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Federal Tax

Latest Crypto Exchange Bankruptcy Spurs Tax Confusion

Tim Shaw  

Tim Shaw  

As another major cryptocurrency trading platform succumbs to market instability and files for bankruptcy in what has been a cataclysmic year for the industry, questions loom surrounding the tax implications for affected stakeholders.

On November 11, offshore crypto exchange FTX Trading Ltd.—which consists of West Realm Shire Services Inc (FTX US) and Alameda Research Ltd., as well as roughly 130 other affiliates—filed for Chapter 11 bankruptcy in the District of Delaware. Collectively, the companies are known as the FTX Group. Sam Bankman-Fried has resigned from his post as CEO, replaced by John Ray III, the group announced in a release posted on social media.

“The immediate relief of Chapter 11 is appropriate to provide the FTX Group the opportunity to assess its situation and develop a process to maximize recoveries for stakeholders,” said Ray in the statement. He went on to ask for patience during the abrupt transition. Stakeholders are advised to monitor docket filings “over the coming days” for more details, Ray said.

Earlier this year, other exchanges like Celsius Network and Voyager Digital proceeded with their own bankruptcy filings. With FTX joining what is quickly becoming a crypto graveyard, stakeholders are left wondering when, or if, they will receive payouts. Given there is little to no precedent for large-scale bankruptcy in the industry, the tax consequences for investors and other stakeholders are unclear due the nature of the technologies surrounding cryptocurrency and their classification as property.

Miles Fuller, head of government solutions at TaxBit, a crypto tax preparation software provider, told Checkpoint in an interview that “this is very new ground for bankruptcy law, because how often is it we have highly volatile assets like this?” He added that the creditors—those who would receive compensation or relief as a result of a claim against the debtor (in this case FTX)—are essentially retail consumers, rather than other sophisticated businesses.

During bankruptcy proceedings, it will be decided which customers would be eligible as creditors, which Fuller said is a novel situation because it is debatable if the crypto assets FTX liquidated belonged to them, or to their customers. In his view, the customer “almost certainly” should be considered an unsecured creditor. If so, customers may have to “take a haircut” and “may not get everything back.”

It remains to be seen if payouts would come in the form of crypto, or fiat currency, and how much. Less clear is the timing of when assets would be valued. Over the course of 2022, cryptocurrency prices have dramatically declined. At the time of writing, Bitcoin, the most prominent stablecoin, is valued at less than $17,000. Bitcoin hit its all-time peak at approximately $69,000 in November 2021 and has steadily fallen since, an industry-wide downward trend.

According to Fuller, who served in the IRS Office of Chief Counsel for over 15 years, it is possible a “snapshot” in time will be selected at the time of distribution to determining the value of the crypto assets. He followed up, though, that when that snapshot should take place will be difficult to decide and will need to be negotiated because of extreme crypto price fluctuations. Fuller stressed that there needs to be a mechanism in place for establishing value upon distribution.

Also unknown at this time is when losses of crypto assets will be assessed. If an exchange that has filed for bankruptcy pauses withdraws on its platform, customers are unable to access their assets. Yet, they have not yet incurred a loss, even though the assets are in a sort of purgatory. A loss will likely not trigger until after bankruptcy process concludes. As Fuller explained, a loss cannot be deducted until it is in some way finalized or concrete. A taxpayer would not be able to calculate a loss if they don’t yet know what amount of payout they would receive from a bankruptcy case.

Fuller maintained that such losses would likely be considered ordinary losses, and not capital losses, because there is no “depreciation base where the asset value changed over time.” Rather, in a bankruptcy context, it is more about the idea that property is lost. Fuller said that the IRS taking a different position is “unlikely” but not impossible.

 

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