Janus, the two-headed Roman deity for whom the month January is
named, could see the past and the future but not the present. The
US Internal Revenue Service (“IRS”) must have been
inspired by Janus when thinking about cryptocurrencies recently. On
one hand, the IRS looked back to 2022 and issued puzzling but
adverse guidance for individuals who were crushed in the
cryptocurrency meltdown.1Looking forward, the IRS
postponed broker reporting for cryptocurrency transactions until
after it issues final regulations on this topic.2 This
Legal Update will explore both of these developments.
I. CCA 202302011
CCA 202302011 provides a relatively simple fact pattern. An
individual investor purchases an on-exchange fungible digital token
for $1.00 in 2022. After the cryptocurrency meltdown, the token is
worth less than $.01 at year-end but is still traded on at least
one cryptocurrency exchange. The taxpayer did not undertake any
overt acts indicating that he abandoned the cryptocurrency. The
taxpayer claims a tax loss for the diminution in value on his 2022
tax return on the theory that the token is either worthless or that
he abandoned the token. There is no discussion as to whether the
taxpayer was “gated,” that is, there is no discussion as
to whether the exchange suspended redemptions so that the taxpayer
was unable to sell the token.3 It’s worth noting
that the “market price” is indicative of value only if
the token can be sold. If the exchange is gated, the “market
price” is pretty much illusory.
A. A Fool’s Errand
One has to wonder what prompted the IRS to issue the CCA in the
first place. As we’ll explore below, the IRS considered two
avenues that a taxpayer have could have considered in generating a
2022 tax loss from the extreme diminution in the value of the
cryptocurrency—worthlessness and abandonment. But deductions
for both of these events are suspended through the end of
2025.4 Accordingly, even if the taxpayer had been
successful in establishing either worthlessness or abandonment, he
would not have obtained any tax benefit. So why the IRS bothered
considering these issues is a mystery. In each case, the taxpayer
would be better off taxwise by sitting tight in 2022 and actually
selling the depreciated cryptocurrency in 2023.
B. Worthlessness
Code § 165(a)5 provides a deduction for losses
sustained during a year, provided that the loss is not compensated
by insurance or otherwise. Treasury Regulation § 1.165-1(d)(1)
states that the loss must be evidenced by closed and completed
transactions evidenced by “identifiable events” occurring
during the year. Courts have sustained the IRS’s position:
“The mere diminution in value of property does not create a
deductible loss.”6 The facts as posited by the IRS
in the CCA clearly fell within this limitation. The IRS stated that
the cryptocurrency was not worthless, although its value was
nominal and that it could be sold. Accordingly, the IRS held that
the taxpayer was not entitled to a loss deduction notwithstanding
the fall in value of 99% to a nominal amount.
The loss from a worthless security is treated as a loss from a
sale or exchange and, accordingly, would not be disallowed under
the rules applicable to miscellaneous itemized
deductions.7 The IRS has stated that cryptocurrencies
are commodities8and, accordingly, do not meet the
definition of a security for this purpose.9 Thus, there
did not appear to be a path for the taxpayer to avoid the
disallowance of the non-deductible worthlessness deduction, even if
one had been available.
C. Abandonment
After concluding that a worthlessness deduction was not
available, the IRS considered whether a taxpayer could generate an
abandonment loss with respect to the cryptocurrency. Abandonment
requires three elements: (1) the loss was incurred in a transaction
entered into for profit, (2) the loss arises from a sudden
termination of usefulness and (3) the property is permanently
discarded from use or the transaction is discontinued.10
Caselaw requires that the taxpayer show some overt express
manifestation of abandonment.11 On the facts given in
CCA 202302011, the taxpayer had no impediment to a sale of the
devalued cryptocurrency and took no steps to evidence an
abandonment. Accordingly, no non-deductible abandonment loss was
available.
D. Theft Loss
In our experience, US cryptocurrency traders and investors were
generally cognizant of the need for a closed and completed
transaction in order to claim a loss. There was a flurry of selling
of cryptocurrencies at the end of 2022 as taxpayers crystallized
their cryptocurrency losses. Those taxpayers who did not sell most
likely were prevented from doing so by the collapse of the various
exchanges. This fact, not even considered by the IRS, leads to the
question as to whether a gated investor could claim a 2022 theft
loss.
Deductible casualty losses include theft losses.12 A
theft loss from a transaction entered into for profit is not
subject to the limitations on casualty losses.13 Theft
losses generally are ordinary in character unless they relate to a
sale or exchange transaction.14 Furthermore, these
losses are not treated as miscellaneous itemized deductions, so any
deduction arising from such a series of events would not be
suspended.15 A theft loss is not available if there is a
reasonable possibility of recovery.16 A theft loss
arises from any criminal appropriation of another’s
property.17 A criminal conviction, however, is not
required to sustain a theft loss.18
Revenue Ruling 2009-9,19an investor in a managed
account discovered that the account manager was conducting a Ponzi
scheme. Under the Ponzi scheme, the account manager issued
fraudulent statements and used money from new investors to make
distributions to investors who had established managed accounts in
earlier periods. The fraud scheme constituted embezzlement, a
criminal activity. The fraud scheme was discovered in “year
8.” The investor did not receive any reimbursement or recovery
in year 8. Revenue Ruling 2009-9 concludes that the embezzlement
loss is an ordinary loss under Code § 165. The IRS issued a
Revenue Procedure to assist taxpayers in taking advantage of the
holding of Revenue Ruling 2009-9.20
To the extent that there is no claim for reimbursement of the
loss, theft losses are deductible in the year in which the taxpayer
discovers the loss.21 Revenue Ruling 2009-9 does not
address whether the holder of the managed account had a reasonable
claim for recovery of the loss. The Ruling sates that such issue is
a question of fact to be determined by examining all of the
surrounding facts and circumstances. In Vennes, Jr. v.
Comm’r,22 a taxpayer caught up in the Petters
scam (a national scale fraud involving the issuance of billions of
dollars of bogus receivables) sought to take advantage of Revenue
Ruling 2009-9 in 2008 to claim a theft loss for his purchase of
bogus receivables. At that time, a bankruptcy of the Petters firm
had just commenced and there were substantial assets in the
bankruptcy estate. These assets ultimately resulted in a recovery
of a portion of the amount that the taxpayer lost. The court
determined that, as of the end of 2008, there was a reasonable
prospect of some recovery due to the existence of assets in the
bankruptcy, the place the taxpayer held in a distribution of
assets, the prospect of recovery against perpetrators of the fraud
and the taxpayer’s involvement in the fraud.
At least one commentator looking at individuals caught up in the
FTX meltdown has concluded that the answer to whether
cryptocurrency investors can claim a 2022 theft deduction is an
unqualified “Nope.”23 Many of the exchanges
that suspended redemptions possessed some amount of assets making
at least a partial recovery likely. In addition, at least a portion
of the losses sustained by investors is attributable to market
revaluations of cryptocurrency and such losses would not qualify as
theft losses.24
II. IRS Announcement 2023-2
The Infrastructure Investment and Jobs Act (“Jobs
Act”) amended Code §§ 6045 and 6045A to require
brokers (broadly defined) to provide tax reporting with respect to
digital assets, including cryptocurrencies. The reporting would
include basis reporting and reporting of transfers between brokers.
The Jobs Act provides that these new reporting requirements apply
to transactions occurring in 2023.25The complexity of
the implementation of these rules effectively prevents market
participants from complying with the new reporting rules without
detailed guidance. In Announcement 2023-2, the IRS stated that the
new reporting rules would not apply until new final IRS
regulations implementing the digital asset reporting rules.
Thus, for everything that went wrong in the cryptocurrency
markets in 2022, the IRS shone a light of hope on the new reporting
rules for the future.
Footnotes
1. Chief Counsel Advice Memorandum 20230211 (Jan. 13,
2023).
2. IRS Announcement 2023-2 (December 2022).
3. FTX was the largest cryptocurrency exchange to suspend
redemptions and declare bankruptcy in 2022. It is also worth noting
that Genesis Global Capital, Babel Finance, Binance, and Celsius
suspended redemptions in November 2022. Genesis declared bankruptcy
in January 2023.
4. Code § 67(g).
5. All “Code §” references are to the
Internal Revenue Code of 1986, as amended.
6. Lakewood Assocs. V. Comm’r, 104 TC 450
459 (1997), cited with approval in CCA
202302022.
7. Code § 165(g).
8. IRS Notice 2014-21, 2014-16 IRB 938.
9. Code § 165(g)(2).
10. Treas. Reg. § 1.165-2(a).
11. See Citron v. Comm’r, 97 TC 200, 213
(1991).
12. Code § 165(h).
13. Code § 165(c).
14. Rev. Rul. 2009-9, 2009-14 IRB 14.
15. Code § 67(b)(3).
16. Treas. Reg. § 1.165-1(d)(3).
17. Treas. Reg. § 1.165-8(d).
18. Vietzke v. Comm’r, 37 TC 504 (1961),
acq. 1962-2 CB 6.
19. 2009-14 IRB 735 (This Ruling is generally known as
the “Madoff Ruling” as it was issued to provide guidance
to individuals who suffered losses by investing with Bernard
Madoff.)
20. Rev. Proc. 2009-20, 2009-14 IRB 749.
21. Code § 165(e).
22. TC Mem. 2021-93,
23. Sheppard, When Can Holders Recognize FTX
Losses?, Tax Notes Magazine (Dec. 5, 2022).
24. Vennes, supra.
25. Oddly, Section 80603(c) of the Jobs Act provides that
the new reporting applies to statements that must be filed after
December 31, 2023. Such statements would include transactions
occurring in 2023.
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