Crypto Hedge Funds Face Tough Choices on Tax Day

Jon P. Brose is a partner and Brett R. Cotler is an associate in the blockchain and cryptocurrency practice at the law firm of Seward & Kissel.

The following article is an exclusive contribution to CoinDesk's Crypto and Taxes 2018 series.

Like so much else in cryptocurrency taxation, the rules for crypto funds - pooled investment vehicles that seek above-market returns from digital asset investments - are far from straightforward.

In some instances, a tax law concept may include (or not include) crypto assets as securities or commodities for tax purposes. In other instances, existing interpretation of U.S. tax law predates the advent of cryptocurrency (thus not considering unique characteristics of crypto as an asset class).

Such discrepancies may lead to non-intuitive outcomes for crypto funds. Here's a quick overview.

US investors

U.S. investors in crypto funds (other than tax-exempt investors) will typically invest in domestic partnerships or LLCs. Onshore funds could stand alone but could also be part of larger structures, incorporating one or more entities accommodating tax-exempt and non-U.S. investors (e.g., mini-master, master-feeder and side-by-side structures).

As partnerships, onshore crypto funds are generally not subject to tax, but rather their investors are taxed on the funds' profits. Each year, investors receive "K-1s" reporting their respective shares of the crypto fund's items of income, gain, loss, deduction and credit for the prior year, regardless of whether profits were distributed.

Investors may be limited when claiming certain deductions or losses, including passive activity losses, business losses, business and investment interest expenses, and miscellaneous itemized deductions, which are currently non-deductible (including for alternative minimum tax purposes).

In addition, crypto funds should restrict withdrawal rights or limit the number of investors to avoid classification as publicly-traded partnerships, which are taxable as corporations. Unlike partnerships, corporations are taxed on their income, and shareholders, on distributions.

Funds that do not limit withdrawal rights or number of investors rely on the "qualifying income" test to avoid publicly-traded partnership classification. It is unclear whether 90 percent of a crypto fund's income would be "qualifying income" to avoid publicly-traded partnership classification.

If crypto funds allow investors to contribute cryptocurrency (rather than fiat) when subscribing for fund interests, investors may be required to recognize gain (but not loss) on the contribution. If contributions in-kind can be made tax free, crypto funds must track the contributors' bases in the contributed cryptocurrency and allocate any pre-contribution gains or losses to such investors.

Investor or trader?

Different U.S. federal income tax rules apply to investors, traders and dealers. Generally, dealers make a market in an asset class by being willing to buy and sell assets at certain prices, profiting from bid-ask spreads. Most crypto funds will not be dealers.

Crypto funds will be traders if their trading activities are substantial, seeking to profit from short-term market swings (rather than "hodling" for long-term appreciation). In determining a fund's status as a trader, relevant factors include the total number of trades in a year, frequency of trading activity, and portfolio turnover.

Unlike traders, investors are not engaged in a trade or business. Crypto funds that are not traders in crypto will be investors.

Classifying crypto funds as traders or investors affects whether expenses (other than investment interest expenses) of the funds are deductible for U.S. federal income tax purposes.

Traders in commodities, which may include crypto for this purpose, can elect to mark-to-market their open commodities positions (other than those identified as held for investment) at the end of each year, recognizing gains or losses as ordinary income or losses. Funds with significant mismatches between long-term capital gains and short-term capital losses may want to make this election, since recognition of short-term capital losses may be limited.

In addition, crypto futures that are "1256 contracts" and remain open at year end must be marked-to-market. Any gains or losses will be treated as 60 percent long-term capital gains and 40 percent short-term capital gains.

This tax treatment carries through to the general partner as part of their carried interests. However, straddle rules might delay recognition of losses if crypto funds hold, for example, crypto long and crypto futures short.

Other investors

Non-U.S. persons and tax-exempt investors in crypto funds will typically invest in an offshore corporation formed in a no- or low-tax jurisdiction.

Offshore funds will either invest into a master fund (master-feeder), into an onshore fund (mini-master) or alongside an onshore fund (side-by-side). Unless an offshore fund's activities is limited to certain investments, the offshore fund (but not its investors) may be subject to U.S. federal income tax to the extent the offshore fund is engaged in a U.S. trade or business.

Generally, offshore funds will not be treated as engaged in a U.S. trade or business if the funds only buy and sell stocks, securities and certain commodities for their own account (and certain other requirements are met). These are known as the "securities trading safe harbor" and the "commodities trading safe harbor." For purposes of the securities trading safe harbor, securities generally means debt instruments.

For purposes of the commodities trading safe harbor, the commodities must be "of a kind" that is customarily dealt in on an organized (i.e. CFTC-regulated) exchange and the transaction is "of a kind" customarily consummated at such place. For this purpose, "commodities" generally means commodities in the ordinary financial sense. The CFTC, which generally regulates commodities markets, has stated that cryptocurrencies are commodities.

The commodities trading safe harbor may apply to crypto trading if the crypto is "of a kind" that is customarily dealt in on an organized commodities exchange. Currently, only bitcoin futures are traded on an organized exchange. While non-U.S. persons' bitcoin trading activity in the U.S. should fall within the commodities trading safe harbor, it is not entirely clear if trading other cryptocurrencies (e.g., ethereum, litecoin and altcoins) come within the commodities trading safe harbor.

For a more comprehensive look at U.S. federal tax issues affecting digital assets, see our white paper entitled "Hand Over Your Digital Wallet: Yes, Cryptocurrency Transactions are Taxable."

Tax form image via Shutterstock

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