The collapse of FTX has left millions of investors with significant losses and a great deal of uncertainty about the future. Not only do they have to wait until after the bankruptcy court determines what, if anything, they can recover, but they’ll also have to wait for the final outcome of the Chapter 11 reorganization, which may not come in 2023.
For cryptocurrency investors and their accountants, the FTX collapse has created challenges for reporting crypto taxes for 2022 and beyond. These challenges and information gaps should serve as lessons in compliance and transparency for a young industry as it matures.
FTX Crypto Tax Issues
Given the size of the case, the IRS might issue guidance to help the affected obtain tax deductions for their losses. Absent any guidance, taxpayers must deal with a combination of unclear rules and incomplete information to decide how and when to report their crypto FTX losses.
The first question is whether taxpayers can even deduct these losses on their tax returns. It doesn’t appear as though taxpayers have a clear path forward for deducting these losses. This is due to the lack of IRS guidance on crypto losses, the tax code’s definition of worthless stock, crypto being considered property for tax purposes, and the changes of the 2017 Tax Cuts and Jobs Act to casualty loss deductions requirements.
The second question involves the value of the tax deductions. While affected taxpayers currently have no access to their crypto funds and might feel as if it was a complete loss, bankruptcy experts say it’s highly likely that investors will recover a portion of their assets. This is better than a complete loss, but it complicates the case to say the investments are worthless. Furthermore, due to the case’s complexities, it’s highly possible that investors and their accountants will have to keep the FTX chapter open until tax year 2024.
Obtaining the correct data and fitting it into the taxpayer’s remaining crypto tax picture also will present a challenge. It’s easy to identify the fair market value of all the FTX-held assets at the time of the collapse, but the tax deductible amount is not the market value, but the tax basis of the crypto. If the lost crypto had been traded multiple times on FTX, not only is each of those trades reportable for tax, but the basis of the lost crypto depends on those trades.
While FTX management is reportedly putting together a plan to provide all the trading data to its creditors, few details are known at this time. Affected FTX investors will not be the only impacted taxpayers; anyone who withdrew all assets from FTX but already had realized crypto gains and losses also will need their data to figure out other taxable transactions after withdrawing the assets.
Further, it’s unclear whether these assets are subject to any clawback by the bankruptcy court. If they are, the tax outcome will prove much different for these customers, further complicating crypto investors’ 2022 tax reporting.
Tax Reporting and Regulatory Lessons Learned
Investors face many tax challenges because the current tax law for digital asset trading doesn’t match the information to which we have access. The problem is that the IRS issued guidance requiring reporting and tracking at the transaction level. While all data on the blockchain can be seen by anyone, the moment in which you enter a centralized exchange, you rely on the exchange’s record-keeping system to maintain this data—exchanges that are often unregulated and not subject to any level of transparency or reporting.
A tax agency may struggle to enforce a set of tax rules based on data kept in an exchange as described by John Ray III, the newly appointed FTX CEO who oversaw the liquidation of Enron:
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”
International regulators have taken some early steps to regulate crypto. The OECD recently published its Crypto Asset Reporting Framework and Amendments to the Common Reporting Standard to provide a standardized framework to capture all transactions involving crypto assets and allow for the reporting of this data to authorities. At the same time, the European Union is working on approving its Markets in Crypto Assets regulation, which would regulate the crypto industry in Europe to protect consumers from shady exchanges.
To Mark Branson, president of Germany’s financial market regulator BaFin, it is clear that to “just let the industry grow as a playground for grownups” was the wrong approach. Steps such as the Crypto Asset Reporting Framework and Markets in Crypto Assets should have been taken years ago.
Likewise, in the US, legislative proposals at various stages seek to protect consumers and implement tax reporting. Sen. Elizabeth Warren (D-Mass.) has introduced legislation to crack down on bad actors hiding behind self-custody wallets or other crypto tools such as mixers. Having some of these regulations in place years ago may have closed the regulatory loopholes that created the opportunity for FTX to do the damage it did.
The Road Ahead
It could be years before we can close the page on the FTX saga and move on. But just like Enron became the poster child for internal controls following the Sarbanes-Oxley Act of 2002, FTX will become the poster child for crypto regulatory transparency and reporting. It might seem easy to label crypto as a high risk, scammy, get-rich-quick industry filled with degenerate gamblers and scammers taking advantage of unsuspecting investors, but we have to remember that most of the pain of 2022 has been caused by bad actors embezzling funds through centralized exchanges.
The scams were perpetrated through fraud and deception, not through the blockchain. Just like the internet was embraced by regulators and accountants and became integrated into our business practices to improve the flow of information, we should embrace blockchain technology by remembering the true ethos of crypto. We must think outside the box and use this immutable technology to improve the transparency at exchanges and information flow to taxpayers, tax authorities, and other stakeholders alike.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
David Canedo, CPA, specializes in taxation of digital assets. He is the head of tax and compliance strategy at Accointing by Glassnode, a subsidiary of Glassnode that provides tracking, consolidation, tax and compliance solutions for crypto investors.
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