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FTX Bankruptcy: Tax Implications of Vanishing Customer DepositsDecember 9, 2022
The massive FTX bankruptcy has rattled the crypto industry. While it may take some time for investors, investigators, and customers to learn what happened in the lead up to FTX’s demise, it seems already clear that many FTX customers will lose cryptocurrency and other digital assets (“Tokens”) they had deposited in FTX trading accounts. News reports suggest that those losses are the result of FTX’s related trading arm, Alameda Research, having borrowed FTX customer deposits using FTX’s proprietary token as collateral at an inflated valuation. Customers who lost assets may find at least some recompense through the tax law—but the tax treatment of those kinds of losses is far from clear. This client alert considers possible routes for FTX customers to receive tax benefits that might ease their pain. At least a little.
Investing or Trading?
While neither Congress nor the Treasury Department has issued comprehensive rules regarding the taxation of Tokens, the IRS has declared that Tokens will be treated as property for tax purposes (and, thus, not as currency or some other special asset class). So, the tax treatment of Token holders will depend on the typical tax analysis for buyers and sellers of property.
When it comes to Tokens, an important distinction when determining how losses are treated is whether the holder is an investor or a trader. That distinction is subject to a complex history of case law and regulatory guidance, but, at a high level, traders buy and sell Tokens more regularly and hold their investments for short periods to benefit from short-term swings in the market; investors buy and sell Tokens less frequently and hold their Tokens to produce long-term income.
As a general matter, an investor acquires Tokens for their own benefit and not to sell to customers in the ordinary course of business (i.e., as capital assets). Any losses on the sale or other disposition of Tokens held as capital assets would result in a capital loss to the investor, and that loss would be considered a long-term capital loss if the applicable asset had been held for more than one year. Capital losses generally can only be used to offset capital gains (with the exception of individual taxpayers, who can deduct up to $3,000 of capital losses against their ordinary income). As a result, if the missing FTX deposits are viewed merely as investment losses, those losses may have limited usefulness unless you’re an investor with significant capital gains or an individual with a small portfolio at FTX.
By contrast, a frequent buyer and seller of Tokens (someone who meets the definition of a “trader”) will generally be able to deduct the losses incurred by trading through FTX as ordinary losses. Ordinary losses will be far more useful to affected taxpayers, since they will be able to use those losses to offset either ordinary income or capital gains. Thus, Token holders will be incentivized to be classified as a trader in the loss context (though they may have sought to avoid it when those Tokens were generating gains).
Alternatively, FTX’s customers could view their missing Token deposits as having been stolen by FTX, its executives, or others involved with the company. Theft losses result in ordinary deductions if those losses are in connection with a transaction entered into for profit (even if not reaching the level of a trade or business) subject to some limitations.
For this purpose, a “theft” is not clearly defined under the existing tax law, but is “deemed to include . . . larceny embezzlement, and robbery.” Courts and the IRS, however, have broadened the term to cover any “criminal appropriation of another’s property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile.” This expansive definition still requires that the action resulting in the theft be criminal in nature in the jurisdiction in which it occurred. Whether this is ultimately the case in the FTX bankruptcy will likely depend on how the FTX customer deposits were lost. For example, it may be the case that FTX or others misappropriated Token deposits but that their acts entail only civil, not criminal, liability.
To summarize, the treatment of taxpayers who lost Tokens they deposited with FTX will depend in part on whether they acted as investors or traders. In addition, taxpayers hoping to claim a theft loss for their lost Tokens will likely need to wait until it is clear that their losses were the result of criminal behavior. Each Token holder with deposits lost by FTX will need to determine the tax consequences of their Token losses.
O’Melveny will monitor further developments in the FTX bankruptcy, including tax and other legal matters impacting FTX’s investors and customers. Please contact the attorneys listed on this Client Alert or your O’Melveny counsel for questions regarding the information discussed here.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Luc Moritz, an O’Melveny partner licensed to practice law in California, Billy Abbott, an O’Melveny counsel licensed to practice law in California and New York, William K. Pao, an O'Melveny partner licensed to practice law in California and Scott Sugino, an O’Melveny partner licensed to practice law in California and Illinois, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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