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FTX Collapse: Expect Loss Deductions, But Not Soon

Tim Shaw  

Tim Shaw  

This article is a collaboration with Ledgible.

Taxpayers anticipating investment loss deductions from a crypto giant’s bankruptcy will need to wait and see how the proceedings conclude, the arduous process of which will venture into parts unknown in caselaw.

Anxious investors with inaccessible assets tied up in crestfallen cryptocurrency exchange FTX Trading Ltd. may wish to cushion the blow to their portfolios since the industry titan filed for Chapter 11 bankruptcy in the District of Delaware earlier in November, but it will take time for the smoke to clear.

“Consumers are likely to incur deductible losses,” Ledgible’s vice president of tax and accounting, Gabriel Brin, told Checkpoint. “However, since FTX filed Chapter 11 bankruptcy, these losses will likely not be recognizable on their tax returns until [at least] 2023 once fully ruled on by the court.”

Impacted customers should review FTX’s terms of service, particularly the section regarding digital assets and to whom assets belong, as well as risk. The following will be examined during the bankruptcy process and directly factor into the bankruptcy court’s findings:

8.2.6 All Digital Assets are held in your Account on the following basis:

(A) Title to your Digital Assets shall at all times remain with you and shall not transfer to FTX Trading. As the owner of Digital Assets in your Account, you shall bear all risk of loss of such Digital Assets. FTX Trading shall have no liability for fluctuations in the fiat currency value of Digital Assets held in your Account.

(B) None of the Digital Assets in your Account are the property of, or shall or may be loaned to, FTX Trading; FTX Trading does not represent or treat Digital Assets in User’s Accounts as belonging to FTX Trading.

(C) You control the Digital Assets held in your Account. At any time, subject to outages, downtime, and other applicable policies (including the Terms), you may withdraw your Digital Assets by sending them to a different blockchain address controlled by you or a third party.

8.2.7 FTX Trading is under no obligation to issue any replacement Digital Asset in the event that any Digital Asset, password or private key is lost, stolen, malfunctioning, destroyed or otherwise inaccessible.

As part of bankruptcy proceedings, the court will determine whether FTX’s estate will consist of consumer accounts. In keeping with the scenario that customers will be named unsecured creditors as predicted by a former IRS Office of Chief Counsel veteran, FTX’s decision to file under Chapter 11 affects the timeline in which customers can take a tax position.

In a Chapter 11 bankruptcy, the debtor reorganizes its debt while continuing daily operations. FTX CEO Sam Bankman-Fried stepped down and was replaced by John Ray as the company intends to move forward in salvaging its business. FTX, upon its voluntary filing, received certain protections granted by an automatic stay.

“The automatic stay arises as a matter of law and, with certain exceptions, suspends most collection activity,” according to an IRS bankruptcy tax guide. “Generally, the automatic stay to collect taxes continues until either the bankruptcy court lifts the stay, the bankruptcy case is closed or dismissed, or the debtor receives a discharge.”

FTX has until early March to submit a proposed plan for reorganization, subject to an approval vote by creditors and a subsequent court ruling. This contrasts with pure liquidation under Chapter 7, where there is no reorganization plan to repay creditors. In Chapter 7 cases, the debtor liquidates its assets to meet its obligations to the degree it can. Reuters News has reported that the number of creditors in the FTX case could exceed 1 million. It is unclear at this time how many creditors will be participating in the plan approval process. Tracking down some customers may prove difficult.

Section 1126 of the U.S. Bankruptcy Code provides rules for determining acceptance of Chapter 11 plans. Per 11 USC 1126(c): “A class of claims has accepted a plan if such plan has been accepted by creditors … that hold at least two-thirds in amount and more than one-half in number of the allowed claims of such class held by creditors … that have accepted or rejected such plan.” 11 USC 1129 details the requirements for confirming plans, but ultimate discretion over which creditor classes are deemed to have accepted, rejected, or not be impaired by a plan is given to courts.

Customers have no choice but to await the outcome of the Chapter 11 plan before recognizing losses on their crypto assets that FTX reportedly used from their accounts to fund its sister company’s (Alameda Research) risky trade activities. Allegedly, billions in FTX customer funds were loande to, and traded by, Alameda, and when this came to light, withdrawals came in droves. This prompted FTX to pause withdraws full-stop, possibly because it did not possess the assets customers were seeking to remove from the exchange.

Thus, taxpayers should not claim a nonbusiness bad debt loss until the court determines if unsecured creditors will receive some sort of payout. If this were a Chapter 7 case, unsecured creditors would receive payouts last but without needing to wait for a reorganization plan agreement. Brin recommends that customers take a conservative approach to their finances and not expect to get anything back at all after a Chapter 11 plan is approved.

Assets must be completely worthless and unrecoverable to be written off as a nonbusiness bad debt. The loss formula incorporates cost basis and the reasonably expected recoverable value, which FTX customers simply will not know or be able to calculate until next year at the earliest. Developments in other major crypto bankruptcies, such as Celsius and Voyager, may occur in the meantime that will provide precedent, but also further delay a FTX ruling.

Brin speculated that the proceedings may take much longer, given the novelty of the case and the complexities surrounding FTX’s balance sheet. He said that customers will likely “not get a ruling in 2023.”

U.S. Treasury Secretary Janet Yellen said in a November 16 statement that FTX’s downfall “and the unfortunate impact that has resulted for holders and investors of crypto assets demonstrate the need for more effective oversight of cryptocurrency markets.” Touting a recent report by the Financial Stability Oversight Council, over which Yellen presides, she said that the “federal government, including Congress, also needs to move quickly to fill the regulatory gaps the Biden Administration has identified.”

 

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