Author: Mark Leeds and Brennan Young, Mayer Brown LLP
Published: January 23, 2020
This White Paper is presented for general information only. It may not be relied upon as legal or tax advice. The distinctions discussed in this White Paper are highly factual and are determined on a case-by-case basis. Interested persons should seek direct advice with respect to the matters covered herein to their own situations.
Investors in cryptocurrency take many forms and can have a variety of U.S. federal income tax classifications. The different classifications can lead to disparate tax treatments for similar transactions. One characteristic to consider for federal tax purposes is whether a taxpayer investing in cryptocurrency is treated as a dealer, trader, or investor for federal tax purposes.
The first distinction is between a dealer and a trader. The U.S. Tax Court has distilled the distinction.1 It has described dealers as sellers who purchase their stock in trade with the expectation of reselling at a profit, not because of a rise in value during the interval of time between purchase and resale, but merely because they have or hope to find a market of buyers who will purchase the assets at a price in excess of their cost. By comparison, it described traders as those sellers whose source of supply for assets is not significantly different from that of those to whom they sell, but who seek to earn a profit from an advantageous purchase price or fluctuations in value. In other words, a dealer makes a profit from a bid-ask spread and a trader depends upon changes in prices to earn a profit.
If a taxpayer is not considered to be acting as a dealer, the next issue is whether a taxpayer investing in cryptocurrency is considered to be engaged in a trade or business as a trader or is an investor for federal income tax purposes. This distinction generally boils down to the frequency, continuity, and regularity of the activities of the participant, which is analyzed on a case-by-case basis under the relevant facts and circumstances. In making this determination, the U.S. Tax Court has looked to the number of purchases and sales transacted by a taxpayer in a taxable year, the number days on which the taxpayer traded assets and whether the activities were conducted in a business-like manner.
There is no bright line rule as to how many trades needs to occur during a taxable year in order for activity to rise to the level of a trade or business in trading. In the stock context, the Tax Court has ruled that 86 purchases and 257 sales in a single taxable year was not sufficiently extensive to give rise to a trade or business.2 In addition to trading volume, cryptocurrency trading activity would need to be continuous in order for such activity to give rise to a trade or business. For example, the Tax Court has ruled that daily trading that occurs only during a single quarter of a taxable year did not result in a taxpayer being treated as a trader.3 Finally, even an active investor may not be treated as a trader for federal income tax purposes where the investor seeks to derive profit from long-term appreciation.4
U.S. Federal Tax Significance
The distinctions discussed above generally have tax implications in three areas: (1) whether expenses can be deducted with respect to a trade or business, (2) whether a mark-to-market election under Code § 475 is available, and (3) whether a non-U.S. entity is engaged in a U.S. trade or business and subject to tax in the United States on a net income basis on income effectively connected with that trade or business. Each is discussed below.
Deductibility of Expenses
If a taxpayer investing in cryptocurrency is characterized as an investor for federal income tax purposes, the taxpayer’s investment expenses are generally miscellaneous itemized deductions. For taxable years beginning after December 31, 2017 and before January 1, 2026, these items are not deductible.
In contrast, if taxpayer investing in cryptocurrency is better characterized as a trader or a dealer, the taxpayer’s expenses associated with its trade or business would generally be deductible.
Code § 475 permits dealers in commodities to elect to mark their securities to market on the last business day of every taxable year and to report unrealized gains and losses as ordinary income or loss. The IRS and the Commodity Futures Trading Commission have issued rules stating that virtual currencies can be treated as commodities.5 For an asset to be considered a commodity eligible for this election, it must be actively traded within the meaning of Code § 1092(d)(1). Whether a particular cryptocurrency is actively traded, and therefore potentially a commodity eligible for mark-to-market treatment, is another factual analysis.
Under Code § 475(f), a trader can elect mark-to-to-market treatment for its securities or commodities, with some exceptions. The advantage of using mark-to-market accounting is that net losses will be treated as ordinary losses that, subject to certain limitations, can be used to shelter other forms of income. The disadvantage of using mark-to-market accounting is that income will always be ordinary and regardless of the taxpayer’s holding period, gains will never be characterized as long-term capital gains.
U.S. Trade or Business
Assume a corporation that invests in cryptocurrency is organized in the Cayman Islands, is treated as a corporation for U.S. federal income tax purposes, but is externally managed from the United States. The activities of the manager could be attributed to the Cayman corporation. The question is whether this activity gives rise to a trade or business in the United States, such that income effectively connected with that trade or business is subject to U.S. federal income taxation on a net basis.
If the Cayman corporation is treated as a dealer for federal tax purposes, the corporation is likely to be treated as engaged in a U.S. trade or business.
If the Cayman corporation is treated as an investor, its gains from cryptocurrency trading should not be subject to net U.S. federal income tax. If the Cayman corporation is treated as a trader for federal tax purposes, if the cryptocurrency is properly treated as a commodity, an exception to the corporation being treated as engaged in a trade or business may be available. Under Code § 864(b)(2), a taxpayer that is trading in securities or commodities for its own account is not treated as engaged in a trade or business in the United States. As discussed above, a cryptocurrency may be a commodity for this purpose (and under current law, is unlikely to be treated as a security). The trading safe harbor for commodities is generally available if (a) the commodities are of a kind customarily dealt in on an “organized commodity exchange,” and (b) the transaction at issue is of a kind customarily consummated at such place.
If the above exception does not apply and the Cayman corporation is a trader, it may be treated as engaged in a U.S. trade or business and be subject to U.S. federal income tax on a net basis on income effectively connect with that trade or business.
1 See Kemon v. Commissioner, 16 T.C. 1026 (1951).
2 See Neuman de Vegvar v. Commissioner, 28 T.C. 1055 (1957).
3 See Chen v. Commissioner, T.C. Memo 2004-132 (2004).
4 See Yaeger v. Commissioner, 889 F.2d 29 (1989), holding that over 1,000 purchase and sale transactions in a taxable year did not cause a taxpayer’s trading activities pursued “vigorously and extensively” to rise to the level of a trade or business of being a trader, because most of the taxpayer’s sold securities were held for more than a year and none were held for less than three months.
5 See https://www.govinfo.gov/content/pkg/FR-2017-12-20/pdf/2017-27421.pdf.