"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.
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”).
Initial coin offerings ("ICOs") are facing increased regulatory scrutiny, and are likely to be seen as securities by agencies. We've written before about the securities exemptions ICOs may use to comply with the Securities and Exchange Commission (the "SEC"): Reg D, Reg CF and Reg A+.
Reg A+ (Tier 2, in particular) has started to get attention in the cryptocurrency world because it offers advantages over the others that make the most sense for digital assets.
Well, there's good regulatory news (...which seems uncommon right now for most of crypto).
The US House of Representatives has passed the "Regulation A+ Improvement Act" (the "Reg A+ Act") that increases the cap on investments under Reg A+.
Increased Reg A+ Caps
Reg A+ is divided into Tier 1 and Tier 2. If you issue an exempt security offering under Tier 1, you can raise up to $20m in a 12-month period. If you issue the offering under Tier 2, you can raise up to $50m in a 12-month period.
The new Reg A+ Act would increase the investment cap by 50% ($30m for Tier 1, $75m for Tier 2).
ICOs & Reg A+
Several ICOs have already used Reg A+: Gab, RideCoin and WeDemand. So Reg A+ has been shown to work in practice for crypto offerings. And with an increase in capital raising potential, it will likely increase.
There are still a few key limits on using Reg A+:
The cryptocurrency market is a prime targets for broker-dealer regulation.
Brokers and dealers are people or businesses that are in the business of buying and selling securities. The formal definitions are below, but, in essence, a broker is an entity like E*Trade that acts as an intermediary between buyers and sellers. You want to buy, say, Tesla stock, so you go on E*Trade, place an order, and E*Trade finds someone selling it. This is the most traditional instance of a broker-dealer.
The "less" traditional type of broker-dealer happens when a company is selling its own securities. If it's not an IPO, the company will want to promote the fact it's selling it's securities. It could hire a third party marketing agency that would go out and promote . . . but that would make the marketing agency "in the business" of buying/selling securities, even if it's not doing any buying or selling. It's still making those transactions happens, so the marketing agency would be a broker-dealer. So anyone a company has promote its securities would count as a broker-dealer.
As a general rule, brokers and dealers are required to register with the SEC and joint a self-regulatory organization (“SRO”). The main US SRO is the Financial Industry Regulatory Authority (“FINRA”). There may also be state registration requirements, depending on your state.
If you act as a broker-dealer without properly registering, the SEC or state securities regulators can seek significant monetary penalties and/or criminal sanctions. Also, they may require rescission (basically, an undoing of the investment).
Why Broker-Dealer Laws Matter for Crypto
Given Chairman Jay Clayton of the Securities & Exchange Commission’s (“SEC”) recent aggressive view that “every ICO I’ve seen is a security,” these broker-dealer laws (“B-D laws”) will apply to most cryptocurrencies, whether utility or not.
Remember how a marketing agency that promotes a securities issuing would be a broker-dealer?
Replace "securities issuing" with ICO.
Now think of all the ads, tweets, emails, shills, etc. you have received and seen promoting ICOs.
*cough* John McAfee *cough*
Yeah . . . kind of a potentially big problem for crypto.
First off, remember that the SEC is viewing most crypto as securities. So when you see the word “security,” it would apply to a crypto or ICO that's being shilled.
The Securities Exchange Act defines “broker” as any person:
Dealer is defined as any person:
The key difference is that brokers buy and sell securities for others, while dealers do so for themselves.
Note that these definitions are really broad. You don’t have to be involved in the actual purchase or sale of a security, you just have be involved somehow. This can mean you promoted the security (read: ICO) or introduced the issuer to an investor.
The “Finder” Exception
The most cited exception to B-D registration is for a "finder," which is someone that finds investors or makes referrals. However, this is a very narrow exception. If a person has helped effect any securities (again, read: ICO) transaction more than once, this exception probably won't apply.
The main factors in determining if someone is a “finder” or “broker-dealer” are:
The determination is made on a case-by-case basis, and if any of the factors weigh in favor of being a broker . . . you’re probably a broker. Again, circumventing B-D laws is not easy; these laws are meant to apply to a lot of situations.
There are a few other exclusions from this requirement to register. The most relevant for crypto are:
The most common way to be compliant with B-D laws is to hire someone as an employee, and pay them on a fixed, regular basis. That way they'll fit in the "associated persons of the issuer" exemption from registration.
Often, these employment arrangements include bonuses. Whether this is transaction-based compensation that would trigger B-D registration depends on the circumstances, but it generally should not be tied to how much “business” an ICO promoter brings in. Key features include:
But Seriously, Consult Legal Counsel
B-D activities have serious repercussions if handled incorrectly, and the exceptions are narrow. This is an area of law where anyone that does any investing-related activities should talk to a lawyer.
Want To Learn More?
This Time Is Not Different: A Brief History of Private Money & Crypto
Initial Coin Offering (ICO) Security Exemptions
Bitcoin Dip Frequency
If a cryptocurrency or altcoin is a security, it must be offered to US investors in an offering registered with the Securities and Exchange Commission ("SEC") or fit into an exemption.
Registration can cost anywhere from hundreds of thousands of dollars to well over a million, and requires that you disclose a lot of information you may not want public. So finding an exemption is usually the preferred route.
Right now, the main exemptions for securities offered in the US are: Reg D, Reg A+ and Reg CF. There is also Reg S for foreign securities offerings, and you’ll read about that in a separate post.
Preemption & Disclosure
Two quick notes before you learn about the exemptions:
Private offerings are the most common security exemption. The key feature that makes private offerings “private” is that you can’t “generally solicit” your offering, meaning you can’t publicly market it.
There is a broad “private offering” exemption via Section 4(a)(2) of the Securities Act of 1933. But Section 4(a)(2) is open-ended and determined on a case-by-case basis, so most private offerings are done through Regulation D ("Reg D").
The digital asset industry is experiencing increased regulatory scrutiny.
For example, Jay Clayton, Chairman of the Securities and Exchange Commission (“SEC”) bluntly said in his Congressional testimony: “I believe every ICO I’ve seen is a security.”
The upside of this attention is that you should want the Bitconnects of the world gutted by regulators.
The downside is blockchain-based businesses need to start treating their native cryptoassets as securities. Even tokens created pursuant to a SAFT aren’t likely safe based on recent SEC stances and statements.
As a result, you will likely see digital asset issuers increasingly relying on securities law exemptions.
One option is for ICOs that wish to be compliant is to qualify as an exempt securities offering under Regulation Crowdfunding (“Reg CF”). Indeed, some ICOs, like Indeco, have already used this option since late 2017.
Increasingly, traders use automated algorithms to execute trades, or at least track and flag indicators. And the use of this kind of code likely won’t slow down anytime soon.
In 2015, the Commodity Futures Trading Commission (“CFTC”) proposed Regulation Automated Trading (“Reg AT”) to deal with this trend.
Reg AT Rules
Reg AT is aimed at reducing market disruptions from automated trading. The best example is probably the May 6, 2010 “Flash Crash” when automated trading caused the S&P 500, Dow Jones and Nasdaq to crash and rebound almost 10% in 36 minutes (...tame compared to crypto, I know).
If implemented, Reg AT could require pre-trad risk controls by:
The "pre-trade risk controls" would include requirements like:
The rule would also impose registration requirements on traders that electronically submit orders directly to a DCM, without routing them through a member of a derivatives (aka, futures) clearing organization.
Crypto-famous CFTC Chairman Christopher Giancarlo has expressed concern over Reg AT potential chilling effects.
In legal context, "chilling" refers to the fact that too much regulation may slow or kill the development of innovation. E.g., regulation of crowdfunding is considered to have been implemented too quickly, stagnating the development of crowdfunding.
Given Chairman Giancarlo’s favorable treatment of crypto, it’s not surprising he’s hesitant to clamp down before the CFTC has more time to watch the development of relatively new technology develop.
Automated trading is valuable in and of itself, but all the algorithms, code and lessons learned in its development could transfer to other fields. It’s possible that a trading algorithm can pick up certain patterns that may surface in diseases, for example.
In early 2017, the CFTC extended the time period in which it was accepting comments on the proposed Reg AT to May 1, 2017. That day has come to pass, and no public developments have happened with Reg AT.
Given that the Trump administration is keen on less regulation, and Chairman Giancarlo’s is hesitant to regulate new tech too quickly, we may not see any form of the proposed Reg AT implemented at all.
It’s safe to say automated trading isn’t going anywhere. Eventually, regulations will need to be imposed to protect against flash crashes and fraud. But it doesn’t look like that will be happening any time soon.
You can read about the history of non-government money like Bitcoin here
You can read about Arizona's proposal to allow residents to pay taxes in crypto here
Crypto regulation stems from a few key sources:
What Are Commodities?
In everyday terms, commodities are raw materials or products. They are goods that are typically transformed into more consumable products or uses. Common examples are steel, coffee beans or pork bellies.
In the pork bellies context, Eddie Murphy gives some deep insight in Trading Places on how commodities investing works.
The Arizona Senate has passed a bill that would allow state residents to pay their taxes in cryptocurrency
Senate Bill 1091 still needs to pass in Arizona’s House of Representatives, but the fact a bill like this has passed in the Senate is unprecedented in the US. Under the bill, the Arizona Department of Revenue would convert the crypto tax payments into US dollars within 24 hours.
Fiat & Taxes
Ok, great, so Arizona is open to experimenting with crypto. So what? Why does it matter, especially if Arizona would just immediately convert the crypto to dollars?
Because there are convincing arguments that what makes fiat money valuable as “fiat” is the fact it’s the only currency the government you live under will accept for tax payments.