Cryptoasset clarity needed for private fund managers

By Cynthia M. Pedersen, J.D., LL.M., Baltimore

Editor: Anthony Bakale, CPA

This item outlines the risks private fund managers should consider when investing their portfolio in cryptoassets.

Current IRS guidance lacks direction for investing through a private fund

The IRS's guidance on cryptoasset income tax reporting standards has been mainly directed toward individual transactions and bitcoin-specific activities. Based on current guidance, the IRS treats cryptoassets as property, and the general tax principles for property transactions apply. However, the IRS has not clarified the type of property cryptoassets may be considered, which limits the application of specific Code sections that private fund managers generally rely upon.

As cryptoassets evolve, resulting in more complex transactions, the lack of guidance for private fund managers has left a void that tax planning professionals attempt to mitigate through taking reasonable positions based on the legislative intent. Additionally, although the IRS is not controlled by other federal agencies' findings in determining the specific treatment of cryptoassets, it may be helpful for private fund managers to review determinations made by the SEC and Commodity Futures Trading Commission (CFTC).

Traditional private fund issues that require clarity

1. Are cryptoasset trading funds considered investment companies under Sec. 721(b)?: Pursuant to Sec. 721(b), a partnership is treated as an investment company (as defined in Sec. 351(e)) if over 80% of the value of its assets (excluding cash and nonconvertible debt) is held for investment and consists of "readily marketable stocks or securities." "Readily marketable stocks or securities" is narrowly defined to include a number of assets (but not the general term "property") that are traded on a securities exchange or traded or quoted regularly in the over-the-counter market. Without further guidance from the IRS, there may be an argument that cryptoassets are not considered "readily marketable stocks and securities." However, taking this position creates risk of underpayment of tax for certain investors. For example, if the investment company rules do apply, private fund managers need to be aware of the application of the Sec. 721(b) diversification rule and Sec. 707(a)(2)(B) disguised-sale rules when determining whether to receive or to distribute cryptoassets in-kind.

2. Are cryptoasset trading funds eligible for the Sec. 864 exclusion from U.S. trade or business treatment?: Traditional private funds that regularly trade securities, or commodities that are of a kind customarily traded on an organized commodity exchange, generally rely on Sec. 864(b)(2) to prevent their fund's activities from being treated as engaged in a U.S. trade or business. This allows the capital gain that is allocable to non-U.S. investors to escape withholding, which would reduce the non-U.S. investors' returns on their investment in the fund. If this "trading safe harbor" did not apply and such private funds trading activity is conducted within the United States, then the capital gains that flow through to a non-U.S. investor would be subject to withholding taxes as effectively connected income (ECI).

Because the IRS has not elaborated on the "property" tax classification, it is unclear if the trading safe harbor applies to cryptoassets. Furthermore, cryptoasset trading may occur across both centralized and decentralized (unregulated "DEX" or decentralized exchange) platforms. Therefore, if cryptoassets are considered commodities, the trading safe harbor still may not apply due to the limitation to only commodities that are of a kind customarily traded on an organized commodity exchange.

In 2017, the CFTC stated in a Customer Advisory that bitcoin is a commodity. Additionally, both the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) Futures Exchange (CFE), which are CFTC-regulated exchanges, allow for trading bitcoin and ether futures products. Based on the futures markets, there may be an argument that cryptoasset private funds that trade in bitcoin or ether are reasonably within the trading safe harbor.

3. Are cryptoasset trading funds eligible for the mark-to-market election under Sec. 475(f)?: Sec. 475(f) allows an election for traders in securities or commodities to recognize gain or loss at the close of each tax year as if the securities or commodities were sold on the last business day for their full fair market value. This election allows private fund managers who trade assets held for less than 12 months in large volumes to recognize ordinary income and loss. Ordinary treatment relieves private fund managers from the capital loss limitations that may have been a burden to their investors.

If a private fund manager makes the election under Sec. 475(f) and it is later determined that cryptoassets are not considered either a commodity or security for this purpose, the general risk is whether ordinary losses recognized under the mark-to-market rules may be challenged and recharacterized to short-term capital losses.

4. Do the wash-sale rules under Sec. 1091 apply to cryptoassets?: Sec. 1091 disallows a deduction under Sec. 165 for a loss sustained from any sale or other disposition of shares of stock or securities where it appears that, within a period beginning 30 days before the date of such sale or disposition and ending 30 days after such date, the taxpayer has acquired substantially identical stock or securities ("wash-sale rule"). The wash-sale rule is intended to prevent loss harvesting where the taxpayer's economic position does not change.

Applying the wash-sale rules to all cryptoasset transactions may be outside of the original intent of Sec. 1091. To see why, consider that many DEX platforms require an exchange to the native token to access the platform (e.g., Uniswap, 1inch Exchange). The native token generally also has a trading market. If the private fund manager is actively trading in and out of a DEX that requires this type of exchange, any loss from these routine transfers would theoretically be disallowed if wash-sale rules are in force.

If cryptoassets are not considered securities, then the wash-sale rules should not apply to this situation or disallow loss harvesting. But the Biden administration's proposed Build Back Better Act would have expanded the application of wash-sale rules to explicitly cover cryptoassets (as defined within the act) and commodities as well as securities. As of this writing, it does not appear that the Build Back Better Act or this specific provision is going to be passed into law.

5. Are "proof of stake" validating rewards considered U.S. trade or business income?: The current leading consensus mechanism for blockchain networks is "proof of stake" (PoS). PoS validators (somewhat comparable to bitcoin miners) "stake" their tokens to earn rewards as a "block producer" on the network. The rewards are earned for supporting the network and arguably for providing a service to the network. The IRS has not currently released any specific guidance around staking activities. This has left many private fund managers with uncertainty about whether PoS validating rewards are considered U.S. trade or business income and are subject to withholding on allocations to non-U.S. investors.

While the mining of bitcoin (which uses the "proof of work" (PoW) consensus mechanism) may rise to the level of a trade or business activity pursuant to Notice 2014-21 and the IRS FAQs released in 2019, PoS is inherently different from PoW. For example, PoS validators "lock" a portion of tokens to earn the right to be a block producer, while miners must solve an algorithmic problem to earn the right as a block producer. Nevertheless, the purpose and the end result of a token reward are the same. Both PoW miners and PoS validators keep the blockchains operational. Therefore, if a private fund manager is acting as a PoS validator, the rewards earned may be considered U.S. trade or business income (ECI) and subject to withholding on allocations to non-U.S. investors. This treatment depends on the sourcing of such rewards. If the private fund manager is located within the United States, or delegates the activity to an agent located within the United States, there is an argument that such rewards may be considered ECI.

Congress and federal agencies are slowly issuing guidance

Congress passed and President Joe Biden signed into law the Infrastructure Investment and Jobs Act, P.L. 117-58 (the Infrastructure Act), which for the first time codified a definition of cryptoassets for information reporting required by brokers. Although this is not an income tax code section, the broad definition of "digital assets" (" 'digital asset' means any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary" (Infrastructure Act, §80603(b)(1)(D)) may be suggestive of future tax guidance. Additionally, Sens. Cynthia Lummis, R-Wyo., and Kirsten E. Gillibrand, D-N.Y., released their draft legislation, S. 4356, the Responsible Financial Innovation Act (RFIA), on June 7, containing expansive tax positions addressing some of the items outlined above.

Many issues besides those addressed above remain unclear for private fund managers. Tax advisers should focus on developing reasonable reporting positions consistently applied in good faith while the industry awaits definitive guidance.


Anthony Bakale, CPA, is a tax partner with Cohen & Company Ltd. in Cleveland.

For additional information about these items, contact Mr. Bakale at

Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

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