Tax Anxiety for Crypto Investors?
FTX Implosion could affect 1 million customers
Income tax season is right around the corner.
Sorry, I know many people despise doing their tax returns. One reason is that they can be very complicated. And as the world changes, so do the tax laws. Take crypto for instance.
FTX crypto exchange could be one big Ponzi
More news is coming out every day about the sudden collapse and bankruptcy filing of the FTX cryptocurrency exchange and about the founder, 30-year old Sam Bankman Fried. Reports are swirling that there is $8 billion unaccounted for. Bankman Fried says he doesn’t yet know what happened, and that the accounting was “sloppy.”
Rumors abound that Sam took out a $3.3 billion “loan” from FTX. It has not been determined yet, by the new CEO, where this money went.
Whether the missing money is due to bad trades, mismanagement, or the founder having his hand in the cookie jar will be especially important to investors. And it could have big tax implications.
Madoff 2.0?
Bernie Madoff, probably the second-most famous Ponzi schemer in US history, surrendered to law enforcement officials on December 11, 2008. Fourteen years ago this week. It doesn’t seem like that long ago.
Madoff defrauded over 40,000 investors and ran one of the longest Ponzi schemes ever, probably for several decades. His clients had invested around $17 billion over the years, and thought that their accounts had grown to $65 billion. In the end, investors will have gotten back a little more than $14.5 billion.
(One big difference between the FTX debacle and the Madoff scheme: Madoff cheated 40,000 investors, while FTX had in excess of 1 million customers. So, however this plays out, it will have far-ranging effects.)
“Madoff Tax Laws”
As a result of the Madoff Ponzi scheme, the IRS issued guidance in the form of Revenue Ruling 2009-09, which instructs taxpayers on how and when to report losses from investment fraud. This was a big development.
Rather than taking the losses as capital losses, fraud losses could be written off in one year. Capital losses, on the other hand, could only be written off against capital gains, or in absense of gains, could only be deducted up to $3,000 per year.
The Ponzi scheme deduction can be used against any other type income, and as a result is much more valuable than a capital loss, generally speaking.
Further, the IRS issued Revenue Procedure 2009-20, also in response to Madoff, which gave taxpayers guidance on computing and deducting “safe-harbor” losses, while the cases were still playing out. In other words, a portion of the losses can be taken before the final settlement outcome is determined.
(Note: The 2017 Tax Cuts and Jobs Act did away with casualty losses for individuals, except for natural disasters, so the fraud loss provision is especially valuable now.)
What Losses Qualify as Fraud?
To qualify as an “investment theft loss,” the founder or insiders would have to be indicted on fraud or embezzlement charges and either admit guilt or have their assets frozen by a court. If no charges are brought solely due to the lead figure’s death, the losses will also qualify.
So the timing of how this FTX case plays out is very important.
Will the IRS issue any “FTX guidance” in early 2023, like before the April 17th tax filing deadline? Will the FTX/SBF case even be sorted out by then? It’s anybody’s guess right now.
Can “Frozen” Crypto Accounts Be Deducted?
This is a huge question in the FTX case, as their implosion has affected many other crypto exchanges, and many millions more investors have had their Bitcoin, Ethereum, and other cryptocurrencies frozen by the exchanges. Facing liquidity crises, many withdrawals from exchanges have been halted.
Are frozen accounts worthless? Maybe, but it can’t be determined right away. A commodity, as crypto is treated by the IRS, must be sold or totally worthless in order to result in a tax loss.
File An Extension
If any of the unfortunate developments in the crypto industry affect you, you probably should do these things:
Stay up on any developments in these cases. This should be self-explanatory.
File for an extension of the filing date for your tax returns. The IRS grants an automatic six-month extension to file. But it is not an extension to pay your taxes. If you owe tax money, not considering any possible investment theft losses, you should pay up by April 17th, with the filing of your extension.
Seek professional help. With your tax situation, I mean.
I’ll be sure to keep everyone apprised of any developments concerning FTX and other tax-related issues involving cryptocurrencies.
Thanks for reading.
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Issue No. 86, December 9, 2022
Rick Mulvey is a CPA, crypto consultant, and frequent contributor to Bitcoin Magazine. He writes about all things Bitcoin, and yells at the Yankees and Giants. He also runs marathons and makes wine, neither professionally.