In the United States, cryptocurrencies have been the focus of much attention by both Federal and state governments. At the Federal level, most of the focus has been at the administrative and agency level, including the Securities and Exchange Commission (the “SEC”), the Commodity Futures Trading Commission (the “CFTC”), the Federal Trade Commission (the “FTC”) and the Department of the Treasury, through the Internal Revenue Service (the “IRS”), the Office of the Comptroller of the Currency (the “OCC”) and the Financial Crimes Enforcement Network (“FinCEN”). While there has been significant engagement by these agencies, little formal rulemaking has occurred. Many Federal agencies and policymakers have praised the technology as being an important part of the U.S.’s future infrastructure and have acknowledged the need for the U.S. to maintain a leading role in the development of the technology.
Coinciding with the proliferation of cryptocurrencies in mainstream society, U.S. Congress has introduced several bills aimed at providing more clarity to the emerging sector. The bipartisan introduced Responsible Financial Innovation Act (“RFIA”) is designed to provide regulatory clarity for agencies charged with supervising digital asset markets, provide a strong, tailored regulatory framework for stablecoins, integrate digital assets into existing tax and banking law and spur innovation in the field of digital assets. Democratic Senator Patrick Toomey introduced a bill that would create a regulatory framework for stablecoins and their issues, currently known as the Toomey Stablecoin Bill. This bills includes authorizing three options for the issuance of payment stablecoins (national limited payment stablecoin issuers, insured depository institutions and money transmitting businesses), subjecting all payment stablecoin issuers to standardized requirements, distinguishing stablecoins from securities by indicating that, at a minimum, stablecoins that do not offer interest are not securities, and applying privacy protections to transactions involving stablecoins and other virtual currencies. Finally, the Virtual Currency Tax Fairness Act is designed to simplify the use of digital assets from everyday purchase by exempting from taxation small personal transactions using virtual currency for goods and services under $50.
Many state governments have proposed and/or passed laws affecting cryptocurrencies and blockchain technology, with most of the activity taking place in the legislative branch. There have generally been two approaches to regulation at the state level. Some states have tried to promote the technology by passing very favorable regulations exempting cryptocurrencies from state securities laws and/or money transmission statutes. These states hope to leverage investment in the technology to stimulate local economies and improve public services. One example, Wyoming, has been mentioned as a state seeking a broader impact on its economy. In furtherance of this objective, Wyoming passed legislation allowing for the creation of a new type of bank or special purpose depository institution. These crypto-focused banks can act in both a custodial and fiduciary capacity and are meant to allow businesses to hold digital assets safely and legally. The state also passed legislation aimed at easing the formation of decentralized autonomous organizations (“DAOs”). By issuing the DAO Supplemental Bill, Wyoming became the first state to regulate DAOs and to recognize them as a form of LLC. The Nebraska Financial Innovation Act was enacted, which establishes digital asset depository institutions as a new kind of state financial institution and allows digital asset banks to receive state bank charters. Virginia legislature passed a bill that permits banks in Virginia to provide virtual currency custody services so long as the bank has appropriate protocols. Utah now allows payments to government agencies to be made with digital assets. The Arizona State Senate introduced a bill that would amend the definition of legal tender to include Bitcoin. On the other hand, Iowa introduced a bill that would prohibit the state and political subdivisions of the state from accepting payment in the form of cryptocurrencies. Authorities in at least 10 other states, like Maryland and Florida, have issued warnings about investing in cryptocurrencies. New York, which passed laws once considered restrictive, has eased restrictions for attaining a BitLicense in the hopes of luring back cryptocurrency companies that previously exited the New York market.
There is no uniform definition of “cryptocurrency,” which is often referred to as “virtual currency,” “digital assets,” “digital tokens,” “cryptoassets” or simply “crypto.” The Uniform Law Commission and the American Law Institute amended the Uniform Commercial Code to include Article 12, which defines and governs digital assets specifically. The new article includes virtual currencies in its definition of “controllable electronic records.” Several states have already adopted the amendment. Other jurisdictions have attempted to formulate a detailed definition for the asset class, most have wisely opted for broader, more technology-agnostic definitions. Those taking the latter approach will be better positioned to regulate as and when the technology evolves.
The Biden Administration released an Executive Order (“EO”) outlining an approach to address risks stemming from the growth of digital assets and blockchain technology while supporting responsible innovation. The EO focuses on six key priorities: (1) consumer and investor protection; (2) financial stability; (3) illicit finance; (4) U.S. leadership in the global financial system and economic competitiveness; (5) financial inclusion; and (6) responsible innovation.
To advance these key priorities, the EO called for a number of reports, studies and plans, including reports from the Treasury Department, on: (1) the future of money and potential impacts of a U.S. central bank digital currency; and (2) policy recommendations around consumer protection and financial inclusion issues. It also calls for the Financial Stability Oversight Council to produce a report on financial stability risks and regulatory gaps.
The sale of cryptocurrency is generally only regulated if the sale (i) constitutes the sale of a security under state or Federal law, or (ii) is considered money transmission under state law or conduct otherwise making the person a money services business (“MSB”) under Federal law. In addition, futures, options, swaps and other derivative contracts that make reference to the price of a cryptoasset that constitutes a commodity are subject to regulation by the CFTC under the Commodity Exchange Act. In addition, the CFTC has jurisdiction over attempts to engage in market manipulation with respect to those cryptoassets that are considered commodities. For example, the CFTC issued an order filing and settling charges against digital asset exchange operator Coinbase Inc. for recklessly delivering false, misleading, and inaccurate reports concerning transactions in digital assets on the electronic trading platforms that it operated.
The SEC generally has regulatory authority over the issuance or resale of any token or other digital asset that constitutes a security. Under U.S. law, a security includes “an investment contract,” which has been defined by the U.S. Supreme Court as an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946).
In determining whether a token or other digital asset is an “investment contract,” both the SEC and the courts look at the substance of the transaction, instead of its form. In 1943, the U.S. Supreme Court determined that “the reach of the [Securities] Act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as matter of fact that they were widely offered or dealt in under terms or courses of dealing which established their character in commerce as ‘investment contracts,’ or as ‘any interest or instrument commonly known as a ‘security’.” SEC v. C.M. Joiner Leasing Corp., 320 U.S. 344, 351 (1943). It has also been said that “Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called.” Reves v. Ernst & Young, 494 U.S. 56, 61 (1990).
The SEC has been clear on its position that even if a token issued in an initial coin offering (“ICO”) has “utility,” the token will still be deemed to be a security that is regulated under the Securities Act if it meets elements of the Howey test. On February 6, 2018, in written testimony to the U.S. Senate Banking Committee, the Chairman of the SEC stated as follows:
Certain market professionals have attempted to highlight the utility or voucher-like characteristics of their proposed ICOs in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions that the federal securities laws do not apply to a particular ICO appear to elevate form over substance. The rise of these form-based arguments is a disturbing trend that deprives investors of mandatory protections that clearly are required as a result of the structure of the transaction. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.
In a more nuanced speech delivered in June 2018, William Hinman, the SEC’s Director of Corporate Finance, stated:
Returning to the ICOs I am seeing, strictly speaking, the token – or coin or whatever the digital information packet is called – all by itself is not a security, just as the orange groves in Howey were not. Central to determining whether a security is being sold is how it is being sold and the reasonable expectations of purchasers. When someone buys a housing unit to live in, it is probably not a security. But under certain circ*mstances, the same asset can be offered and sold in a way that causes investors to have a reasonable expectation of profits based on the efforts of others. For example, if the housing unit is offered with a management contract or other services, it can be a security.
Later in the same speech, Mr. Hinman made clear that a digital token that might initially be sold in a transaction, constituting the sale of a security, might thereafter be sold as a non-security where the facts and circ*mstances have changed over time, such that the Howey test is no longer met, specifically, if the blockchain protocol becomes truly decentralized like Bitcoin and Ethereum; negating the “efforts of others” prong of Howey. While such comments are not official policy of the SEC, they are a good indicator of it. If a digital asset is determined to be a security, then the issuer must register the security with the SEC or offer it pursuant to an exemption from the registration requirements. For offerings that are being made under a Federal exemption from securities registration, the SEC places fewer restrictions on the sale of securities to “accredited investors.” An individual investor is an “accredited investor” only if he or she (i) is a director or executive officer of the company issuing the securities, (ii) has an individual net worth (or joint net worth with a spouse) that exceeds $1 million, excluding the value of the investor’s primary residence, (iii) has an individual income that exceeds $200,000 in each of the two most recent years, and has a reasonable expectation of reaching the same individual income level in the current year, or (iv) has a joint income that exceeds $300,000 in each of the two most recent years, and has a reasonable expectation of reaching the same joint income level in the current year. See SEC Rule 501(a)(5). Significant enforcement actions by the SEC have included actions brought against Telegram and Kik. These actions highlight the SEC’s willingness to aggressively enforce U.S. securities laws in cases involving digital assets. In October 2019, the SEC filed a complaint against Telegram alleging that the company had raised $1.7 billion through the sale of 2.9 billion GRAMS (the company’s native cryptocurrency) to finance its business. GRAMS were to allow customers of the messaging service to use the token as a means of payment for goods and services within the Telegram ecosystem. The SEC sought to enjoin Telegram from delivering the GRAMS it sold, which, using the Howey test, the regulator alleged were securities and were not properly registered. In March of 2020, the U.S. District Court for the Southern District of New York (“SDNY”) issued a preliminary injunction. The SEC argued that the Simple Agreement for Future Tokens (“SAFT”) – mirrored after the commonly used Simple Agreement for Future Equity – and the subsequent resale of GRAMS delivered pursuant to the SAFT, could not be viewed as two isolated phases, but rather should be viewed holistically as a single integrated scheme to issue securities that yield a profit. Ultimately, Telegram abandoned its plan to issue the GRAMS tokens, and agreed to repay the $1.2 billion to investors and pay an $18.5 million civil penalty. The SEC’s position could make it more difficult for token issuers to bifurcate between capital-raising activities and the bona fide sale of tokens intended to provide some utility other than as an investment.
In October 2020, a Federal district court entered a final judgment against Kik Interactive Inc. (“Kik”) relating to Kik’s unregistered offering of digital “Kin” tokens in 2017, which the SEC argued violated U.S. securities laws. More specifically, the SEC alleged that Kik sold securities to U.S. investors without a valid registration as required under U.S. securities laws. The court found that sales of “Kin” tokens constituted investment contracts; and hence, were securities. Kik had argued that its private sales were limited to accredited investors, but the court held that even those sales did not qualify for an exemption because its private and public sales were a single integrated offering. As part of the final judgment, Kik agreed to pay a $5 million penalty.
In December 2020, the SEC announced that it filed an action in the SDNY against Ripple Labs, Inc., alleging that it raised over $1.3 billion through an ongoing unregistered digital asset securities offering. The complaint alleges that Ripple raised funds, beginning in 2013, through the sale of the XRP digital coin in an unregistered securities offering to investors in the U.S. After the SEC’s announcement, most major U.S. crypto exchanges, including Coinbase, delisted or halted trading of XRP. However, defendants assert that XRP is a cryptocurrency and does not need to be registered as an investment contract. In March 2022, the SDNY denied the SEC’s motion to strike Ripple’s “fair notice” defense. Ripple asserted that the SEC failed to provide Ripple with fair notice that its unregistered sales of XRP violated Federal law. Among other things, Ripple asserted that the SEC failed to take action in 2015 when Ripple reached a settlement with the U.S. Department of Justice (“DOJ”) and the U.S. Department of the Treasury’s FinCEN, which described XRP as a “convertible virtual currency,” permitting future sales of XRP subject to laws and regulations applicable to MSBs. The Ripple litigation remains ongoing and the ruling in this case should help answer many questions regarding what characteristics differentiate a digital asset security from a cryptocurrency. The outcome of the Telegram and Kik proceedings and the ongoing XRP litigation have made it incredibly difficult to consummate most token-generating events involving U.S. persons. Many issuers have opted to exclude U.S. persons from token offerings, and instead have elected to limit sales to non-U.S. persons (e.g., pursuant to the Regulation S safe harbor).
In addition to Federal securities laws, most states have their own laws, referred to as blue sky laws, which are not always preempted by Federal law. Anyone selling digital assets likely to constitute a security should check with counsel about the applicability of blue sky laws. Of particular importance, there are certain exemptions from registration under Federal law that do not preempt the application of state blue sky laws.
It is worth noting that state securities regulators increased their scrutiny of digital assets during 2021. An area of particular focus has been exchanges and others offering interest-bearing crypto accounts. New Jersey and several other states issued cease and desist orders against BlockFi, a well-known crypto exchange, for offering such interest-bearing accounts. In February 2022, the North American Securities Administrators Association (“NASAA”) and the SEC reported that BlockFi agreed to pay a $50 million civil penalty to settle charges from state regulators that BlockFi failed to comply with state registration requirements and deprived investors of critical information and disclosures necessary to understand the potential risks of its crypto lending products. NASAA noted that the 32 state securities regulators agreed to the terms of the BlockFi settlement.
Two other implications for a token constituting a security are (i) the requirement that a person be a broker-dealer licensed with the SEC and a member of the Financial Industry Regulatory Authority (“FINRA”) in order to facilitate the sale of securities or to act as a market maker or otherwise constitute a dealer in the asset, and (ii) the asset can only trade on a licensed securities exchange or alternative trading system (“ATS”) approved by the SEC. Several exchanges attained approval as an ATS and several firms have been registered as a broker-dealer, in each case, with the intent to deal in cryptocurrencies that are considered securities. To date, however, there are only a handful of security tokens actively trading on these ATS platforms. This is likely the result of the difficulties in integrating traditional securities laws around the transfer of securities and the notion of a peer-to-peer network that seeks to operate without intermediaries.
In an attempt to harmonize securities laws with blockchain technology, the SEC has proposed two amendments to the Exchange Act, redefining the terms “exchange” and “dealer.” In January 2022, the SEC the proposed amendments to Rule 3b-16 and the term “exchanges:”
- exchanges are defined in terms of buyers and sellers with trading interest as opposed to orders;
- exchanges include organizations, associations, or groups of persons that simply make available – rather than use – established, non-discretionary methods that allow for interaction and agreement on the terms of trades; and
- exchanges include not only organizations, associations, or groups of persons that provide trading facilities or set rules, but also organizations, associations, or groups of persons that merely provide communication protocols.
These proposed amendments, which deformalize the criteria for being an exchange, have clear and potentially profound implications for decentralized finance (“DeFi”). Under the proposed definition of exchange, an organization, association, or group of persons that passively makes available a communication protocol under which buyers and sellers with trading interest can interact and agree on the terms of trades is an exchange.
In March 2022, the SEC proposed rules that would greatly expand the Exchange Act definition of “dealer” and essentially kill the distinction between dealers and traders long recognized by the SEC. The likely outcome is that most proprietary trading firms will need to register with the SEC as dealers and become members of FINRA or a national securities exchange. The SEC’s focus is on “market participants who engage in a routine pattern of buying and selling securities for their own account that has the effect of providing liquidity.” The proposed qualitative standards are below, any one of which would be sufficient to push what today is viewed as a non-registered trading to the category of registered (and regulated) dealer activity “regardless of whether the liquidity provision is a chosen consequence the activity:”
- routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day;
- routinely expressing trading interests that are at or near the best available prices on both sides of the market and that are communicated and represented in a way that makes them accessible to other market participants; or
- earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interests.
In addition to covering proprietary traders in equities, fixed income, and other traditional financial assets, the proposal may lead to a dealer registration requirement for automated market makers and other liquidity providers in the cryptocurrency and DeFi space. Between the exchange and dealer proposals, a staggering number of companies and software developers in the crypto and DeFi space may become subject to the SEC’s broker-dealer framework, including registration with the SEC and FINRA membership. In a certain way, this outcome would be consistent with SEC’s long-enunciated approach that it will employ the existing laws and regulatory framework to new technologies.
In July 2022, the DOJ and the SEC each brought insider trading charges against a former Coinbase product manager for using material non-public information to purchase a variety of cryptoassets prior to announcements by Coinbase that the assets would be listed on the company’s platform.
The SEC’s allegation that the product manager violated Section 10(b) and Rule 10b-5 of the Exchange Act requires that the tokens traded were securities. Significantly, while the SEC alleges that the manager used material, non-public information to purchase 25 different digital assets ahead of listing announcements, the complaint only alleges that nine of the assets were securities. The other 16 are not even identified, let alone alleged to be securities. Coinbase has strongly challenged the notion that any of the cryptoassets on its platform are securities.
In response to the SEC complaint, CFTC Commissioner Caroline Pham issued an unusually harsh statement criticizing the SEC’s approach. Commissioner Pham states she comes to a different view than the SEC on whether utility and governance tokens are securities. Specifically, she notes that: “The SEC complaint alleges that dozens of digital assets, including those that could be described as utility tokens and/or certain tokens relating to DAOs, are securities.”
Commissioner Pham also urged the CFTC to take a leading role in this space, which highlights the tension between the SEC and CFTC as to who should regulate digital assets. As mentioned above, the RFIA would give the CFTC a leading role in the regulation of digital assets.
Under the Bank Secrecy Act (the “BSA”), FinCEN regulates MSBs. On March 18, 2013, FinCEN issued guidance that stated the following would be considered MSBs: (i) a virtual currency exchange; and (ii) an administrator of a centralized repository of virtual currency who has the authority to both issue and redeem the virtual currency. FinCEN issued guidance that stated as follows: “An administrator or exchanger that (1) accepts and transmits a convertible virtual currency or (2) buys or sells convertible virtual currency for any reason is a money transmitter under FinCEN’s regulations, unless a limitation to or exemption from the definition applies to the person.” See FIN-2013-G001, Application of FinCEN’s Regulations to Persons Administering, Exchanging or Using Virtual Currencies (March 18, 2013).
An MSB that is money transmitter must conduct a comprehensive risk assessment of its exposure to money laundering and implement an anti-money laundering (“AML”) program based on such risk assessment. FinCEN regulations require MSBs to develop, implement, and maintain a written program that is reasonably designed to prevent the MSB from being used to facilitate money laundering and the financing of terrorist activities. The AML program must: (i) incorporate written policies, procedures and internal controls reasonably designed to assure ongoing compliance; (ii) designate an individual compliance officer responsible for assuring day-to-day compliance with the program and BSA requirements; (iii) provide training for appropriate personnel, which specifically includes training in the detection of suspicious transactions; and (iv) provide for independent review to monitor and maintain an adequate program.
All U.S. persons are prohibited from doing business with foreign nationals who are on the Specially Designated Nationals and Blocked Entities List (“SDN List”) of the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”). OFAC provides an updated and searchable version of its SDN List at: (Hyperlink); OFAC requires all U.S. citizens to “block” (i.e., freeze) the assets of individuals and companies who are engaging in transactions with (i) countries that are subject to U.S. economic sanctions, (ii) certain companies and entities that act as agents for such countries, and (iii) certain individuals that act as agents for such countries. It is important to have a compliance program in place to avoid (or mitigate) receiving civil and criminal penalties from OFAC for non-compliance. See 31 C.F.R. Part 501 (OFAC Reporting Regulations); OFAC Economic Sanctions Enforcement Guidelines (November 9, 2009).
On February 13, 2018, in response to a letter from Senator Ron Wyden, an official within the Treasury Department issued a correspondence that called into question whether ICO issuers were de facto MSBs that were required to register with FinCEN. While there were several flaws in the logic set forth in the letter, it remains an area of concern for anyone considering a token sale. To add more confusion, speaking at a conference on November 19, 2019, FinCEN Director Kenneth Blanco, responding to a question about Facebook’s plan to issue a cryptocurrency pegged to the USD, stated that stablecoin issuers and dealers are money transmitters and must follow the BSA’s AML laws.
State laws on money transmission vary widely but can generally be grouped into a few categories. Most states define money transmission as including some or all of three types of activities: (1) money transmission; (2) issuing and/or selling payment instruments; and (3) issuing and/or selling stored value. A few states only regulate these activities when “money” is involved, and define money as “a medium of exchange that is authorized or adopted by a domestic or foreign government.” Generally, state money transmission laws apply to any entity that is either located in the state or is located outside of the state (including in a foreign jurisdiction) but does business with residents of the state. A novel solution to the redundancy of attaining state licenses is to become a New York limited purpose trust company. This may seem counterintuitive, as New York has the most onerous money transmitter licensing requirements for cryptocurrency companies, but this type of trust company charter exempts the company from many states’ money transmission laws and requirements, while also providing the ability to conduct a broad range of custody and fiduciary services related to cryptoassets. Nevada and Wyoming have since followed New York and now permit the creation of special purpose depository institutions.
Another tension point for AML laws is the emergence of DeFi. DeFi is the permissionless decentralization version of various traditional financial instruments with a focus on exchanging assets, lending and borrowing and the creation of synthetic assets. For example, Uniswap is a decentralized exchange in the form of two smart contracts hosted on the Ethereum blockchain, as well as a public, open-source, front-end client. This ultimately allows for anyone with an internet connection to trade many Ethereum-native tokens with other users of the application. Inherent with its open-source nature, Uniswap does not have a customer identification vetting process and, in fact, circumventing AML laws is touted as one of Uniswap’s foundational values amongst the cryptocurrency community. During August 2021, over $40 billion of transactions occurred using the Uniswap Protocol. In September 2021, it was reported that the SEC had begun an investigation into Uniswap Labs and its Uniswap Protocol.
In August 2022, OFAC sanctioned the popular cryptocurrency mixer Tornado Cash, adding it to the SDN List with 38 unique cryptocurrency addresses included as identifiers. Built on the Ethereum blockchain, Tornado Cash is the predominant example of a smart contract mixer. Tornado Cash is non-custodial. Users simply send the funds they want to mix to the Tornado Cash smart contract, and in return receive a cryptographic note they can use to withdraw their mixed funds to a new address by sending a transaction that references their note. OFAC specifically pointed to Tornado’s role in laundering over $455 million worth of cryptocurrency stolen from Axie Infinity’s Ronin Bridge Protocol by the North Korea-affiliated hacking organization, Lazarus Group. This designation suggests that decentralized protocols may be subject to some of the compliance obligations to which centralized services are held. Under Secretary of the Treasury for Terrorism and Financial Intelligence, Brian E. Nelson said the following in OFAC’s press release on the Tornado Cash designation:
Despite public assurances otherwise, Tornado Cash has repeatedly failed to impose effective controls designed to stop it from laundering funds for malicious cyber actors on a regular basis and without basic measures to address its risks. Treasury will continue to aggressively pursue actions against mixers that launder virtual currency for criminals and those who assist them.
Nelson’s words make it clear that cryptocurrency services, whether they are decentralized or not, must at least make an effort to implement controls to prevent bad actors from abusing them.
In March 2014, the IRS declared that “virtual currency,” such as Bitcoin and other cryptocurrency, will be taxed by the IRS as “property” and not currency. See IRS Notice 2014-21, Guidance on Virtual Currency (March 25, 2014). Consequently, every individual or business that owns cryptocurrency will generally need to, among other things, (i) keep detailed records of cryptocurrency purchases and sales, (ii) pay taxes on any gains that may have been made upon the sale of cryptocurrency for cash, (iii) pay taxes on any gains that may have been made upon the purchase of a good or service with cryptocurrency, and (iv) pay taxes on the fair market value of any mined cryptocurrency, as of the date of receipt.
For an individual filing a Federal income tax return, the gains or losses from a sale of virtual currency that was held as a “capital asset” (i.e., for investment purposes) are reported on (i) Schedule D of IRS Form 1040, and (ii) IRS Form 8949 (Sales and Other Dispositions of Capital Assets). Any realized gains on virtual currency held for more than one year as a capital asset by an individual are subject to capital gains tax rates. Any realized gains on virtual currency held for one year or less as a capital asset by an individual are subject to ordinary income tax rates. The IRS requires, on Form 8949, for each virtual currency transaction, the following information be disclosed: (i) a description of the amount and type of virtual currency sold; (ii) the date acquired; (iii) the date the virtual currency was sold; (iv) the amount of proceeds from the sale; (v) the cost (or other basis); and (vi) the amount of the gain or loss. It should be noted that the record-keeping requirements of IRS Form 8949 can be particularly onerous for those who have used cryptocurrency to make numerous small purchases of goods or services throughout the year.
For transactions completed on or after January 1, 2018, the Internal Revenue Code now prohibits the use of Section 1031(a) for cryptocurrency transactions, and requires a taxpayer to recognize taxable gain or loss at the time that any cryptocurrency is converted into another cryptocurrency. Section 13303 of P.L. 115-97 (the tax act signed into law on December 22, 2017) changes Section 1031(a) to state as follows: “No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
For transactions completed on or prior to December 31, 2017, the IRS has not issued any guidance on whether different cryptocurrencies are “property of like kind” that would qualify for non-recognition of gain under Section 1031(a). Generally speaking, exchanges between different cryptocurrencies are usually done by either (i) a simultaneous swap of one cryptocurrency for another, or (ii) a deferred exchange, in which one cryptocurrency is sold for cash, followed by the purchase for cash, of a different cryptocurrency.
For transactions completed on or prior to December 31, 2017, Section 1031(a)(1) of the Internal Revenue Code states the following: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” In 26 C.F.R. 1.1031(a)-2(b), “like kind” is defined as follows: “As used in section 1031(a), the words like kind have reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class.” It should be noted that, in order to attempt to utilize the tax treatment of Section 1031(a) for transactions done on or prior to December 31, 2017, (i) each transaction must comply with certain requirements set forth in IRS regulations (such as the use, in certain instances, of a “qualified intermediary”), and (ii) the taxpayer must file a Form 8824 with the IRS.
There is a risk that the IRS could use its prior revenue rulings on gold bullion as a basis for taking the position that, for transactions completed on or prior to December 31, 2017, different cryptocurrencies are not “property of like kind” under Section 1031(a). In Rev. Rul. 82-166 (October 4, 1982), the IRS ruled that an exchange of gold bullion for silver bullion does not qualify for non-recognition of gain under Section 1031(a). The IRS stated: “Although the metals have some similar qualities and uses, silver and gold are intrinsically different metals and primarily are used in different ways. Silver is essentially an industrial commodity. Gold is primarily utilized as an investment in itself. An investment in one of the metals is fundamentally different from an investment in the other metal. Therefore, the silver bullion and the gold bullion are not property of like kind.” The IRS also stated in Rev. Rul. 79-143 (January 5, 1979) that an exchange of $20 U.S. gold numismatic-type coins and South African Krugerrand gold coins does not qualify for non-recognition of gain under Section 1031(a). The IRS stated: “The bullion-type coins, unlike the numismatic-type coins, represent an investment in gold on world markets rather than in the coins themselves. Therefore, the bullion-type coins and the numismatic-type coins are not property of like kind.”
With respect to digital assets acquired via a hard fork or airdrop, the IRS issued Rev. Rul. 2019-24. Pursuant to this revenue ruling, the IRS confirmed that the new assets resulting from such events can result in revenue to the taxpayer. The IRS also concluded, however, that a taxpayer does not have gross income as a result of a hard fork if it does not receive the new cryptocurrency. In April 2021, the IRS released Chief Counsel Advice memo 202114020 (Hard Fork CCA) that specifically addressed the tax consequences of the 2017 hard fork that created Bitcoin Cash. The IRS concluded that a taxpayer who received Bitcoin Cash as a result of the hard fork had realized gross income. The IRS further concluded that when the taxpayer obtained “dominion and control” over the Bitcoin Cash would determine, for tax purposes, its date of receipt and the determination of its fair market value.
In November 2021, President Biden signed into law the Infrastructure Investment and Jobs Act (“IIJA”), which will require digital asset brokers to report to the IRS digital asset transactions valued at more than $10,000. IIJA defines the term “broker” broadly, which could subject parties that are peripheral to digital asset transactions, including cryptominers, software developers, and parties validating cryptocurrency transactions or selling cryptocurrency storage devices, to the reporting and compliance requirements of IIJA. In February 2022, the Treasury indicated that it is inclined to adopt a narrow interpretation of the term “broker” in the context of IIJA, which would limit compliance requirements for digital asset transactions to parties that can provide information useful to the IRS. These rules are scheduled to take effect in January 2024.
Arizona became the first state in the U.S. to adopt a “regulatory sandbox” to shepherd the development of new emerging industries like fintech, blockchain and cryptocurrencies within its borders. The law grants regulatory relief for innovators in these sectors who desire to bring new products to market within the state. Under the program, companies are able to test their products for up to two years and serve as many as 10,000 customers before needing to apply for formal licensure. Other states have since followed suit and created similar programs including Wyoming, Florida, Utah, West Virginia, Kentucky, Vermont, Nevada and Hawaii.
Cryptocurrency fund managers that invest in cryptocurrency futures contracts, as opposed to “spot transactions” in cryptocurrencies, are required to register as a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) with the CFTC and with the National Futures Association (the “NFA”), or satisfy an exemption. Also, because of additions to the Dodd-Frank Act, cryptocurrency hedge fund managers that use leverage or margin would also need to register with the CFTC and NFA. The Dodd-Frank Act amended the Commodities Act to add new authority over certain leveraged, margined, or financed retail commodity transactions. The CFTC exercised this jurisdiction in an action against BFXNA INC. d/b/a BITFINEX in 2016. Fund managers should be cautious when using margin/leverage as it may require them to register as a CTA and CPO with the CFTC and register with the NFA. In April 2022, FalconX, a prime broker for digital assets that provides institutional investors access to the over-the-counter crypto derivatives market, announced that it has become the first cryptocurrency swap dealer registered with the NFA.
The Investment Company Act of 1940 (the “Company Act”), the Investment Advisers Act of 1940 (the “Advisers Act”), as well as state investment advisor laws, impose regulations on investment funds that invest in securities. The Company Act generally requires investment companies to register with the SEC as mutual funds unless they meet an exemption. Cryptocurrency funds, and hedge funds generally, can be structured under one of two exemptions from registration under the Investment Company Act. Section 3(c)(1) allows a fund to have up to 100 investors. Alternatively, Section 3(c)(7) allows a fund to have an unlimited number of investors (but practically it should be limited to 2,000 to avoid being deemed a publicly traded partnership under the Securities Exchange Act) but requires a significantly higher net worth suitability requirement for each investor (roughly $5 million for individuals, $25 million for entities). As a general rule, most startup funds are structured as 3(c)(1) funds because of the lower investor suitability requirements.
Until the SEC provides more guidance on classifying individual cryptocurrencies as securities or commodities, the likelihood of many cryptocurrencies being deemed securities is high. As such, we recommend that cryptocurrency funds that invest in anything other than Bitcoin, or Ether, and the handful of other clearly commodity coins, comply with the Company Act preemptively. For most startup funds, this would mean limiting investors within a given fund to fewer than 100 beneficial owners.
Regardless of whether a startup cryptocurrency fund manager is required to register as a CPO/CTA with the CFTC under the Commodities Act, or register or seek exemption from the SEC as an investment advisor (under the Advisers Act), or investment company (under the Company Act), every cryptocurrency fund manager will be subject to the fraud provisions of the CFTC and/or the SEC. In September 2017, the CFTC announced its first anti-fraud enforcement action involving Bitcoin. These anti-fraud actions can be taken by the SEC and CFTC regardless of the cryptocurrency fund’s exempt status.
In July of 2020, the OCC affirmed in an interpretive letter that national banks and savings associations can provide custody services for cryptocurrency. The letter noted that banks can also provide related services such as cryptocurrency-fiat exchanges, transaction settlement, trade execution, valuation, tax services and reporting. The effort supplements a patchwork of state regulation and guidance that to date has encouraged only a select few national banks and financial services companies to embrace cryptocurrency (see above: Money transmission laws and anti-money laundering requirements). While the OCC agreed that underlying keys to a unit of cryptocurrency are essentially irreplaceable if lost, it said that banks could be a part of the solution by offering more secure storage services compared to existing options.
The development of cryptocurrency and other popular blockchain applications has captured the attention of energy and environmental policymakers, global economists, and renewables industry players. Now home to over a third of the global computing power dedicated to mining Bitcoin, the U.S. has turned its attention to domestic miners and their impacts on the environment and local economies. On January 20, 2022, the U.S. House of Representatives Committee on Energy and Commerce’s Subcommittee on Oversight and Investigations held a hearing, where the externalities of cryptocurrency mining were the focus of the agenda. An early indicator of the Subcommittee’s views on the issue, the title for the hearing was “Cleaning up Cryptocurrency: The Energy Impacts of Blockchains.” As the federal government studies the viability of crypto mining at a national level, states have been active in regulating crypto mining. In June 2022, the New York State Senate passed Senate Bill S6486D, which would establish a two-year moratorium on cryptocurrency mining operations that use proof-of-work authentication methods to validate blockchain transactions in the state of New York. If signed into law, the bill would require comprehensive generic environmental impact review and effectively suspend all blockchain mining operations running on carbon-based power sources. Conversely, the Oklahoma Senate introduced Bill 590, which would establish the Commercial Digital Asset Mining Act of 2022 to provide certain tax exemptions for the sale of certain crypto mining equipment and machinery. Kentucky also enacted certain state-tax exemptions for cryptocurrency miners and mining facilities.
A group of U.S. lawmakers has proposed a requirement that individuals declare their cryptocurrency holdings when entering the U.S., but to date no such requirement has gone into effect.
On December 31, 2020, FinCEN issued a notice stating that it intends to amend regulations implementing the BSA to include virtual currencies as a type of reportable account for the requirement to file a Report of Foreign Bank and Financial Accounts.
Cryptocurrency, such as Bitcoin, has value and therefore is increasingly likely to become an estate asset. While there are few, if any, laws specific to cryptocurrency, due to the nature of cryptocurrencies, typical wills and revocable living trusts may not be well suited to efficiently transfer this new type of asset. Consequently, new estate planning questions and clauses may be needed.
While cryptocurrency is not sufficiently mature to allow existing legal structures to promulgate a complete set of rules and regulations, cryptocurrency’s technological character allows estate planning to protect the intent of clients holding cryptocurrency. However, the lack of statutory structure necessitates proactive steps. Accordingly, someone who wants greater certainty of bequeathing cryptocurrency to their heirs will need to provide specific and detailed written instructions in your estate planning documents. The information they will need to include will depend upon the type of virtual currency wallet they have.
There are a wide range of cryptocurrency wallets that are available at this time. The current types of cryptocurrency wallets include: (i) a single device software wallet in which you hold the private keys (example: BitPay Wallet), (ii) a multiple device web wallet in which you hold the private keys (example: Blockchain Wallet), (iii) a multiple device web wallet in which you do not hold the private keys (example: Coinbase Wallet), (iv) a USB hardware dongle wallet in which you hold the private keys (example: Trezor Wallet), and (v) a “paper wallet” in which the private keys and public keys are written down (which can be later loaded into a software wallet of your choice to be spent).
The instructions that you provide in a will (for your personal representative) or in a declaration of trust (for the successor trustee of a revocable living trust) should be written in a manner that is easy to understand for individuals who are not familiar with cryptocurrency. For example, in the case of a single device software wallet in which you hold the private keys, instructions could include (i) a description of the name and version of the wallet software, (ii) a description of the name and version of the operating software system of the wallet device (i.e., iOS, Android, macOS, Windows or Linux), (iii) a description of the types of virtual currency held by the wallet, (iv) either the long-form private and public keys for the wallet or the 12-word “seed” BIP39 or BIP44 recovery phrase for the wallet, and (v) step-by-step instructions (which may include screenshots) showing how the wallet can be restored onto a new device, if the current wallet device cannot be accessed.
As transfers from a Bitcoin wallet and most other wallets are irrevocable, private key information about your cryptocurrency accounts will need to be kept in a secure manner. Security can be enhanced by storing the private key information in a safe-deposit box or vault, which could only be accessed after your death by the personal representative designated in your will (or the successor trustee designated in your revocable living trust).
