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How many government agencies does it take to regulate cryptocurrencies?

by: Anthony Parent   2018-06-25

There is confusion and contradiction between government agencies about how to regulate cryptocurrency. Because of this patchwork regulatory framework, there is much confusion among lawyers and financial experts about what exactly the regulations of cryptocurrency are. The Security and Exchange Commission (SEC) further complicated matters last week when it announced that it does not consider Bitcoin or Ether to be securities. This distinction matters because classifying Bitcoin or Ether as securities would require that they be subject to the same regulations as stocks and bonds.

 

Securities are determined according to the Howey test, which comes from a 1946 Supreme Court Case.  See SEC v. W.J Howey Co.  The ruling states that an investment is a security if “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

 

Why Bitcoin and Ethereum are not considered to be securities

 

So, how are Bitcoin and Ether different from securities investments?   Bitcoin and Ether have decentralized their networks, and there's no third party that either network is reliant on for their success and operation.  In contrast, smaller cryptocurrencies - initial coin offerings (ICO) - are securities because the tokens are built on top of the Ethereum and Bitcoin networks. So while buying and trading Ether or Bitcoin tokens are not seen as making a traditional securities investment, buying and selling specific tokens that run on top of those networks are.  Therefore, we can anticipate the SEC to take increasingly strong action against ICO’s.  

 

Are cryptocurrencies commodities?

 

So does this mean that the SEC considers Bitcoin and Ethereum to be commodities?  Bitcoin and Ethereum have already been subject to Commodity Futures Trading Commission (CFTC) regulations.  In 2014, the CFTC declared virtual currencies to be a “commodity” subject to oversight under its authority under the Commodity Exchange Act.  This classification gave Bitcoin and Ethereum a place on futures exchanges.  The SEC’s classification of Bitcoin and Ethereum as securities made many investors hesitant to put their money into Bitcoin futures. Investors hope that this news from the SEC will encourage investors to enter into Bitcoin futures contracts.   

 

What FinCEN has to say about cryptocurrencies

 

Once one examines the different classifications of cryptocurrency by different administrative agencies, this patchwork regulatory framework becomes very confusing to investors.  The Financial Crimes Enforcment Network (FinCEN)  considers cryptocurrency to be virtual currency. 

 

And then the IRS has an opposite vision

 

The IRS takes the opposite approach. It considers cryptocurrency to be property.  The CFTC considers cryptocurrency to be a commodity.  The SEC used to consider all cryptocurrencies to be securities –but now it considers most cryptocurrencies to be securities (except Bitcoin and Ethereum).      

 

Because of this confusing framework, I’ve received many emails from cryptocurrency investors questioning whether the news from the SEC has any tax implications on capital gains and losses reporting.  My answer short answer - no.  

 

The term security doesn’t really have significance pertaining to cryptocurrency taxation.  Cryptocurrency has never been a “covered security” for Form 1099-B issuance, so coin investors and the IRS don’t receive a 1099-B.  But, that doesn’t mean that cryptocurrency is considered a “non-covered” security.  Despite not fitting neatly into either of these categories coin investors are required to report their cost basis.  Specifically, coin investors are responsible for generating their accounting and tax reports on IRS Form 8949.  

 

For IRS purposes, cryptocurrency is taxable property.  General tax principles applicable to property transactions apply to transactions using virtual currency.  The tax rate depends on both the investor's tax bracket and the amount of time the investment was held. Short-term capital gains are taxed at the investor's ordinary income tax rate and are defined as investments held for a year or less before being sold. Long-term capital gains, on dispositions of assets held for more than one year, are taxed at a lower rate.

 

And remember, the ObamaCare surcharges have not been repealed, thus long terms capital gains may be subject to the net investment income tax.

 

If Bitcoin was considered to be a commodity for tax purposes, investors could elect mark-to-market treatment under section 475(e) and (f).  In theory, this would allow Bitcoin to receive 60/40 tax treatment.  The sale of a commodity futures contract traded on a U.S. commodities or futures exchange means lower 60/40 tax rates under Section 1256.  Therefore, if Bitcoin or Ethereum had status as a commodity it would give coin investors preferential tax treatment.  


Nonetheless, coin investors hoping for a more favorable tax rate are going to have to wait for changes in the tax code from the IRS or Congress.  Back in 2014, the IRS was silent when it was probed with questions about whether virtual currency could be considered a commodity.  This news from the SEC, and the contradictory belief from FinCEN does not change the IRS’s position on how cryptocurrency is taxed.  

 

It remains to be seen if the Qualified Business Deduction (QBI) can be used to offset income related to a cryptocurrencies trade or business, but at this point we see no reason why not.

 


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