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Special Tax Rules Apply to Bitcoin Futures and Options

MEMORANDUM  

Date: January 31, 2020  

To: Lukka Library  

From: Andrea S. Kramer  

Re: Special Tax Rules Apply to Bitcoin Futures and Options and Might Apply to Positions in  Other Virtual Currencies in the Future* 

As a general rule, taxpayers are not taxed on gains in virtual currency positions until the positions are sold, exchanged, or otherwise disposed of. Special tax rules can apply, however, to require taxpayers to treat their gains on certain virtual currency positions as taxable even though they still hold their positions. This is referred to as marking their positions to market for tax purposes.  

Special tax rules—including the requirement to mark open positions to market annually—apply to futures and options that qualify as Section 1256 Contracts. Two of the five types of enumerated Section 1256 Contracts are potentially relevant to taxpayers buying, selling, and holding Bitcoin futures and options. Such contracts currently trade on the Chicago Mercantile  Exchange (CME).1 As discussed in this Memorandum, Bitcoin futures and options currently qualify as Section 1256 Contracts and, therefore, are subject to the special tax timing and tax  character rules available under I.R.C. § 1256(a). As is also discussed in this Memorandum,  Section 1256 treatment could apply to other virtual currency positions in the future.  

* This material is for general information purposes only and should not be construed as legal advice or any other  advice on any specific facts or circumstances. No one should act or refrain from acting based upon any information  herein without seeking professional legal advice. McDermott Will & Emery makes no warranties, representations,  or claims of any kind concerning the content herein. McDermott and Andrea S. Kramer expressly disclaim all  liability to any person in respect of the consequences of anything done or not done in reliance upon the use of  contents included herein. For a complete list of McDermott entities, visit mwe.com/legalnotices.  

©2020 McDermott Will & Emery. All rights reserved. Any use of these materials including reproduction,  modification, distribution or republication, except as part of the Lukka Library is strictly prohibited without the prior  written consent of McDermott. This material may be considered attorney advertising. Prior results do not guarantee  a similar outcome. 

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Section 1256 Contracts Defined  

Section 1256 Contracts are defined to include regulated futures contracts (RFCs) and nonequity  options, both of which are defined below.  

Regulated Futures Contracts  

RFCs must meet two requirements. First, the amounts required to be deposited or allowed to be  withdrawn on the contracts must follow a system of marking to market.2 Second, the contracts  must be traded on (or made subject to the rules of) a qualified board or exchange3 (QBE), which  includes a registered national securities exchange and a domestic board of trade (designated as a  contract market by the CFTC). Bitcoin futures are subject to a system of daily marking to  market, and the CME is a QBE. As a result, the CME’s Bitcoin futures are RFCs. It is important  to note that not all U.S. securities exchanges and commodities exchanges that trade virtual  currency positions will qualify as QBEs. This means that the first step is to determine whether a  particular exchange is a QBE.  

Nonequity Options  

Nonequity options must meet a circular definition that involves the definitions of “listed options” and “equity options.”4 For these purposes, a listed option is any option that is traded on or  subject to the rules of a QBE.5 And a nonequity option is on products other than individual  stocks or narrow-based stock indexes.6 Working our way through this circular definition,  nonequity options must be traded on a QBE and can be options based on convertible virtual  currency. The CME’s Bitcoin options meet this definition and qualify as nonequity options.  

Other Virtual Currency Derivatives Are Not Section 1256 Contracts  

At the date of this writing, only the CME’s Bitcoin futures and options qualify as Section 1256  Contracts.7 No other virtual currency derivatives currently meet this definition. All other virtual  currencies and derivatives will not be marked-to-market annually and remain subject to the  general tax rules that apply to capital or ordinary assets. But what about the possibility of futures  and options on Ether or other activity traded virtual currencies? They could become Section  1256 contracts in the future.  

Section 1256 Treatment  

As Section 1256 Contracts, the CME’s Bitcoin futures and options are subject to the Mark-to Market Rule and the 60/40 Rule.8 Section 1256 is not elective. Transactions that meet these  definitions are subject to these two rules, discussed in what follows.  

The Mark-to-Market Rule  

The Mark-to-Market Rule provides that Section 1256 Contracts open on the last day of the  taxable year are market-to-market, that is, treated as if they were sold on that date. All  unrecognized gains and losses are taken into account. In other words, open Section 1256 futures  and options are treated as if they were sold for their fair market value on the last business day of 

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the taxable year. The fair market value of such futures or options is their settlement prices. For  Bitcoin futures and options, for example, their settlement prices are determined by the CME on  the last business day of the taxable year.9 All gains and losses are tallied up and used to compute  taxable income.  

When taxpayers terminate Bitcoin futures or options during the year (by offset or otherwise),  these contracts are taxed at their sale or close-out price.10  

Because taxes are paid on recognized and unrecognized gains and losses, taxpayers holding  Bitcoin futures and options can be required to pay tax on gain that, in fact, they may never  actually realize.11 If they continue to hold contracts that were marked-to-market at year end,  gains and losses realized in a subsequent tax year are adjusted to reflect gains and losses taken  into account in the preceding taxable year.12 The Mark-to-Market Rule can, therefore, distort  income and cause economic hardship if gains that were reported in the first year do not  materialize in a subsequent tax year.  

The 60/40 Rule  

Under the 60/40 Rule, CME’s Bitcoin futures and options that are capital assets in the taxpayers’ hands are taxed as 60% long-term and 40% short-term capital gain or loss. The 60/40 Rule  applies without regard to the length of time taxpayers hold such positions, meaning that the  capital gain holding period requirement is eliminated for Section 1256 Contracts. Futures or  options that are ordinary assets in the taxpayers’ hands are not eligible for 60/40 treatment even  though they remain subject to mark-to-market.13 The Mark-to-Market Rule applies to all Section  1256 Contracts, without regard to whether they are ordinary or capital, unless the taxpayer is a  hedger that made a valid hedge identification.  

Straddles Consisting Only of Bitcoin Futures and Options  

If taxpayers hold tax straddles that consist only of Bitcoin futures and options, the general  straddle rules of I.R.C. § 1092 do not apply.14 This is because the Mark-to-Market Rule taxes all  gains and losses on Section 1256 Contracts as of the last business day of the taxable year,  preventing taxpayers from deferring their gains or accelerating their losses. For a discussion of  the straddle rules, see McDermott’s Memorandum, “When Virtual Currency Positions are  Subject to the Straddle Rules.”  

Straddles Consisting of Bitcoin Futures or Options as Well as Other Positions  

Taxpayers who hold Bitcoin futures or options might also hold actual Bitcoins or other Bitcoin  derivatives. If the taxpayers’ positions meet the requirements of a straddle (offsetting positions  in actively traded personal property), their straddles are subject to the straddle rules. Straddles  that include both Section 1256 Contract positions and non-Section 1256 Contract positions are  

treated as mixed straddles, subject to various elections available to mixed straddles. For a  discussion of the straddle rules, see McDermott’s Memorandum, “When Virtual Currency  Positions Are Subject to the Straddle Rules.”

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Special Loss Carryback Rules  

Taxpayers who are not corporations, trusts, or estates can elect special loss carryback rules for  losses on Section 1256 Contract that qualify for 60/40 treatment. Eligible taxpayers can use their  section 1256 losses incurred in one year to reduce income generated on such contracts in prior  tax years. This carryback rule provides a form of income averaging not available to other  taxpayers. Taxpayers can carry net Section 1256 Contract losses back to each of the three  preceding years and apply the losses against net Section 1256 Contract gain recognized in those  prior years.15 

Losses that are carried back are treated as if 60% were long-term and 40% were short-term.16  Carry-back losses cannot be used to increase or produce a net operating loss for the prior taxable  year.17 Such losses are carried back to the earliest of the three preceding taxable years in which  there is a net Section 1256 Contract gain.18 Any portion of the loss not absorbed in the earliest  year can then be carried forward to the next taxable year and, if any loss remains, to the next  (most recent) taxable year.19 Any net Section 1256 Contract loss carried forward from the first  carry-back year is again recharacterized as 60% long-term and 40% short-term capital loss.20  The loss carryback election is quite complicated in its application, applying only after netting  Section 1256 Contracts losses with unrelated capital gains and losses.  

* * * * *  

Taxpayers should keep these special rules for Section 1256 Contracts in mind for their Bitcoin  futures and options and for other positions in other virtual currencies if and when QBEs begin  trading futures and options on additional virtual currencies.  

1 https://www.cmegroup.com/trading/bitcoin-futures.html  

2 I.R.C. § 1256(g)(1)(A).  

3 I.R.C. § 1256(g)(1)(B).  

4 I.R.C. § 1256(g)(3).  

5 I.R.C. § 1256(g)(5).  

6 I.R.C. § 1256(g)(6)(A).  

7 Options on exchange-traded funds that hold Bitcoin and that are formed as trusts or pass through entities but not  corporations might also qualify as nonequity options.  

8 Section 1256 treatment does not apply to qualified hedging transactions, identified section 1256(d) mixed straddles  (where mixed straddle election has been made), or mixed straddle accounts.  

9 I.R.C. § 1256(c)(3).  

10 I.R.C. § 1256(c)(1). 

11 On the other hand, a taxpayer can report a mark-to-market loss on a section 1256 contract that is never realized.  12 I.R.C. § 1256(a)(2).  

13 I.R.C. §§ 1256(a)(3), 1256(f)(2).  

14 I.R.C. §§ 1092(d)(5)(A), 1256(a)(4).  

15 I.R.C. § 1212(c).  

16 I.R.C. § 1212(c)(1). 

17 I.R.C. § 1212(c)(3). 

18 I.R.C. § 1212(c)(2). 

19 I.R.C. § 1212(c)(2). 

20 I.R.C. § 1212(c)(6)(A). 

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