"If a token forks in the woods...how should it be taxed?"
The taxation of forks is a vexing, unresolved issue right now.
Consider for example, that a forked cryptocurrency is like a stock split (which is taxed one way) or a stock dividend (which is taxed another way). Or maybe it should be taxed like interest, and treated as a "capital" asset.
The American Bar Association ("ABA") recently called on the Internal Revenue System ("IRS") to provide guidance on the issue.
Specifically, the ABA has asked the IRS to provide a temporary safe harbor while they sort out just what the heck a fork is.
The ABA proposed that the harbor treats forks as taxable events, and that the owner gets a basis of zero. This effectively means the owner is taxed on the full amount of the newly forked digital assets. Additionally, under these rules, the holding period starts at the time of the fork. This matters because once a "capital" asset is held for a year, it gets a much more favorable tax rate.
So you could say that the ABA's proposal isn't exactly friendly to fork recipients. But since there's no guidance whatsoever on how to actually account for forks, it may be better for crypto holders to be able to comply with a tax law (even if it's unfavorable) than be potentially non-compliant depending on whatever the IRS later decides.
Lately, there's been a flurry of activity from federal and state agencies targeting cryptocurrency exchanges lately. Exchanges have been the predicted "next target" by professionals in the industry that I've talked to ever since the Securities and Exchange Commission ("SEC") started sending letters related to initial coin offerings ("ICOs").
For example, New York sent a barrage of letters in April to crypto exchanges, probing for more information. Similar to the SEC's letters to investment funds, NY's letters seem to be aimed at educating regulators for the time being, rather than any type of actual enforcement or regulation. This makes sense; you can't regulate what you don't understand.
But since digital asset exchanges are likely to only grow bigger and bigger (like how NASDAQ could add a crypto exchange soon) it's inevitable that regulators will start taking enforcement actions and actively regulating these exchanges with increasing frequency and intensity. But, as the crypto regulation refrain goes, this is OK because it's a crucial step in the growth, stability, and credibility of the crypto industry.
But how, exactly, could exchanges be regulated?
SEC Exchange Registration
Exchanges must be registered with the SEC or qualify for an exemption.
The most feasible exemption for crypto exchanges is the Regulation Alternative Trading System ("Reg ATS"). Reg ATS is the more likely option for crypto exchanges, since full registration with the SEC is extensive, and associated more with public stock exchanges like NYSE and NASDAQ.
ATS exchanges don't need to fully register with the SEC. They must register as broker-dealers and make some initial filings and give some forms of notice to the SEC. But overall, they're more lightly regulated than fully registered exchanges.
The SEC issued a release in March 2018 expressing concern over the fact that, currently, no crypto exchanges are registered or have qualified for the ATS exemption. Oops. Coinbase is leading the charge to be the first ATS, though.
Internal Revenue Service ("IRS")
The IRS has already imposed (some) user reporting requirements on crypto exchanges like Coinbase. How extensive their reporting and disclosure requirements will end up being are up for debate, given Coinbase successfully pushed back and limited the IRS request.
In 2013, FinCEN released a report on "virtual currencies". In this report, the agency determined that crypto exchanges must register as "money service businesses" ('MSBs"). One sub-type of MSB is a money transmitter, which you can read about more here, and is one of the main ways many crypto-related businesses are currently facing regulation. Any crypto exchange that has custody of users' cryptocurrencies will be regulated as an MSB, meaning it must register with FinCEN, collect certain information on its users, and have certain compliance policies in place.
The Bank Secrecy Act ("BSA") imposes anti-money laundering ("AML") and know-your-customer ("KYC") requirements on exchanges. Many exchanges are currently self-imposing these requirements (think about that driver's license you had to upload when registering on Kraken). Generally, these requirements are aimed at identifying who actually owns assets and accounts, in order to minimize money laundering and/or other illegal behavior.
The SEC may also target exchanges with anti-fraud tools. For example, this may include targeting exchanges that seem to be manipulating prices themselves.
And, of course, in addition to the above regulations, each state may impose its own regulations on exchanges that operate in-state.
Want To Learn More?
This Time Is Not Different: A Brief History of Private Money & Crypto
Initial Coin Offering (ICO) Security Exemptions
Questions? Comments? Let us know below!
UPDATE - I spoke with a VC in San Francisco that confirmed he/she considerably saw the adverse selection effect in ICOs in 2017. As noted, this effect likely doesn't apply to all ICOs, but it is another layer to consider.
Zhao Changpeng, the CEO of Binance, recently wrote a post claiming that initial coin offerings are "necessary" in light of the venture capital world.
"[R]aising money through ICOs is about 100 times easier than through traditional VCs, if not more," he wrote. He focused on the absurdity of courting VCs, preparing business plans and presentations, negotiating terms with lawyers, VC control, and other "drawbacks" of the VC world.
"ICO investors are early adopters (and learners)," Changpeng writes.
Counter argument: VCs sift and winnow the good from the bad, so that companies that spurn VC funding and choose to do an ICO are actually subject to adverse selection.
VCs function as hurdles many entrepreneurs need to face. Yes, it's additional work to making your idea reality. But maybe it's a necessary hurdle to proving your idea has some viability.
Changpeng writes that having to come up with business plans and pitches is a "downside" of the VC process. But this ignores the fact that many entrepreneurs haven't fully formed their idea or even thought about logistically bringing it to market.
The VC System Has Benefits
Business plans force nascent companies to ask hard questions. For example, many tech entrepreneurs start by valuing their total addressable market with a top-down approach. They say "well, we think it's reasonable we could get 1% of the market, which is worth..."
But that's lazy. That's the easy way. And a good VC will call it out by asking the hard questions, because they've likely seen the failure of companies that didn't ask those tough questions.
"We can't get what we want so we're gonna make our own capital raising ecosystem!"
The VC system vets and snuffs out this self-deceiving naivety.
It forces founders to learn skills like pitching, thinking through the true costs involved, actually verifying demand, etc. And VCs bring experience and networks.
While ICO investors may be "early adapters", as Changpeng writes, what are they early adopters of? Most of them don't have the first-hand experience helping companies grow that VCs do. They don't add much value other than capital. They may be early adapters, but maybe they're early adapters of a system where the blind lead the blind.
Throw irrational herd behavior on top of that and you should be skeptical that ICO investors can accurately choose and value tokens (see, for example, the current crypto market value despite very, very few validated test cases outside of a "store of value"). All an ICO needs to be successful is effective (...scammy?) marketing **cough** BitConnecct **cough**.
It's possible that ICOs attract the worst businesses, the ones that weren't good enough to get VC funding. There are many companies that truly and earnestly belong on blockchains and require native digital assets...but it's possible many token companies out there slapped a blockchain in their model so they don't have to face the hard, experience-earned vetting that venture capital requires.
And so there may be an adverse selection ICO effect: it's possible the companies that choose ICOs over VC funding are companies that aren't viable since they couldn't (or wouldn't) have gotten funding under the VC model.
Thoughts? Comments? Let us know below.
This Time Is Not Different: A Brief History of Private Money and Crypto
Initial Coin Offering (ICO) Security Exemptions
Given increasing scrutiny from the Securities and Exchange Commission (“SEC”), Initial Coin Offerings (“ICOs”) are trying to limit their exposure to SEC regulation by placing themselves outside SEC jurisdiction.
The main way ICOs are doing this (...or are unintentionally trying to do this) is by fitting into Regulation S (“Reg S”).