Editor: Paul Bonner
The increasing adoption of cryptoassets as investments has been met with less than universal awareness of how to treat and properly report these new financial products from a federal income tax perspective. While tax practitioners are becoming familiar with activities such as buying and selling cryptoassets, as well as less common enterprises like mining and staking, the unique characteristics of this new asset class present a host of additional issues unique to digital asset transactions.
One investment vehicle for cryptoassets, a virtual currency grantor trust, currently represents a minority of the various types of investments making use of cryptoassets. As large institutions seek to expose their clients to cryptoassets, however, a greater number of similar offerings, as well as the possibility of crypto exchange-traded funds (ETFs), may eventually force more stakeholders and their associated advisers to become familiar with these products. This item begins by defining virtual currency grantor trusts and describing their similarities to ETFs for tax purposes. The discussion then focuses on how administrative expenses connected to virtual currency grantor trusts are taxed and how to make yearly basis computations to ensure taxpayers are in full compliance with the reporting requirements for these trusts.
Current virtual currency tax treatment
To date, the IRS defines “virtual currency” as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. This definition comes from Notice 2014-21, which along with separate guidance released five years later, Rev. Rul. 2019-24, comprises almost the entirety of the IRS’s guidance on the overall tax treatment of cryptoassets such as bitcoin. Despite the apparent similarities to “real currency,” the IRS established in Notice 2014-21 that for federal tax purposes, virtual currency is treated as property. Therefore, taxpayers and tax advisers must evaluate cryptoasset transactions under Sec. 1001, which generally governs the treatment of gains and losses on the sale or other disposition of property.
Since cryptoassets are treated as capital assets of similar character to stocks, bonds, and other investment property, cryptoasset transactions are often subject to preferential long-term capital gains rates. Recently, there has been a huge push by investment firms to introduce financial products that consist of a “basket” of cryptoasset holdings wherein the investor is removed from direct control of any underlying cryptoassets and hence does not need to be aware of or report transactions in any accompanying capital holdings. However, cryptoasset ETFs and investment trusts either have emerged or appear emergent as current and future vehicles that, while they may distance investors from direct control of these virtual assets, nonetheless still impose tax liabilities on these indirect owners.
Virtual currency grantor trusts and commodity ETFs
An ETF is a type of investment fund traded on a stock exchange, with the shares predominantly bought and sold from the owners of the fund rather than the original issuing managing company. Typically, ETFs hold multiple underlying assets, usually stocks, which are ultimately chosen by the management company that determines the “basket” of investments. Included within the broad category of ETFs are commodity funds, which are structured as trusts or partnerships that physically hold only a single type of commodity. ETFs are managed by a sponsor who enters contractual relationships with one or more authorized participants in the financial markets — typically broker-dealers who foster the sale of shares between buyers and sellers.
The primary benefit of commodity ETFs lies in the difficulty normal investors have in acquiring the underlying assets held by the ETF; for example, gold or silver in the case of metal commodities or bitcoin and ether in the case of cryptoassets. This task is handled and managed by the ETF sponsors, who act as administrators and custodians, acquiring the assets on the investors’ behalf. Because the SEC has yet to rule on whether cryptoassets constitute investment contracts and are therefore subject to SEC regulation and market registration, there are currently no ETFs of cryptoassets available for trade on any public exchanges within the United States. There are, however, a handful of ETF-like funds in existence operating as closed-end grantor trusts, which are regulated by the SEC. Specifically, shares of these trusts are registered pursuant to Section 12(g) of the Securities Exchange Act of 1934.
These trusts, all of which are currently offered through the New York City–based firm Grayscale Investments LLC, periodically sell a limited number of private shares to investors who must meet strict income, net-worth, and experience requirements and who, later on, may sell their shares through public markets themselves. Yet, because they are not securities, based on the nature of their underlying assets, these offerings have been organized as investment trusts pursuant to Regs. Sec. 301.7701-4(c), owing to the fact that they include only a single class of ownership interest, they represent an undivided beneficial interest in the underlying assets of the trust, and there is no power under the trust agreement to vary the investment of the certificate holders.
From a tax-reporting perspective, these trusts are nearly identical to exchange-traded commodity funds, such as SPDR Gold Shares (GLD) or iShares Gold Trust (IAU), lacking only the recognition as securities. The IRS has previously issued guidance on how taxpayers are to account for transactions involving shares of these commodity funds.
In the case of precious-metal ETF shares, each share is physically backed by the underlying metal, thus each share represents ownership of an underlying commodity. Grayscale’s virtual currency grantor trusts feature shares that are likewise backed by underlying cryptocurrencies held in trust by the sponsor and therefore constitute ownership on the part of the shareholder. This indirect ownership, in turn, attaches federal income tax reporting requirements to transactions involving the totality of currencies owned by the trust but apportioned at a pro rata share to individual shareholders. Taxpayers who own shares of these trusts may therefore be unaware of the realized gains and losses that are incurred when the sponsors sell portions of these holdings to pay for yearly trust expenses, and they may be even less aware of the ramifications of these sales as they relate to their overall basis.
Investment trust basis and yearly expenses
Determining the basis of an investor’s share in a virtual currency investment trust is necessary not only for the eventual disposition of a taxpayer’s position but is also required to account for yearly sponsor fees. These fees are a small percentage of the aggregate value of the trust’s assets, paid out by the trust and accrued monthly. The only assets these trusts have are the underlying cryptoassets themselves, so the only means of paying these sponsor fees is by selling small lots of the cryptoassets held in trust. Since these sales are relatively small (de minimis) and are not distributions to shareholders, neither the trust nor the brokers are required to report the gross proceeds of the sales to shareholders on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions, according to Regs. Sec. 1.671-5(c)(2)(iv)(B).
Under Notice 2014-21, the sales of virtual currency to pay the sponsor fees, however, must still be treated as sales of capital assets that result in capital gains or losses for the owners of the underlying cryptocurrencies. By way of comparison, when an investor in a physically backed metal ETF treated as a trust sells or redeems an interest in that ETF, the sale or redemption is treated as a sale of the investor’s proportionate share of the metal held by the physically backed metal ETF (IRS Program Manager Technical Advice 2008-01809 (5/2/08)). Because a virtual currency investment trust does not issue a Form 1099-B for these sales, taxpayers inadvertently could fail to report the yearly sales made to pay the sponsor fees, opening them up to the possibility of audit or adjustment for every year they did not account for them. Such an accuracy-related audit could easily be triggered when a taxpayer finally sells shares of the trust and accounts for a gain or loss on their personal taxes.
Just as the IRS issued a summons to Coinbase Inc. (see Coinbase Inc., No. 17-cv-01431-JSC (N.D. Cal. 11/28/17)), pursuant to Sec. 7602(a), in order to investigate virtual currency compliance through that exchange, it is entirely possible that Grayscale could one day be issued a similar summons, exposing information about private investors who participated in its initial offerings in the process. While current holders in these trusts who have not yet sold any shares may have had little to worry about in the past, beginning in 2021, even the purchase or acquisition of cryptoassets must be reported on an individual’s tax return. Once again, with the treatment of shares of virtual currency investment trusts translating to ownership of the underlying assets, investors in these trusts who fail to report their purchases may be deemed to have filed an inaccurate return.
Even though these trusts may not report Forms 1099-B to the IRS on the shareholders’ behalf, Grayscale does provide trust tax information to facilitate year-end reporting of investors’ taxable positions. Once again, these trusts follow very closely the precedent set by commodity ETFs in that they include a gross proceeds file, which transcribes per share expenses and purchases similar to reporting statements issued by metal-backed ETFs such as SPDR Gold Trust (see SPDR Gold Trust 2020 Grantor Trust Tax Reporting Statement).
The following example, based on one in Grayscale Bitcoin Trust’s 2020 tax information letter, demonstrates the burdensome nature of these yearly basis and expense computations.
Example: Investor A purchases 20,000 shares of a bitcoin (BTC) trust on Feb. 10, 2020, at a price of $9.62 per share for a total cost basis of $192,400. This is her only purchase into the trust for the year. At the beginning of 2021, she receives the year-end 2020 grantor trust tax information and accompanying gross proceeds file, which lists the daily BTC owned per share for the trust as well as the number and proceeds for BTC that were sold throughout the year to cover the trust expenses.
On the purchase date, as previously noted, Investor A acquired 20,000 shares, and the gross proceeds files list an ownership amount of 0.00096719 BTC per share; therefore, her pro rata share of BTC owned at the date of acquisition is 19.3438 BTC: 0.00096719 per share × 20,000 shares = 19.3438 BTC. This establishes the starting basis for Investor A and her accompanying pro rata BTC ownership allotment. Her starting basis on Feb. 10, 2020, is $192,400: 20,000 shares × $9.62 per share price = $192,400.
The next step is to calculate the pro rata amount of BTC sold by the trust and attributed to Investor A that was used to pay for sponsor fees and administrative and custodial expenses determined at the trust’s inception, noted on its individual fact sheet and payable to Grayscale, the sponsor. Because the trust has no other assets outside of the underlying cryptoassets, these fees must be paid through conversion of the currencies into fiat.
To begin this calculation, first look at the total amount of BTC per share paid out as listed on the gross proceeds file. In this example, the total amount for the year is 0.00001916 BTC. Because Investor A did not own her shares for the full year, to determine her amount of BTC per share paid out, she must subtract out of the total amount the BTC sold during the period of the year she did not own any shares of the fund. In her case, she subtracts out the January BTC paid out (0.00000164) plus the pro rata share of BTC paid out in February prior to the purchase date of Feb. 10, 2020 — 10 days out of 29 days for the month, multiplied by the aggregate February amounts sold, or (10 ÷ 29) × 0.00000152. This results in a BTC per share paid out for Investor A in 2020 of 0.00001699.
Multiplying the BTC per share amount by the 20,000 shares owned by Investor A yields a pro rata share of BTC paid out attributable to her of 0.33991724 BTC. This is her share of BTC sold to pay her yearly apportioned sponsor fees. This also represents her yearly investment management expenses, which, prior to the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, would have been deductible on her personal income tax return.
Once her share of BTC sold to cover the sponsor expenses is determined, Investor A’s proportional cost basis for these BTC can be determined based on the value of her initial investment. This is accomplished by taking the BTC she sold, dividing it by the total BTC she owned, and multiplying the result by her cost basis for the total initial purchase. This results in a cost basis for Investor A’s share of the BTC sold of $3,380.93: (BTC pro rata sold to cover yearly sponsor expenses [0.33991724] ÷ BTC pro rata ownership [19.3438]) × cost basis ($192,400) = $3,380.93.
With the amounts determined above, the year-end basis for Investor A can be calculated. This is accomplished by subtracting the cost basis for the pro rata share of sponsor expenses from the initial purchase cost. Her adjusted shareholder’s basis at Dec. 31, 2020, is $189,019.07: Cost basis on Feb. 10, 2020 ($192,400) less BTC pro rata sold to cover sponsor expenses ($3,380.93) = $189,019.07. Her adjusted BTC balance also can be calculated in the event she buys or eventually sells shares at a later date. The adjusted shareholder’s BTC owned at Dec. 31, 2020, is 19.00388276 BTC: BTCs purchased with initial investment (19.3438 BTC) less BTC pro rata sold to cover sponsor expenses (0.33991724 BTC) = 19.00388276 BTC.
At this point, it is important to note that, due to these monthly sponsor expenses, a taxpayer’s basis in these investment trusts will automatically decrease over time. Thus, even if a taxpayer has only a single initial purchase, and his or her investment neither appreciates nor depreciates in value, there will most likely be a gain when the taxpayer eventually sells the investment, which will be taxed at the taxpayer’s applicable capital gains rate. This may not be fully understood by investors in these trusts who have not accounted for yearly basis adjustments, leading them to believe that a sale will result in a loss, when it will result in a gain due to the basis adjustments. Therefore, it is crucial that tax advisers make clients aware of the yearly basis adjustments so they can carefully consider their sales against the totality of their financial position for a given year.
Now that Investor A’s year-end basis has been determined, the dollar value of her portion of the sponsor expenses and the gain or loss from her portion of the BTC sale to pay the expenses can be calculated. To calculate the dollar value of her portion of the sponsor expenses, again take a pro rata approach and pull from the gross proceeds file the total proceeds per share of BTC sold by the trust, which for 2020 was $0.21804604.
As with expenses that occurred outside the holding period of her purchase, gross proceeds amounts that occurred in January ($0.01419641) and a proportionate share of proceeds from sales that occurred in February ($0.00504730) must be excluded from the total proceeds per share of BTC. For Investor A, this yields a proceeds per share amount of $0.1988023: $0.21804604 (January through December 2020 gross sales per BTC) minus ($0.01419641 January sales + $0.00504730 February sales) = $0.1988023. Her pro rata BTC proceeds, multiplied by her total shares owned, gives Investor A’s total proceeds for the year for the proportionate share of BTC, which is $3,976.05: total proceeds of BTC sold on a pro rata amount = $0.1988023 per share × 20,000 shares = $3,976.05.
To put this amount into a tax perspective, this is the sales price of the underlying virtual currency assets the investor owned and disposed of for the year. Her cost basis for her portion of the BTC sold to pay the sponsor expenses, as calculated above, is $3,380.93. Thus, Investor A’s gain on the BTC sold to pay the trust’s expenses is $595.12: total proceeds of $3,976.05 less total cost $3,380.93 = $595.12.
So, for the investor, the proceeds from the trust’s sale of BTC to pay expenses resulted in a capital gain of $595.12. This amount is reported by the taxpayer at year end and is taxed as capital gains at the appropriate rate based on her filing status and total taxable income. It is important to note that, although the taxpayer did not actively participate in this sale, she still has a tax responsibility attached to its occurrence and must report it on her return. This example is pulled directly from the Grayscale Bitcoin Trust tax information letter and more fully articulated in that document. As the example shows, an investment in a virtual currency investment trust is much more involved than the typical investment in mutual funds, or even ETFs, and that even simply holding such assets results in a taxable event at year end.
Future developments: Toward a true ETF
While a true virtual currency ETF has yet to materialize on a U.S. exchange, in 2021 alone companies including Fidelity, WisdomTree, Cboe/VanEck, and SkyBridge Capital all filed preliminary registration statements with the SEC, which has denied or pushed back every application to date. Even so, a handful of Grayscale’s current investment trusts, which were initially sold through private offerings, have now entered regulated secondary markets, and thus the complexity of year-end tax reporting for these products may now be the responsibility of less-sophisticated owners. Grayscale has even expanded its product line and is now offering a DeFi (decentralized finance) fund, which according to its fact sheet holds a basket of nine underlying cryptocurrencies. Depending on how the assets are being stored, and the fees being charged, such a bundled fund may require multiple basis calculations to account for the differing coins, adding even more work to properly report annual transactions.
Even without Grayscale, several BTC ETFs are already trading in Canada on the Toronto Stock Exchange, opening up investors to the same calculations as Grayscale’s trusts and the increasingly thorough reporting requirements imposed by the IRS. As the mainstream adoption of cryptoassets continues in the United States, the likelihood of a true, domestic cryptoasset-backed ETF, or several, becoming approved by the SEC means the basis computation and expense analysis outlined in this item will become more common and will create a corresponding need for education, similar to the arrival of cryptoassets themselves.
Paul Bonner is the editor-in-chief of The Tax Adviser.