In 2022, several centralized cryptocurrency exchanges filed for bankruptcy, dragging the overall cryptocurrency market down. This article looks at federal income tax considerations resulting from bankruptcy filings by a cryptocurrency exchange. For more background on the rise and fall of cryptocurrencies in 2022, and the various types of stablecoins, view FORsights article, “Failures in Cryptocurrency Exchanges Create Tax Challenges for Investors.”
Bankruptcy Procedures
Many taxpayers who fell victim to crypto-industry bankruptcy filings may likely be left waiting on a resolution for an extended time. For example, another high-profile bankruptcy proceeding, Enron, took almost seven years for shareholders and investors to reach a lawsuit settlement.1
Secured creditors receive priority over unsecured creditors in bankruptcy proceedings. Secured creditors are granted priority on debt collection from the property on which they hold a lien. Unsecured creditors don’t have this luxury. In general, one of the best ways for unsecured creditors to recoup their money is from voluntary repayment. If voluntary repayment isn’t an option, unsecured creditors must sue and win a judgment to get repaid or work with the court system on a settlement. It’s best to consult with an attorney to determine if you’re considered a secured or unsecured creditor and how you may be able to recoup your money if you’re impacted by a cryptocurrency bankruptcy.
Federal Tax Options & Considerations
Taxpayers who fell victim to a cryptocurrency bankruptcy filing may likely want to recoup their economic loss in their tax filings. There are several different Internal Revenue Code (IRC) sections that may apply and working through a waterfall decision tree can shed light on which one may be best for your situation. In addition, the IRS Office of Chief Counsel released an internal memo on January 13, 2023 detailing the treatment of these losses. It’s important to note that the IRS internal memo isn’t authoritative, but these memos generally signal the direction of future guidance.
| Type of Tax Loss | Applicable Tax Law | Availability for 2022/2023? |
|---|---|---|
| Casualty/Theft Loss | 165(e), 67(g) | Unlikely |
| Worthless Investment | 165(g) | Unlikely |
| Non-Business Bad Debt | 166(d) | Potentially – facts and circumstances based |
| Abandonment Loss | 165(a), 67(g) | Unlikely |
| Ponzi Scheme Exception | Rev. Rul. 2009-9, Rev. Proc. 2009-20 | Potentially – facts and circumstances based |
| Capital Gain or Loss | 1222 | Potentially – facts and circumstances based |
Casualty or Theft Loss
An argument can be made that the cryptocurrency exchange’s actions resulted in theft of taxpayers’ deposits. While this argument may have merit, the Tax Cuts and Jobs Act sunsets 2% itemized deductions through 2025—IRC Section 67(g). The 2% rule limits certain miscellaneous itemized deductions for items like investment and advisory fees. Since casualty and theft losses fall under the 2% itemized deduction category and theft losses are reportable in the year they’re discovered, reporting a theft loss in 2022 shouldn’t result in any tax deductions for the 2022 tax year. Note that certain casualty and theft losses may still be deductible but only if attributable to a federally declared disaster.
Worthless Investment
Section 165(g) allows taxpayers to write off worthless securities. However, IRS guidance in Notice 2014-21 provides that cryptocurrency should be treated as property. This creates an unfortunate disconnect where cryptocurrency is classified as property instead of securities for federal tax purposes. In addition, this option also assumes that the investment is worthless. As noted earlier, while bankruptcy proceedings may drag out for years, taxpayers can reasonably expect to receive a portion of their initial investment; as such, this eliminates the notion that a taxpayer’s cryptocurrency investments are truly worthless. As a result, taxpayers facing cryptocurrency losses likely cannot take advantage of §165(g). As the IRS internal memo also points out, taking this deduction would fall under §67(g). As mentioned earlier, §67(g) has been repealed through 2025 so taxpayers still end up with no deduction in 2022.
Non-Business Bad Debt Loss
In some cases, taxpayers may have entered a debtor-creditor relationship. The terms and conditions of the investment determine if a debtor-creditor relationship exists. For example, terms and conditions for the cryptocurrency exchange Celsius say that any digital asset transferred to the earn platform constitutes a loan from the user to Celsius.2 If it’s determined that the taxpayer had a debtor-creditor relationship, then a non-business bad debt deduction under §166(d) may be an option for a taxpayer to reduce their tax liability. In general, non-business bad debt losses are treated as short-term capital losses. Documentation and taking action to recoup the loan are key in taking this deduction, and the debt also must be considered wholly worthless. Partial deductibility of a non-business bad debt is not allowed.
Abandonment Loss
Abandonment losses are allowed for intangible property under §165(a). However, the taxpayer must prove three items:
- Ownership of the property prior to abandonment
- An intent to abandon the property
- Affirmative action to abandon the property
The taxpayer shoulders the burden of proof for all three items. In the case of the multiple cryptocurrency exchange insolvencies, it’s wise to keep documentation of the purchases on each platform. This could help substantiate ownership of the property before the abandonment. The second and third criteria are typically determined based on facts and circumstances. To meet the criteria for intent to abandon the property, “express manifestation” is required. This may require documentation of conversations with legal counsel and written documentation with the entities that filed for bankruptcy themselves. As is common in cryptocurrency reporting, accurate records are key. Documentation for the amount claimed as a deduction for the abandonment of property is critical. As such, taxpayers should download a copy of their transaction history before these entities potentially remove access to user accounts.
Abandonment of intangible property is generally treated as an ordinary loss. The burden of proof and proper documentation are critical when taking this position to preserve the ordinary loss characterization. For example, in Watts v. Commissioner of Internal Revenue, the IRS reclassified an ordinary loss to a capital loss because the taxpayer failed to provide proper documentation.
While the abandonment loss deduction may seem like an option to recoup crypto losses, we must again reference the IRS internal memo suggesting that this deduction would not be allowable in tax years 2018 through 2025 due to the suspension of §67(g).
Ponzi Scheme Exception
IRS Revenue Ruling 2009-9 provides tax relief to taxpayers who fall victim to Ponzi schemes. The example provided in the Revenue Ruling describes Taxpayer A opening an investment account with Investment Advisor B. Taxpayer A entered into a transaction for profit and A instructed B to reinvest any income and gain earned on investments. In a later year, it was discovered that B’s activity was in fact a fraudulent investment arrangement known as a Ponzi scheme.
The Revenue Ruling describes a scenario allowing a reportable loss for the amount of A’s original investment. The Revenue Ruling states, “A’s loss also includes the amounts that A reported as gross income on A’s federal income tax returns. If A has a claim for reimbursement with respect to which there is a reasonable prospect of recovery, A may not deduct in Year 8 the portion of the loss that is covered by the claim.” The reportable loss also is reduced by any withdrawals provided to the client.
The question at hand then becomes: Was FTX a Ponzi scheme? Revenue Ruling 77-17 states that officers or directors merely committing fraud isn’t sufficient to deem their actions as a Ponzi scheme, but that their intent to defraud is a material factor.
This deduction is claimed on Form 4864 and Schedule A of Form 1040. A safe harbor under Revenue Procedure 2009-20 is an additional option. While this is considered a theft loss (previously discussed above), it’s still allowed as a deduction in tax years 2018 to 2025.
Until further guidance is provided by the IRS, it’s unclear if this scenario is applicable. Taxpayers should work with their tax advisor to consider all the facts and circumstances and make a decision on a case-by-case basis.
Capital Gain or Loss
If you still have access to your cryptocurrency and are looking to cut ties with some or all of your tokens, selling them would incur a “closed and complete transaction.” In most cases, if your activity is considered investment activity, selling your crypto will result in a capital gain or loss. Capital losses can offset other capital gains or are otherwise limited to $3,000 per year. Limited capital losses carry over indefinitely. The key in taking a capital loss is making it a closed and complete transaction. Simply holding a cryptocurrency that has lost a significant amount of its value isn’t enough to capture the loss. Closing and completing a transaction typically requires selling or trading the asset.
Calculating the Economic Benefit
Working through the arithmetic in each scenario outlined above likely has a different outcome. For example, if Taxpayer A held $10,000 on FTX and has an effective tax rate of 21%, and Taxpayer A reports the $10,000 as an ordinary loss under the abandonment of intangibles rules, the taxpayer should realize a net tax benefit of $2,100 (10,000 x 21%). However, had the taxpayer waited until the FTX bankruptcy proceedings were complete and hypothetically received $4,000 of their $10,000 investment, this cash position may be better than paying $2,100 less tax. In this example, the taxpayer also may be able to claim a $6,000 capital loss on top of the $4,000 they received because of the bankruptcy proceedings. Of course, the taxpayer also will need to weigh the time value of money since these bankruptcy proceedings could drag on for years. However, if taxpayers can reasonably expect to receive a portion of their initial investment, they may have no other option than to wait.
Ultimately, the facts and circumstances for each taxpayer may be different. There is no blanket answer for all taxpayers who have been impacted by these cryptocurrency insolvencies. These unfortunate situations have created a complex tax situation for many taxpayers. As such, accountants and tax advisors should independently analyze the facts and circumstances of each taxpayer before assessing how to report these losses.
If you have any questions or need assistance, please reach out to a professional at Forvis Mazars or submit the Contact Us form below.