Withum: Taking account of crypto

This article is sponsored by Withum

Crypto is a new, evolving and exciting asset class. But the landscape for investment is changing rapidly, and some of the considerations for finance and accounting professionals dealing with crypto are highly nuanced and unusual compared with traditional assets, says Withum tax principal Colleen Fay.

Private Funds CFO spoke with Fay to get a high-level view of the state of the market, the most important events on the crypto horizon, and the top considerations CFOs involved in the asset class need to keep in mind.

Where are we in terms of broader acceptance of crypto assets?

Crypto really entered the market in 2008 and 2009, at which point it was often associated with the dark web and as a way to make anonymous payments for certain nefarious goods and services, but since then it’s obviously come a long way.

At this point, it’s become widely accepted, especially as a method of payment. For example, Venmo now includes an option to make payments with cryptocurrencies. Many large, well-known corporations accept Bitcoin payments, while others hire crypto experts to bring their companies up to speed with the new crypto ecosystem. El Salvador even just became the first country to add Bitcoin as legal tender, alongside its official currency, the US dollar.

The evolution of blockchain technology has been compared to the introduction of the internet in the 1990s. No one using a dial-up modem back then could have easily imagined we’d someday be storing data in the cloud or using smartphones that can do all the things they do, but that’s where we’ve ended up. Blockchain might be seen as the base layer for continuous evolutions and innovations of products and services within the financial system.

And, importantly, crypto offers a lower barrier to entry than many traditional financial assets and services. People who haven’t historically been able to access the financial system can access it via the blockchain. It also provides higher-speed transactions and less third-party involvement. That’s not to say there aren’t risks involved – volatility, security concerns, among them – but it’s revolutionizing participation in financial markets.

What types of fund managers are dipping their toes in the waters?

Some traditional private funds are starting to add some form of cryptocurrency assets to their portfolios, often with the more common coins like Bitcoin and Ethereum, and in some cases derivatives such as crypto futures.

Then you have some of the more unique crypto products and strategies, which are generally being set up via crypto-specific private funds. This is where we’re seeing some of the managers entering into the DeFi space. DeFi encompasses various different activities such as trading, lending and borrowing. Most of the DeFi platforms are built within the Ethereum ecosystem right now, and this space is changing the way that we think about lending activities. For example, by doing away with the traditional verification process banks go through with their potential borrowers, and instead allowing the borrower and lender to be anonymous, with collateral that the lender automatically receives if a loan defaults.

Interest from fund of funds is also starting to emerge, as those funds can diversify into these types of unique crypto funds and strategies for investors.

What are some of the tax issues that managers interested in crypto should be aware of?

Most people know there’s not much guidance out there around crypto from tax authorities. But as new platforms and new strategies hit the market, tax issues in regard to crypto can be very nuanced and you have to look at how a transaction is structured to see what the tax implications would be.

Generally, any time you’re dealing with a tax issue, the main points are timing of recognition and the character of the income. If you’re, say, trading between Bitcoin and Ethereum, or if you’re spending crypto to purchase goods or services, or if you’re earning crypto as income, those are realization events for tax purposes.

For tax purposes, you have a realization event when there is a sale or exchange. In the example where you purchase a good, although you might be thinking of it as spending your cash, you are exchanging your Bitcoin for the good. Therefore, there is a gain or loss to calculate for the difference in the basis of your bitcoin when you purchased it and the fair market value of the good that you exchanged your bitcoin for.

Now, when it comes to the character of the income, whether income in crypto is ordinary or capital gains, it depends on the specifics of the transaction. You could be earning interest income as a result of, say, lending out your crypto. But there are instances where that would be considered an appreciation in the value of a token that you received as a result of lending, and therefore you may have capital gains when you sell or exchange that token.

How focused is the Internal Revenue Service on the asset class and what should private fund managers expect from the agency?

The IRS launched an active compliance campaign related to virtual currency in 2018, and in 2019, they started sending letters to taxpayers that had potentially either failed to, or didn’t accurately, report some of their virtual currency transactions. So, the agency has come out and said that they’re expanding their efforts related to virtual currency, which includes increasing their use of data and analytics to try and identify underreporting or lack of reporting.

A big focus here is the infrastructure bill that was recently passed by the Senate and is now sitting with the House, which includes a provision related to crypto that estimates reaping a projected $28 billion over the next decade from taxes on cryptocurrency transactions.

As part of that, the bill proposes to increase reporting related to crypto transactions, defining ‘brokers’ as subject to this reporting requirement. Problematically, the definition of ‘broker’ is very broad in the bill – so broad that it would potentially pull in a host of players from cryptocurrency miners to software developers and require them to supply information that they may not actually have access to. The hope, now, is that the House will narrow the definition before finalizing and passing the bill.

What are the most important audit considerations for crypto investors?

Valuation is always a primary concern when it comes to preparing for an audit. It’s often a hot topic among our client managers investing in these new asset classes and strategies, which often may not be considered active enough to provide Level 1 valuations for. So, valuation approaches are a common conversation we have with clients.

The second big one is custody. Typically, if you’re trading securities in, say, a hedge fund, you have a custodian as a third party. But with more and more activity shifting to this decentralized finance model, there may not be a third-party custodian – the fund stores the digital assets itself. That brings about a different set of considerations when managers are preparing for an audit. They need to ensure that they have all the right controls in place, since there’s no longer that third-party custodian specializing in such controls.