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Several federal and state agencies have taken the initiative to regulate cryptocurrencies because Congress has not created (and the courts have not interpreted) a system for doing so. Until Congress does so, prudent investors must plan to file with and survive scrutiny from a number of federal agencies, private exchanges themselves, and possibly also the state in which the crypto comapny is licensed to do business.
With Congress silent on an official cryptocurrency regulator and the time it takes for litigation to ripen, several state and federal agencies have begun to regulate cryptocurrencies in the civil court system and require crypto companies to file forms and reports. Who are the major federal regulators and what forms and reports should cryptocurrency entrepreneurs and companies prepare to file before an initial coin offering?
The Western District of New York recognized that several agencies claim “concurrent regulatory power over virtual currency in certain settings, but concede their jurisdiction is incomplete.” CFTC v. McDonnell, No. 18-CV-361, 2018 U.S. Dist. LEXIS 36854 at *11, 2018 WL 1175156 (Mar. 6, 2018). The Securities & Exchange Commission (SEC), Internal Revenue Service (IRS), the Commodity Futures Trading Commission (CFTC), Treasury’s Financial Enforcement Network (FinCEN), Department of Justice (DOJ), and some state regulators like New York Department of Financial Services (DFS), were all recognized as having a hand in cryptocurrency regulation.
Register with the SEC if Cryptocurrency Meets the Legal Definition of a Security
As one may infer from the name, the Securities and Exchanges Commission is concerned with regulating securities and exchanges to protect investors against fraud and unfair practices. Securities are instruments “that evidence the holder’s ownership rights in a firm (e.g. stock), the holder’s creditor relationship with a firm (e.g. bond) or the holder’s other rights (e.g. option).” Black’s at 1124 (8th ed. abr. 2004); 15 USC Section 77b(a)(1); 15 USC Section 78c(a)(1). An exchange is a marketplace for “the organized purchase and sale of securities, esp. stocks.” Black’s at Id.
A form of currency (digital or otherwise) does not meet the definition of a stock or bond in most cases. More specifically, ownership of the currency that a crypto company produces generally does not equate with ownership of the crypto company itself. Yet cryptocurrency (“coins”) can act like a security and platforms on which coins are exchanged can act like a securities exchange, behavior which has drawn the attention of the SEC. See SEC v. Plexcorps, No. 17-CV-7007 (E.D.N.Y. Filed Dec. 1, 2017) SEC Compl., ECF No. 1 (“This is an emergency action to stop Lacroix, a recidivist securities law violator in Canada, and his partner Paradis-Royer, from further misappropriating investor funds illegally raised through the fraudulent and unregistered offer and sale of securities called ‘PlexCoin’ or ‘PlexCoin Tokens’ in a purported ‘Initial Coin Offering.'”).
As cryptocurrencies mature and their use diversifies, companies offering virtual currency must monitor the extent to which their product might act like a security and where their coin trading platform might behave like a securities exchange. If the coins begin to guarantee rights to a company in the way stock, bonds, securities, or debt financing does, professional help will be necessary to complete the appropriate SEC forms, filings, and reports. There are over 158 different forms of registration and registration-related actions are possible with the SEC. These are used to enforce securities laws, such as the Securities Act of 1933 (15 USC Section 77a et seq.), Securities and Exchange Act of 1934 (15 USC Section 78a et seq.), the Sarbanes-Oxley Act of 2002 (15 U.S.C. Section 7201 et seq.), and several others, enumerated at 15 U.S.C. Section 78c(a)(47).
For the IRS, Report Exchanges for Gain & Loss Like Any Other Property
The IRS’s position is that the sale or exchange of convertible cryptocurrency, or the use of convertible cryptocurrency to pay for goods or services in a real-world transaction, has tax consequences that may result in a tax liability. It treats virtual currency as property to which federal tax principles applicable to property transactions are operative. IRS Notice 2014-21. This means that the fair market value of cryptocurrency received (including by mining) must be computed and any amount greater than the basis in that currency must be recognized as gain. Conversely, amounts received less than basis can be recognized as loss.
Note that ICOs are different from Initial Public stock Offerings (IPOs) despite the name similarities and congruences of electronic currency and stock. No authority (no law, regulation, case, or IRS notice) provides for the same corporate and individual tax laws and regulations that apply to stock and IPOs to also apply to cryptocurrencies or ICOs. Until Congress, the courts, and the IRS have a chance to weigh in on the tax treatment of cryptocurrency, equating ICOs with IPOs represents an aggressive tax position.
A much more conservative tax position is that each exchange of cryptocurrency is a recognition event, gain or loss form which must be reported to the IRS. The character of this gain or loss from cryptocurrency exchanges depends on whether those assets are capital assets in the hands of the taxpayer. A taxpayer will realize ordinary gain or loss on the sale or exchange of cryptocurrency that is not a capital asset in the hands of the taxpayer. The IRS’s only guidance on cryptocurrency stops short of stating it outright, but the discussion of the matter in IRS Notice 2014-21 leads this author to believe that the IRS might consider cryptocurrency to be more like inventory than a capital asset like stock. If so, each exchange of currency for anything else (including other cryptocurrency) is a recognition event for which gain or loss must be reported. Crytpo companies log all these exchanges electronically, so complete and accurate records of exchanges are no more than one discovery request away from IRS attorneys.
All this means that a crypto company planning an ICO must be prepared to deal with the IRS’s very basic treatment of cryptocurrency as property. Logs of cryptocurrency exchanges must be preserved. Valuations of coins each day must also be saved. Any exchanges of customers’ cryptocurrency of over $600 are reported to the IRS with a 1099-MISC (for which an alien taxpayer’s Individual Taxpayer Identification Number (ITIN) is necessary). This means customers’ W-9 information must be collected by a new crypto company, which is most easily accomplished as part of the login account creation process. Backup withholdings of 24% will need to be made for customers who are not exempt or who fail to provide complete W-9s. Failure to report cryptocurrency transactions may lead to Internal Revenue Code (IRC) Section 6721 and 6722 as well as Section 6662 accuracy-related penalties.
Trading on Commodities Exchanges has Brought Cryptocurrency within CFTC Purview
As implied by its name and statutory mandate, the Commodity Futures Trading Commission is concerned with regulating trading in commodity futures and options as well as monitoring the behavior of commodity-exchange members. Black’s at 229; 7 USC Section 2(a). The statutory definition of a commodity enumerates several kinds of tangible articles such as wheat, cotton, rice, corn, etc., as well as “all other goods and articles “in which contracts for future delivery are presently or in the future dealt in.” 7 USC Section 1a(9).
Although it is a bit out of place for an intangible item like cryptocurrency to be regulated by an authority traditionally concerned with trade in futures of tangible items, late-2017 decisions by the Chicago Mercantile Exchange and the CBOE Futures Exchange to certify contracts for bitcoin futures, along with the Cantor Exchange’s certification of new contracts for bitcoin binary options effectively opened cryptocurrencies to regulation by the CFTC in certain contexts. See CFTC v. McDonnell at *20-21 (Pursuant to Title 7 USC Section 13a-1(a) the CFTC may seek injunctive or other relief when it believes that a person or entity is in violation of the Commodities Exchange Act). So crypto companies looking to offer futures and options that are traded on commodities exchanges should plan to file and comply with CFTC regulations to avoid costly litigation with the agency.
Money Laundering with Crtyptocurrencies will Draw Attention of Treasury’s FinCEN and the Justice Department
The Treasury Department’s Financial Enforcement Network’s mission is to detect and stop money laundering. Readers are probably most familiar with FinCEN for reporting Foreign Bank and Financial Accounts, a.k.a. FBAR. FinCEN form 114. These reports and other monitoring activities allow FinCEN to enforce an array of anti-money laundering laws, such as the Intelligence Reform and Terrorism Prevention act of 2014 (50 USC Section 401 et seq), the USA Patriot Act of 2001 (see 115 Stat. 272 (2001)), the Money Laundering and Financial Crimes Strategy Act of 1988 (P.L. 105-310, 105th Congress), and several others.
Along with the Department of Justice, FinCEN seeks, in part, to enforce the criminal and civil laws against money laundering, which is the “act of transferring illegally obtained money through legitimate people or accounts so that its original source cannot be traced.” Black’s at 843; 18 USC Section 1956. FinCEN guidance makes clear that an administrator or exchanger who (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. “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies,” FIN-2013-G001 (Mar. 18, 2013).
Crypto companies planning an ICO have a duty to avoid laundering money and protect themselves from customers who may be interested in using the cryptocurrency to launder money. Information about customers’ identities and the source of their income ought to be known as part of a “know your customer” policy when they create accounts to buy and exchange cryptocurrency.
States like New York, Where Finance Is Big Are Also Stepping Up Regulation
State regulators are often overlooked, but should never be forgotten. The State of New York’s Department of Financial Services, for example, has established an application and approval system for crypto companies to obtain licenses to sell and trade cryptocurrency. “DFS Grants Virtual Currency License to Bitflyer USA, Inc.” (Nov. 17, 2017), www.dfs.ny.gov. Such applications must cover demonstrate how the company combats and prevents money laundering, the extent to which it is capitalized, safeguards for consumer, and promotes cybersecurity.