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When Capital Contributions of Cryptocurrency and Tokens Lead to Unexpected Taxation of Domestic Investments in Funds under Sections 721(b) and 351(e)

By Jess A. Bahs and Adam T. Ettinger, partners at FisherBroyles, LLP.

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Promoters forming hedge funds are frequently dealing with a relatively new issue involving  cryptocurrencies. Capital contributions to LLCs (and usually corporations) by investors in a fund are generally not taxable. When Capital Contributions of Cryptocurrency and Tokens Lead to Unexpected Taxation of Domestic Investments in Funds under Sections 721(b) and 351(e), but there is a significant exception: if assets from different  investors in the fund are effectively diversified when making capital contributions to the fund,  such capital contributions are taxable. It is not a problem for the fund to purchase a diversified  portfolio of assets; it is the contribution of certain types of assets by multiple owners that creates the issue. If you represent a startup domestic fund that will only accept fiat currency (U.S.  Dollars, Euros, etc.) as capital contributions, this issue will not exist. However, if owners will  contribute property, then the types of property need to be considered carefully in order to verify  that contributing owners will not face tax costs. 

The intent of the rule described in this article is to ensure that a taxpayer cannot liquidate  appreciated assets without paying tax on the resulting gain. If a person sells an appreciated asset  and buys another asset, that person must pay tax (absent finding an exemption to this general tax  rule). A common exception exists if the asset sale qualifies as a like-kind exchange under  Section 1031. However, Section 1031 exchanges now only apply to real property and not any  types of personal property. If one wants to sell their Apple stock so they can buy various other  stocks in order to diversify asset exposure, one would need to pay tax on the sale of the Apple  stock. The rules in Sections 721(b) and 351(e) of the Internal Revenue Code were intended to  prevent people from combining their investments in order to minimize exposure without needing  to pay tax. In the eyes of the IRS, if gain is locked in so there is no or little risk of loss, the IRS  wants their tax money— the IRS views this as if you sold the asset for cash and used the cash to  buy other assets. 

Section 721(a), which applies to LLCs and limited partnerships taxed as partnerships, provides  that no gain or loss is recognized to either the partnership or to any of its partners in the case of  property contributed to the partnership in exchange for a partnership interest. Section 721(b)  provides a big exception to this general rule: nonrecognition does not apply to gain realized upon  a transfer to a partnership that would be treated as an “investment company” within the meaning  of Section 351(e) (analyzed as if the partnership were a corporation).  

A transfer of property is treated as a transfer to an investment company if: 1. the transfer results in “diversification” among assets contributed to the company; and  2. the transferee is an “investment company” immediately after the transfer. 

Investment company status applies if more than 80% of the value of the company’s assets are  comprised of “marketable stocks or securities.” For purposes of analysis, the terms  “diversification,” “investment company,” and “marketable stocks or securities” are determined 

pursuant to the Internal Revenue Code and its interpreting regulations. For purposes of the  definition of “marketable stocks or securities,” commodities are generally not considered  “securities.” 

For tax purposes, most advisors believe bitcoin should be viewed as a commodity, rather than as a security. Assuming bitcoin and cryptocurrencies are treated as commodities, a partnership  which receives from owners only bitcoin and other cryptocurrencies would not be treated as an  “investment company.” Hence, a transfer of bitcoin or other crypto to a fund would not be  subject to the Section 721(b) rule that causes unwanted tax costs. 

Unlike a contribution that includes only cryptocurrencies that are not treated as securities,  investors in a domestic fund should be concerned if they are contributing blockchain-based  tokens that constitute securities, or blockchain-based tokens that are convertible into other  cryptocurrencies or securities. We note that a token that constitutes a derivative interest in  bitcoin or other property may be classified as being a stock or security for tax purposes, which  would then cause a partnership to be treated as an “investment company.” Other types of  property that are considered stocks and securities for tax purposes under Sections 721(b) and  351(e)(1)(B) are evidences of equity, indebtedness, options, forward or futures contracts,  notional principal contracts, derivatives, foreign currency, precious metals, REIT and RIC  interests, and any equity type interest that is readily convertible into, or exchangeable for, any  asset described above. Any conversion rights into any of the above described assets would pose  risks. Due to the convertibility feature, a token would likely be considered a derivative interest  that could be treated as a security for tax purposes. In these cases, the investor risks taxation of  the contribution if diversified. 

Even if cryptocurrencies or tokens constituting stocks or securities are involved, there remains the threshold question of whether diversification of the assets occurs. A transfer will be viewed  as resulting in diversification if two or more persons transfer nonidentical assets to a  partnership. However, the regulations for Section 351(e) provide an exception for transfers of  stocks and securities resulting in diversification of the transferors’ interests if each transferor  transfers a diversified portfolio of stocks and securities. The tests for determining whether this  exception can be satisfied are complicated and beyond the scope of this article. 

We hope this article will help you spot the issue when handling fund-formations involving  investors that contribute cryptocurrencies or blockchain-based tokens. We believe that this issue  will become increasingly common as more and more funds are being formed by limited partners  who contribute cryptocurrency and tokens to the fund. 

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Jess Bahs and Adam T. Ettinger are partners with the law firm FisherBroyles, LLP.  

Jess Bahs leads the tax practice group of FisherBroyles, LLP. As part of his tax and business  practice for clients, he also lectures accountants and attorneys on tax issues, and has taught law  school classes as an adjunct professor. 

Adam T. Ettinger leads the FinTech and Blockchain practice group of FisherBroyles, LLP as co chair. Mr. Ettinger represents leaders in blockchain technologies and digital currencies and has  done so since 2012, with clients that have included BitGo, Brave, Lightning Labs, MasterCard, and RealUSD (Tether, before its acquisition). 

You can learn more about their practices here and here. 

Legal Disclaimer: You should not consider any information in this article as legal advice for  you. Our article, and any answers and comments of ours to our article do not create an  attorney-client relationship, nor are they a solicitation to offer legal advice. If you ignore this  warning and convey confidential information in a private message or comment, there is no duty  to keep that information confidential or forego representation adverse to your interests. Seek the  advice of a licensed attorney in the appropriate jurisdiction before taking any action that may  affect your rights. If you believe you may have a claim against someone, engage and consult an  attorney immediately, otherwise there is a risk that the time allotted to bring your claim may  expire.

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