors can take advantage of certain tax benefits. Specifically, crypto investors can do something called “loss harvesting” to offset taxable income from other sources.

How does the IRS verify income from crypto trading? In 2020, the IRS asked taxpayers about their participation in any cryptocurrency transactions as part of their 1040 filing. In large part, the tax system is based on self-reporting, but with third party verification checks. Bigger exchanges like Coinbase report your transaction history to the IRS and you should have received a copy of the 1099-MISC for tax year 2020. The IRS will then flag any returns that do not match the information received from the exchange and what the taxpayer puts on their return. Off-brand or off-shore exchanges may not report to the IRS, but you still have to report those transactions yourself and pay tax on any gains. As mentioned above, the Biden administration is cracking down on underreporting of taxable crypto income. This means expect to see significant and highly-publicized enforcement actions, including penalties, interest, and even jail time for tax evaders. If you do use an off-shore crypto exchange, you should also be aware of your tax obligations in the host country. The United States has tax treaties with many (but not all) countries – for example, while there is a treaty with mainland China, the treaty does not apply to Hong Kong and there is no separate treaty with Hong Kong. International tax law will also come into play if buy and sell crypto abroad or exchange it for goods or services in other countries.

What about NFTs? Non-fungible tokens or NFTs are unique digital-only objects or unique digital versions of real-world objects. This is basically computer code. Mostly associated with collectibles and art, NFTs use blockchain technology like cryptocurrency but can represent almost anything, including virtual real estate and personalized avatars. The IRS has not issued definitive guidance on how NFTs will be taxed, but most commentators agree that they will probably be considered property like cryptocurrency and be subject to capital gains tax. If you buy an NFT for U.S. Dollars, you do not pay tax on that transaction. If you sell an NFT for a profit, you just incurred capital gains tax liability, even if you are exchanging an NFT for another NFT or trading it for cryptocurrency. If you are buying an NFT with cryptocurrency, the purchase will also be subject to capital gains tax, as the IRS treats the transaction as a sale of an asset (cryptocurrency), income, and then use of that income to purchase the NFT. Currently, there are no tax exemptions or safe-harbor periods that allow traders avoid capital gains tax on exchange type transactions.

An additional question with NFTs is whether the tax rate will change based on what the NFTs represents. Is it a collectible piece of art? Then there is a special collectibles tax rate. Is it real estate? Something else? There are a lot of unanswered questions about NFT taxes at this time. But like with cryptocurrency trading, make sure to keep meticulous records of all transactions, including any gains or losses on sales.

A final item of note – estimated quarterly tax payments. The IRS (and state tax authorities) require the payment of estimated quarterly taxes from self-employed individuals or independent contractors. If you buy and sell crypto (and NFTs) make sure you are reporting and paying expected capital gains tax before the due date for payments that apply to the quarter of the sale. If you wait until the end of the year to pay taxes, you may be subject to penalties and interest for failing to pay quarterly. Additionally, you may have to liquidate other investments to pay taxes, instead of simply setting aside the capital gains estimate at the time of the original sale.

In short, if you are investing and trading crypto or NFTs, keep good records. Pay attention to any new guidance issued by the IRS. Beware false or misleading information on the internet. And above all, retain a trusted advisor to answer your questions and guide you through your tax obligations in this evolving field.

Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

Can a Self-Directed IRA (“SDIRA”) Invest in Cryptocurrency and NFTs?

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Self-directed IRAs (“SDIRAs”) can be a powerful investment tool when used the right way. Instead of relying on a bank or brokerage to hold and invest your retirement accounts, the SDIRA gives you direct control over what to invest in for your retirement. Best of all, the SDIRA is not limited to the traditional stock and bond market portfolios. Savvy and knowledgable investors willing to take on high levels of risk can direct their tax-advantaged savings into private companies, debt portfolios, real estate, and other non-traditional assets. While the personalized control and expanded investment opportunities may sound great, SDIRAs are subject to complex tax rules and other pitfalls, including extreme volatility and investment risk. The government rules and regulations ensure that individuals are not abusing the tax advantaged status of their retirement accounts. The Internal Revenue Code (“IRC”) governs what retirement accounts (including SDIRAs) can and cannot invest in.

What about cryptocurrency like Bitcoin? Can an SDIRA invest in cryptocurrency? Yes. In general, the IRC prohibits any IRAs (including self-directed ones) from owning life insurance, S-Corporation stock, and collectables. 26 USC 408. The term “collectable” includes art, antiques, collectable stamps, coins, alcoholic beverages, and “any other tangible personal property” specified by the IRS. Pursuant to Notice 2014-21, the IRS considers cryptocurrency to be intangible property for the purpose of taxation. This means it is treated the same as stocks or bonds – if you sell at a profit, you are paying capital gains tax. Note that cryptocurrency is not treated the same as cash – this also means that if you are paying for a product with Bitcoin, it is a taxable event. For the purposes of an SDIRA and retirement investment, you can certainly buy and hold (or HODL) cryptocurrency. Or sell it for a gain – the tax consequences are the same as they would be with a stock or bond portfolio (depending on whether you have a 401k or Roth-type setup). Remember that any profits that an SDIRA makes go right back into the SDIRA and may only be withdrawn for the benefit of the individual under certain conditions (like being 59 and a half years old) to retain the tax advantage. With cryptocurrency, it is critical to set up an SDIRA-owned LLC to establish and own the cryptowallet in conjunction with a bank account. The LLC structure allows the SDIRA beneficiary to act as a manager and direct investments right from the bank account rather than going back to the SDIRA custodian and waiting for an approval of a particular transaction. However, remember that the manager cannot receive compensation or commingle personal and SDIRA assets, accounts, or cryptowallets.

What about non-fungible tokens or NFTs? Can an SDIRA invest in those? Maybe. NFTs are digital property that exist only online, but unlike “traditional code,” NFTs are unique and cannot be copied. More accurately, they can be copied (like a print of the Mona Lisa can be copied), but there can be only one original. In that sense, they are like real-world property and their non-fungibility creates scarcity, and theoretically value. Although NFTs are based on the Ethereum blockchain (and Ethereum is a cryptocurrency like Bitcoin), cryptocurrency and NFTs are not necessarily treated the same way. As explained above, the IRS treats cryptocurrency the same as intangible property for the purposes of taxation – meaning like stocks, bonds, and mutual funds. Section 408 of the Internal Revenue Code prohibits any IRA from investing in art, antiques, collectable stamps, coins, alcoholic beverages, and “any other tangible personal property” specified by the IRS. 26 USC 408. Will the IRS treat NFTs like cryptocurrency and therefore permitted SDIRA investments? Or will NFTs be treated like restricted collectables?

The IRS has not issued guidance on this matter. Some commentators (including the top search result on Google as of the writing of this article) have concluded that the IRS treats NFTs as collectibles and therefore they subject to a “higher minimum gains tax rate of 28%.” This is simply not true. While the IRS certainly treats NFTs as taxable property, it remains uncertain exactly how the IRS will tax these digital assets.

At its core an NFT is code. Cryptocurrency is also code, which the IRS expressly treats like “property” for the purpose of taxation. It follows that NFTs are also “property” for the purpose of taxes. But what kind of property? Are NFTs always considered art or collectibles? Or are they cryptocurrency and can be owned by an SDIRA? What about NFTs that represent virtual real estate in “worlds” like Decentraland, Cryptovoxels, Somnium Space, Sandbox? What if the NFT is an avatar, a name, a virtual outfit? There are several possible ways for the IRS to treat NFTs:

  • One, the IRS can take a pragmatic approach and tax them in accordance with what they would represent in the real world. Some NFTs have real-world counterparts – for example, Forbes reported that a digital collectible startup called Ethernity is set to auction limited edition real world baseball bats that include an NFT counterpart. Nike also patented something called “CryptoKicks,” which presumably will tie real sneakers to some sort of digital authentication certificate. If an NFT represents art, then it is treated like art for tax purposes. If an NFT is a trading card, then it is treated like a collectible. If the NFT represents virtual real estate, it is treated and taxed like real estate (which raises a whole different set of questions).
  • Two, the IRS can take a simple approach and classify NFTs as “property” that is treated exactly like cryptocurrency regardless of what the NFT “represents.” This second approach avoids litigation over what how a particular NFT should be taxed – for example, is an in-game avatar “art”? The second approach also would give SDIRA investors the flexibility to invest in virtual assets, including virtual real estate.

Finally, is the IRS really going after unreported cryptocurrency and NFT transactions? Absolutely. In 2020, the IRS established the Office of Fraud Enforcement and announced in 2021 that a special investigative team was conducting “Operation Hidden Treasure” to identify individuals who failed to report cryptocurrency (and presumably NFT assets).

Investing in cryptocurrency and NFTs is a hot trend in 2021. Although these digital assets may “exist” only as part of the virtual blockchain, the IRS considers them very real and very taxable. This is a constantly changing and developing area, so it is especially critical to consult a tax and legal professional before making any investment decisions. As I pointed out in my earlier post about SDIRAs, even if you are right, you may still end up litigating against the IRS in Tax Court.

More questions? Thinking about investing in cryptocurrency or NFTs? Funding your retirement through an SDIRA? Contact Dan Artaev by email or call or text to set up your initial consultation.

Disclaimer: This guide is for general informational and promotional purposes only. Nothing herein constitutes legal, investment, or tax advice. Every situation is different and faces its own unique set of challenges. Do not take any action or sign any contract until you have obtained specific guidance from a qualified professional.

© 2021 Artaev at Law PLLC. All rights reserved.

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