June 1, 2017
By: Ryan A. Brown, Esq. and David J. Barton
This article is intended to provide an overview of the current legal landscape for taxation of cryptocurrencies and other blockchain tokens in the United States. This article is for informational purposes only, and does not constitute legal, tax, or accounting advice. Please consult with an appropriate professional to obtain advice specific to your situation.
Remember when you were a kid and you placed a $5 bill into the token machine at the arcade? Remember the excitement when twenty gleaming gold tokens poured into your cupped hands. Startups are now digitally recreating that arcade token machine for investors with blockchain cryptocurrency initial coin offerings (ICO). As a kid those tokens had real value because they provided access to the arcade games and there was demand to play those games. Similarly, blockchain cryptocurrencies, which are digital mediums of exchange, have value because the coin’s worth increases if the startup prospers.
Some examples of recently developed cryptocurrencies being offered by startup companies include Eon coins by Exscudo, MinexCoin by Minex Systems and MaskCoin by MaskNetwork. Businesses are turning to cryptocurrencies to avoid the regulated capital-raising process required by banks or VC’s. This year alone ICOs have raised $180 million, according to Smith and Crown[1]. The founders of the startups keep a large portion of the new currency and give the rest to investors in exchange for capital investments. Many of these startup-sponsored cryptocurrencies are then exchangeable for Bitcoin (BTC), Ethereum (ETH), Ubiq (UBQ), and other cryptocurrencies, or for U.S. Dollars (USD) and foreign currencies.
ICOs and cryptocurrencies bring up a litany of questions in the legal world to which there are currently only muddied answers. One important aspect of ICOs is whether they fit inside the scope of securities regulations. Because if they qualify as securities and you disregard the law, the SEC can file a lawsuit that could severely damage a startup business.
To determine whether an ICO is a security and must be regulated by the SEC, one must look to the test developed in SEC v. Howey, 328 U.S. 293 (1946)[2]. In Howey, the Supreme Court determined that for a deal to be regulated there must be an (1) investment of money due to an (2) expectation of profits arising from a (3) common enterprise, which depends solely on the efforts of (4) a promoter or third party. The first of the four prongs is usually satisfied because there is already a ruling by a court that says Bitcoin is a currency or form of money. The second prong of expectation of profits runs into problems due to lack of voting rights in the company. This might prevent an investor from having an expectation of profits or enough of a stake in the company to qualify. Because of the lack of an official stake in the company when one buys a coin it is known simply as a donation. The last two prongs, including “common enterprise” and “efforts of a third party,” are also grey areas that can go either way. It is advisable to investigate each coin-buy to see if all four prongs are met. However, even if your deal fails one of the prongs does not mean you don’t have a security are not subject to SEC regulations.
The SEC has yet to offer guidance on whether an ICO is a security in the broad sense. This classification decision will be massive news for the startup technology community. While it is important for companies to continue to use the Howey test to determine the securities status of their donations, a risk assessment will not protect you from the arbitrary wrath of the SEC and it is recommended you hire a lawyer. To be clear, U.S. Federal Courts give regulators considerable latitude in determining what is and what is not a security. In instances like cryptocurrencies where the instrument is novel, the law will disregard the form of the investment and instead focus on the economic reality of the transaction. ICOs may yet fall into the official grasp of the SEC.
What if you take a risk-averse approach with an ICO by following securities laws closely or complying with the rules around exceptions from registration such as crowdfunding? Unfortunately there is still risk because due to the lack of guidance by the SEC, it is up to issuers to proactively self-regulate. Even though ICOs have the potential to be extremely profitable for investors and a unique and inventive method of fundraising for startups, lack of regulatory oversight creates uncertainty. With volume of investments in cryptocurrencies tending to be on the higher end, this can spell disaster. One reason that companies issue tokens is to skirt around securities regulations. If startup companies creating their own cryptocurrency have to follow these regulations closely, this cryptocurrency method loses some of its value as compared to an Initial Public Offering.
There is even a greater risk if investors or startups disregard the securities regulations altogether. This could result in civil or administrative suits, where the SEC could ask the courts for a remedy. Instead, it is advisable to make proper disclosures to future investors as well as follow best practices to avoid a legal battle or complications. Coinbase Inc. advises adherence to six principles when conducting ICOs[3]. The principles include publishing a white paper, committing to a development roadmap, using an open public blockchain, using fair pricing in a token sale, marketing the token as something other than an investment and determining the amount of tokens set aside by the development team. Coinbase says that using a public blockchain may strengthen the arguments against the second and third criteria of the Howey test, because participants are less reliant on the initial developers and the coins are seen as a separate entity from the startup.
Government regulators have issued guidance on ICOs but there is no centralized government body or framework where investors or startups can go for answers. Some of the regulatory guidelines include FinCEN in 2013 that classified cryptocurrency businesses as money services businesses, then CFTC made clear they want to regulate cryptocurrency as a regular currency and the SEC added to the noise in 2014 which will be discussed below. Regulators are having difficulty understanding the complex issue of cryptocurrency and ICOs that has led to a slow and uneven progress in their recognition and regulation.
Taxing ICOs is just as important as the securities aspect and can be equally as tricky. Businesses involved in ICOs want to know when their virtual money will be taxed and for how much. In 2014, the IRS published guidance[4], which said that cryptocurrencies should be, treated as property so the general tax rules associated with property transactions apply. This also means that the short-term capital gains tax applies to cryptocurrencies.
On one hand this is a great outcome for investors because if they keep the coins for a year and a day then all profits will be taxed at the preferential long term capital gains rates. On the other hand, where a taxpayer exchanges one currency for another, 26 U.S. Code § 1031 says that the gains from exchanging foreign currencies can be deferred if both currencies are held for trade or business or for the production of income and both currencies are considered to be of “like-kind.” Cryptocurrencies are not considered, as of now, “like-kind” because they are not legal tender so those deferments of capital gains taxes on exchange do not occur. Also, the IRS does not consider cryptocurrencies a “foreign currency” because they are not sponsored by foreign governments.
Beyond taxes and the regulation of cryptocurrencies, there is the legal question of compensating employees with cryptocurrencies. Considering the fluctuation of cryptocurrency prices and the Fair Labor Standards Act, which requires U.S. dollar payment for the satisfaction of overtime and minimum wage pay, employee compensation is difficult where cryptocurrencies are concerned. And, even when employees are paid in cryptocurrency, their tax withholdings, unemployment contributions, and other payroll taxes have to be remitted in U.S. Dollars to the appropriate taxing authority. Furthermore, payments of cryptocurrency with vesting schedules to employees or independent contractors as compensation for services can be taxed as income under 26 U.S.C. §83 (1934)[5], just like stock options. Employees receiving such compensation may need to make an 83(b) election to avoid having a tax recognition event at a time when they may not be able to liquidate their cryptocurrency holdings. With this complexity, the tax repercussions must be looked at closely for each individual situation.
There are many reasons that a company would choose an ICO over a traditional IPO but as we can see there are risks associated with investing in such unchartered waters.
If you are interested in making or participating in an initial coin offering, or are otherwise involved in a blockchain or cryptocurrency startup, please contact us for more information or to schedule an initial consultation.
[1] Ari Levy, Here comes the ICO, a Wild New Way for Cryptocurrency Start-Ups to Raise Money, CNBC (May 26, 2017), http://www.cnbc.com/2017/05/25/bitcoin-ico-cryptocurrency-start-up-civic-raising-money-initial-coin-offering.html.
[2] SEC v. Howey, 328 U.S. 293 (1946).
[3] A Securities Law Framework for Blockchain Users, COINBASE.COM, https://www.coinbase.com/legal/securities-law-framework.pdf (May 25, 2017).
[4] Notice 21, 2014- I.R.B. 36.
[5] 26 U.S.C. §83 (1934)
