What are the US Tax Considerations for Cryptoassets?

Cryptoassets can come in many different forms, from cryptocurrencies to non-fungible tokens (“NFTs”) and a myriad of functionally distinct blockchain-related tokens. The terminology alone can be as overwhelming as the media furore surrounding it, but that hasn’t dissuaded investors.

For all the recent market volatility, cryptoassets are an increasingly popular target sector for professional investors. This includes funds established solely for the purpose of making and holding such crypto investments, as well as more traditional fund managers looking to add a new category of alternative investment to their portfolio. Venture capital, in particular, is increasingly starting to see the issuance of tokens in lieu of equity as a common means for early-stage businesses to seek financing.

So, whatever your impression may be of this sector, cryptoassets are still here and remain a significant focus of the financial sector. As always, this means the tax authorities will do what they can to seek their share of the profit, and fund managers will need to be aware of their obligations. In this article, we will answer the question: “What are the US tax considerations for a crypto fund?”

To answer this question, we need to look at how these types of assets are accounted for and the types of technical issues that can arise from investing in, holding, or trading these assets.

Before we begin, it’s important to recap the fundamental terminology and concepts. The basics of cryptoassets and tax can be found in our earlier article on the subject. As a high-level summary, a cryptoasset refers to a digital store of value, which can come in various forms including digital “coins” and “tokens”. Most are built on blockchain technology, essentially an encrypted form of decentralized ledger that verifies information by consensus and is in theory very difficult, if not impossible, to hack or manipulate.

These types of assets have drawn interest from investors for several reasons, including the nature of the underlying cryptographic technology, to their potential as a means of exchange, and of course the immense growth in value that some of these assets have seen. Many early-stage businesses have also begun to see these assets as a potential means for seeking financing in lieu of traditional debt or equity.

As with any profit-generating activity, this can result in income subject to taxation. Currently, the primary IRS guidance on the taxation of cryptoassets comes from Notice 2014-21 (as modified by Notice 2023-34), Revenue Ruling 2019-24, and Revenue Ruling 2023-14. The sector remains in a state of flux, with further changes and refinement to the rules likely in the years to come.

Acquisition
The first thing that needs to be considered is how the cryptoasset was acquired. There are various methods for obtaining these assets, including through mining, staking, purchasing from the market, forks, and airdrops. These different methods of acquisition can have tax consequences for both fund and investors.

Mining is the process by which a cryptocurrency generally enters the marketplace. The precise mechanism may differ depending on the specific asset, but it typically involves computer hardware that has been specifically designed to solve mathematical equations and, in doing so, verify the coin’s existence. The Internal Revenue Service’s (“IRS”) position on this method is relatively clear. Per IRS Notice 2014-21, any cryptocurrency received in a mining transaction is treated as gross income at the virtual currency’s fair market value on the receipt date. The miner may deduct against this income certain expenses related to mining activities, including the cost of hardware, electricity, cooling and maintenance. Crucially, mining may be considered a trade or business activity. Funds with tax-exempt investors will need to consider whether this could result in Unrelated Business Taxable Income (UBTI). US domestic Funds or funds invested into other companies engaged in mining activities will need to consider whether this could result in US sourced income, creating potential reporting issues for any non-US investors. In general, this depends on the location of the hardware.

Staking is a process where asset holders can lock their cryptoasset for the purpose of supporting the operation of a blockchain, in exchange for rewards. With Revenue Ruling 2023-14, the IRS has established that staking rewards should be treated like mining. For cash-method taxpayers, staking rewards should be treated as ordinary income based on the fair market value of the tokens when the coins are received and included in gross income for the taxable year in which the taxpayer acquires control of the awarded assets. This ruling is silent on the tax treatment for accruals-basis taxpayers, with further, specific guidance expected to be provided at a later date.

Purchasing is the purchase of a cryptoasset from the marketplace, either using government-backed fiat currency or, by exchange with another cryptoasset. When purchasing the cryptoasset, the taxpayer needs to note the date of purchase, the quantity, and the purchase price. This will later help when the taxpayer sells, distributes, or otherwise disposes of the asset. The purchase itself may be a taxable event if obtained by exchange with another cryptoasset. Otherwise, a cryptoasset purchased with fiat currency does not create an immediate taxable event, nor is the expense immediately deductible.

Forks are a fundamental change or divergence in the rules of a blockchain, resulting in two effectively separate and distinct chains. These fall into two categories: hard forks and soft forks. The distinction between them comes down to how strong the split is between the two chains, with hard forks generally incompatible and irreconcilable, while soft forks maintain a degree of backward compatibility. When a cryptoasset forks, that is not in itself treated as a disposition or other taxable event of the existing assets. However, if you receive additional new coins as a result of the fork, that may be treated as taxable income, includible in gross income at fair market value as of the date of receipt and taxable in the year in which the taxpayer acquires control of the asset.

Airdrop is a method of marketing a blockchain by distributing free cryptoassets to users, typically as part of a promotional campaign or as a reward for loyal customers. Usually, the IRS considers this to be a taxable event, with the received assets includible in gross income at fair market value as of the date of receipt, taxable in the year in which the taxpayer acquires control of the asset. However, there are circumstances in which airdrops may not be taxable if certain criteria are met. For example, if the airdrop is a result of a hard fork but the recipient has no control over whether they receive the tokens, it may be treated as a non-taxable event.

SAFT/SAFTE is an increasingly popular means by which an early-stage business might seek financing from investors. They are a derivative of the popular simple agreement for future equity (SAFE), through which an investor may enter into an agreement to receive equity at a later date, following some specified trigger. A SAFT/SAFTE involves an investor paying the target company a purchase fee for an agreement that, after the triggering event, will result in tokens being issued at a fixed price or discount. This point of conversion is not itself a taxable event. Rather, the investor will be deemed to receive the token on the date of conversion (which is the date that the holding period starts), with cost basis equal to their prepaid purchase price. They will then be subject to tax on any gain at the point where they use, spend, swap, or sell the token at a later date.

Holding
The holding of cryptoassets in general does not generate passive income, such as interest or dividends. However, there are situations where taxable income may yet arise. Some crypto platforms do enable “lending”, allowing the asset to function similar to debt and generate interest income. Other platforms may also issue certain specific forms of asset known as dividend tokens, which generate dividend income. Currently, the IRS has not issued specific guidance as to the treatment of these types of assets, but in most cases these will be considered analogous to the ordinary receipt of interest and dividend income and taxed accordingly.

In addition, the asset holder will need to consider income that may arise through staking, forks and airdrops, which can arise as a result of the fund’s use of existing assets, as described in the previous section. As noted above, these activities can be considered to be trade or business activities, which in a fund context can result in US income for non-US investors and taxable UBTI for tax-exempt investors.

Asset Sales
Notice 2014-21 established that virtual currency is generally treated as analogous to property. Therefore, an event where property would give rise to taxable income can be considered likely to do the same with respect to cryptocurrency. Such taxable events may include selling or exchanging property as a service, like-kind exchanges between different coins, and purchasing goods with cryptocurrency.

As property, a taxpayer must report the sale as a capital gain or loss, classified as either short or long-term depending on the holding period. For most investors, a capital gain is taxable at the lower long term capital gains rate only if it was held for more than a year before disposal, and at the higher short term capital gains rate if it was not. In order to make this determination, a taxpayer can use two accounting methods: the specific identification method or first-in-first-out (“FIFO”).

The more beneficial method for a taxpayer is generally the specific identification method, which allows the seller to pick the stock with the largest basis to sell first, minimising potential taxable gains. To prevent abuse, this method is subject to more stringent recordkeeping, the requirements for which are outlined in Rev Ruling 2019-24. Investors must maintain a record of: (1) the date and time each unit was acquired, (2) the basis and the fair market value of each unit at the time it was acquired, (3) the date and time each unit was sold, exchanged, or otherwise disposed of, (4) the fair market value of each unit when sold, exchanged, or disposed of, and (5) the amount of money or the value of property received for each unit. When it comes to cryptoasset, specific units of inventory are not always identifiable. In such cases, the IRS specifies the default methodology as FIFO basis.

Per IRS Publication 550, with respect to FIFO, a taxpayer must keep records of purchases to record the basis of assets. The taxpayer uses the basis of the assets they acquired first as the basis of the assets sold, the oldest assets owned first. For example, a taxpayer buys 20 coins of Cryptocurrency A in year 1 and 20 coins of Cryptocurrency A in year 2. In year 3, the taxpayer sells 30 coins of Cryptocurrency A; the taxpayer will sell the 20 coins purchased in year 1 and 10 coins purchased in year 2. The basis will be the purchase price of the 20 coins in years 1 and 10 from year 2.

Funds will also need to consider the potential implications for carried interest partners. As a capital gain, this income is subject to IRC 1061. These rules govern the classification of capital gains allocated to carried interest partners, and state that such partners are only able to use the more favourable long term capital gains rate for dispositions of assets held for more than three years. Thus, a gain on a cryptoasset held longer than one year, but less than three, may be reclassified from long to short term capital gain and taxed accordingly. The IRS has not specifically weighed in on the application of IRC 1061 to cryptoasset, but the rules as written are taken to apply to any capital gain, unless a specific exception applies.

Fund managers will also need to consider the potential application of the “wash sales” rules. More commonly seen in hedge funds, the wash sales rules disallow the recognition of loss on the sale of securities where, within 30 days before or after sale, the taxpayer acquires substantially identical securities. Currently, there is no formal guidance or codified legislation as to the applicability of these rules to cryptoassets, but proposals have been put forward to include these types of assets within the remit of those rules, which may become law in the future.

Distributions
In certain situations, a fund may wish to distribute a cryptoasset to investors rather than selling the asset and distributing cash.

A distribution of a cryptoasset is taxed in the same way as distribution of property: the “distribution in kind” rules apply. A distribution in kind is generally taxable at the time of distribution, with the fair market value of the distributed asset reported as income. However, a distribution in kind made by a fund with a partnership structure could potentially be a non-taxable event if it meets the requirements for certain non-recognition provisions in the Code. The recipient would instead be taxable when they ultimately dispose of the asset.

To ensure the correct reporting and tax, the recipient of such a distribution would carry forward the original basis of the distributed asset. This must be tracked, along with the number of shares received. It should be noted that the applicability of these rules to cryptoassets, and in particular whether they can be considered a form of marketable security, remains a topic of significant discussion. Currently, with the guidance written to confer property status to these assets, the rules would seem to apply as they would for any other form of property, although this could change in the future.

Properly accounting for fund transactions involving cryptoasset can be burdensome, but it is essential. The H.R.5376 – Inflation Reduction Act of 2022 provided the IRS with an additional $3,181,500,000 and enforcement “to provide digital asset monitoring and compliance activities.” So, this is something IRS is closely following. The IRS is homing in on the treatment and reporting of digital currencies. It is becoming increasingly crucial to follow that correct tax reporting for cryptocurrencies and digital assets and that funds disclose the necessary information.

If you have any questions regarding the taxation of your cryptocurrency or cryptocurrency funds, please do not hesitate to contact a member of our team.