It's Official: The Tax Man is After your Crypto Coins

On Tuesday, February 5th, the Chairmen of the U. S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) testified before the U. S. Senate banking committee regarding regulation of cryptocurrency trading. Both agencies have recently brought major cases against, and issued cease-and-desist orders to multi-million dollar operations. The Chairmen agreed that cryptocurrency trading has outgrown the current state-based regulation. Referring to the recent pullback in the cryptocurrency markets, CFTC chairman J. Christopher Giancarlo said, “Now you are seeing it in the bitcoin prices as word is getting out that we will go after misconduct.” SEC Chairman Jay Clayton stated that extension of his agency’s regulation of cryptocurrencies requires Congressional action and that the SEC “may be back with our friends from Treasury and the Fed to ask for additional legislation.”


The SEC recently shutdown the $3 billion operations of BitConnect in Texas and North Carolina which promised regular payouts to coin-holders and was considered a Ponzi Scheme within the cryptocurrency world. The CFTC shut down another alleged scam called My Big Coin in January that had gathered $6 million from naïve investors. The Proof of Weak Hands Coin, referred to by its own creators as a Ponzi scheme, raised $800,000, but hackers grabbed the money before the original scammers could. The New York Times quotes Kevin Werbach of Wharton saying, “Cryptocurrencies are almost a perfect vehicle for scams. The combination of credulous buyers and low barriers for scammers were bound to lead to a high level of fraud.”


Major US banks have also been putting on the brakes. J. P. Morgan and Bank of America announced that they would no longer allow their credit card customers to purchase cryptocurrencies. Neither banks nor brokerage firms allow credit card purchases of securities like stocks and bonds. Buying securities on credit has been allowed, since securities regulation was written after the Crash of 1929 and during the Great Depression, with collateralized margin loans only.


Foreign governments are ahead of the U. S. government regulatory agencies in taking action to control the blossoming cryptocurrency markets. China has cracked down on bitcoin mining operations and has ordered the closure of cryptocurrency exchanges. Japan may need to revisit its favorable stance on cryptocurrency after a hack of the Coincheck exchange lost $530 million of the NEM coin (No one knows yet where it went.) India said recently that it would “take all measures to eliminate use of these crypto-assets in financing illegitimate activities or as part of the payment system.” South Korea’s customs service has found $594 million, so far, of illegal foreign remittances. South Korean law requires any overseas transactions greater than $3000 to include supporting documentation. One of the most attractive features of bitcoin and other cryptocurrencies is that transactions can be placed anonymously.


At the other end of the influence spectrum are the latently powerful individual actors affecting the market prices of cryptocurrency. South Korea is the third largest market for virtual money after the US and Japan. South Koreans initiate 20% of global cryptocurrency transactions even though they pay about 30% more on their exchanges. So it seemed an incredible stroke of stupidity or an act of temporary madness when on January 7th the programmer behind, without notice, removed South Korean exchanges from his price-quote algorithms. Collective market values of all cryptocurrencies subsequently lost $100 billion in market capitalization. Brandon Chez, the programmer at fault, said in an email that he “didn’t realize how big of an impact” his action would have. 


Motivations of others, made powerful of late by their cryptocurrency good fortune, are blatantly clear. In December a maker of peach and lemon iced tea changed its name to Long Blockchain from Long Island Iced Tea because it intends to “explore and invest in” blockchain technology. Long Blockchain stock immediately rose to $6.01 per share from $1.30 and added $35 million in market value. Bioptix, a Colorado maker of medical diagnostic machinery rose to $46 in December from $8 after it changed its name to RIOT Blockchain. Barry Honig, an insider who supported the name change, then sold 500,000 shares. The stock now trades at about $14. “When stock goes up, you take a profit,” Mr. Honig said. “Every good investor does it.”


Other individuals with significant cryptocurrency holdings followed that same advice. Steve Wozniak, co-founder of Apple, sold the bitcoin he bought for about $700 when the coin traded near $20,000 in December because, he said, “I don't want that kind of care in my life.” When litecoin (LTC) was trading for $345 in December its creator, Charlie Lee, sold his entire stake. “You can’t compare me to a CEO selling all his shares,” Mr. Lee said, “I’m the creator. Litecoin is like my kid.” His kid now trades at $150.


Mr. Honig, having sold his Riot Blockchain in December of 2017 and depending upon his purchase dates, may have to pay 39.6% of his gain to the Internal Revenue Service in April. The tax bills for Messrs. Wozniak and Lee may not be so straightforward a calculation. Perhaps no calculation will be necessary if their cryptocurrency purchases and dispositions were entirely anonymous. The IRS may not be aware of their disposed bitcoin and litecoin except for reports in mass media.


Other fabulously successful blockchain entrepreneurs have read the writing on the wall and are taking proactive steps to mitigate their future tax bills. A change of residence from California to Puerto Rico (Puertopia, Crypto Rico) could double a crypto-billionaire’s after-tax income. Residents of Puerto Rico pay neither federal personal income tax nor capital gains tax. Electricity after Hurricanes Maria and Irma has been inconsistent at best, but that’s a small price to pay for one who has the opportunity to live the life of a feudal lord. Puerto Rico for bitcoin billionaires may be what Cuba was for enterprising and well-connected casino operators before Castro.


For those who have prospered creating, marketing and trading cryptocurrencies and who wish to maintain residence in one of the fifty United States, regulation and taxation are on the legislative horizon. Blockchain businesses will have to “go legitimate” as did the mafia when they built their desert oasis in Las Vegas. They will need the support of sophisticated and informed investors, advisors and accountants. In order to protect their businesses from thievery, they will need more than steel vaults and armed security guards because robbers will not come through an unlocked back door but through the cable that connects them to the Internet.


Instead of hiring Goldman Sachs or Morgan Stanley for advice on an Initial Public Offering (IPO), they may need to hire a firm like Pantera to guide them through their Initial Coin Offering (ICO). Before putting an ICO on the market and instead of hiring Ernst and Young or KPMG for a premarket audit, a new distributed ledger technology firm may hire the Hosho Group to protect potential investment capital from hackers. Issues heretofore unknown in the securities industry confront potential investors and investments. Yo Sub Kwon of the Hosho group details one such potential problem; An investor lost $70,000 worth of the Ethereum virtual coin when his trade failed but was charged the transaction fee or “gas.” During the attempted transaction the unfortunate investor was informed, “Error encountered during contract execution [Bad instruction]”.


Fear of Missing Out (FOMO) drove cryptocurrencies up by thousands of percent while the Fear, Uncertainty, and Doubt (FUD) crowd stood by and criticized. Those who knew better watched from the sidelines as those who knew only one thing celebrated their newfound riches. Then a third team entered the arena to take advantage of the distraction—pocket-pickers, con men, and thieves. Where there is a party, there is trouble. New parties got started, with new people to listen to the same free-money story.  Everybody wanted to go where the free money flowed. The Bitcoin and cryptocurrency surge in price followed the model of all other markets. Similar patterns emerged: FOMO led the surge; FUD crushed the elation.


In the same way, a stock bubble accompanied the revolution of the late 1990’s, so too has a cryptocurrency bubble associated itself with the coming blockchain and distributed ledger societal and commercial transformation. In the same way Amazon and Google emerged dominant from the multitude of startups two decades ago, so too will legitimate blockchain businesses with long-term plans and loyal customers emerge from the current market mania.