Tax Treatment of Initial Coin Offerings

Tax Treatment of Initial Coin Offerings

An Initial Coin Offering (ICO) is an event in which a new cryptocurrency project sells a portion of its cryptocurrency tokens to early enthusiasts in exchange for convertible virtual currency (e.g., bitcoin, ether) or government fiat. ICO “tokens” or “coins” are, in essence, digital coupons used by new cryptocurrency startups to raise funds for their operations, with most companies only accepting convertible virtual currencies in exchange for these tokens. Although some guidance regarding the tax treatment of convertible virtual currencies is available, no clear guidance has been provided regarding the tax treatment of tokens offered in an ICO.

Guidance on Tax Treatment of Convertible Virtual Currencies

The Internal Revenue Service (IRS) issued Notice 2014-21, Virtual Currency Guidance, in March 2014 to describe how existing general tax principles apply to transactions using convertible virtual currency. In general, the IRS considers the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services, a taxable event. The IRS explicitly stated that Notice 2014-21 only describes the tax treatment of convertible virtual currencies and “no inference should be drawn with respect to virtual currencies not described in this [N]otice.”

Related Article: ICOs 2018: The Current State of the Law, Regulation and Taxation

Notice 2014-21 defines convertible virtual currency as “virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency.” Examples of a convertible virtual currency include, but are not limited to, bitcoin and ether. The term virtual currency is defined as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value,” but “it does not have legal tender status in any jurisdiction.” Examples of a virtual currency include, but are not limited to, coins issued for an online game that allow users to purchase items within that game. As a general matter, convertible virtual currencies are treated as property and the general tax principles applicable to property transactions apply to transactions using convertible virtual currency.

Payment for Services Rendered

Those receiving convertible virtual currency as payment for goods and services will report the fair market value (FMV) of the convertible virtual currency, measured in U.S. dollars, as of the date the convertible virtual currency was received, as income on their federal and state income tax returns.  In turn, those issuing convertible virtual currency in exchange for goods or services must report the FMV of the convertible virtual currency on Form W-2 to an employee or 1099-MISC to an independent contractor.  Employee compensation in the form of convertible virtual currency is subject to Federal income tax withholding, Federal insurance contributions act tax, and Federal Unemployment Tax Act tax.  Compensation paid to an independent contractor in the form of convertible virtual currency is subject self-employment taxes.

Sale or Exchange of Convertible Virtual Currency

A taxpayer generally realizes capital gain or loss on the sale or exchange of convertible virtual currency that is a capital asset in the hands of the taxpayer.  Generally, property held for personal use is a capital asset.  Examples of capital assets include, but are not limited to, stocks, bonds, or other investment property.  A taxpayer generally realizes ordinary gain or loss on the sale or exchange of convertible virtual currency that is not a capital asset in the hands of the taxpayer.  Inventory and other property held mainly for sale to customers in trade or business are examples of property that is not a capital asset.

If a taxpayer sells or exchanges convertible virtual currency that is held as inventory for sale to customers in a trade or business, the taxpayer would report any gain or loss from the sale or exchange as ordinary gain or loss.  If a taxpayer sells or exchanges convertible virtual currency held for personal use as investment property, the taxpayer would report any gain or loss from the sale or exchange as capital gain or loss.

Tax Treatment of Tokens Issued in an ICO

There is an argument to be made that tokens issued in an ICO are not subject to the same tax treatment as convertible virtual currencies.  As stated above, Notice 2014-21 explicitly states the guidance applies to convertible virtual currencies such as Bitcoin, and no inference should be made regarding virtual currencies not described in the guidance.  Notice 2014-21 mirrored the Financial Crimes Enforcement Network’s (FinCEN) Guidance on the Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (FIN-2013-G001, March 18, 2013), which also explicitly limits its guidance to convertible virtual currency.

Companies that are issuing tokens in an ICO are likely still subject to reporting revenue received from these sales as taxable income.   As most of these companies are only accepting convertible virtual currencies in exchange for these tokens, companies will need to determine the FMV of the convertible virtual currency received and report this amount in U.S. dollars.  If they chose not to immediately convert the convertible virtual currency into U.S. dollars and converts them at a later time, any realized gain or loss would likely be reported as capital gain or loss.

With respect to purchasers of these ICO tokens, the guidance is less clear as to how they must report any potential gain or loss on the future sale or exchange of these tokens.  Depending on the type of company and what rights and utilities are given to these tokens, in most cases, these tokens have no value or utility outside of the issuing company’s platform.  These tokens do not have an equivalent value in U.S. dollars and cannot act as a substitute for real currency.   Therefore, the questions remains that if the tokens continue to have no value or utility outside of the issuing company’s platform, are taxpayers required to report any sale or exchange of these tokens between users of the platform?

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Jennifer Han
jhan@rroyselaw.com

Jennifer Han received her LL.M. in Taxation from the University of San Francisco School of Law in 2015. She received her J.D. from McGeorge School of Law in 2013. Her areas of focus within the tax practice include corporate transactions, business structure planning, deferred compensation, and federal and state tax compliance. Ms. Han also assists the estate planning team with domestic and international tax planning research.
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