Chapter 13

Taxation & Regulation

If you are anything like me, your brain shuts off when you read the word regulation. Taxation? Snooze fest. No one wants to read about how your money is viewed, taxed, or watched. Yet understanding how the historical powers of the world view your investment is valuable. Their story is just as much tangled up with blockchain and cryptocurrency as anyone else.

Assets are typically tangible, companies are physically auditable, and the systems in place are accountable to some known entity. Enter the gray area that is digitized assets and contracts built in a decentralized manner hosted on blockchains.

Many first-time investors get caught up in the excitement of investing. Tax sometimes becomes an afterthought.

“I feel like I might have accidentally ruined my life because I didn’t know about the taxes.” Meet Reddit user thoway, a Californian office assistant who was making a modest $47,000 a year. A group of friends recommend he invest in Bitcoin in early 2017, so thoway purchased eight Bitcoin for the price of $7,200 per Bitcoin. In the next couple of months, the price of Bitcoin skyrocketed to $15,000 per Bitcoin and thoway sold all of his position, netting $120,000 for the sale!

This was amazing. A 108 percent return on investment is breathtaking. Unfortunately, thoway immediately reinvested this USD into other cryptocurrencies. What thoway realized in hindsight was that he owed income tax worth $50,000 on the initial profitable sale of his Bitcoin for $120,000. During the time thoway took to realize he owed income taxes, the value of his reinvested position into other cryptocurrencies dropped to $30,000. He no longer had the capital to pay off the income taxes due for the initial successful sale of Bitcoin.

Stories such as thoway’s are saddening, but the simple truth must never be forgotten. The IRS or whatever country you exist within expects to be paid a portion of your investment, which is only fair. You benefit from society; thus, you should contribute to society as a taxpaying compliant citizen.

The Powers at Play

We shall start with the main players: Who cares about you as an investor?

•Securities and Exchange Commission (SEC)

•Commodities and Futures Trading Commission (CFTC)

•Federal Trade Commission (FTC)

•Department of the Treasury

•Internal Revenue Service (IRS)

•Financial Crimes Enforcement Network (FinCen)

Not surprisingly, where money moves and how it moves is a huge concern for sovereign nations. These departments are all focused on collecting the fair share of money for the state, enforcing regulation such that investors are protected, and ensuring the trust and validity of markets in the eyes of the public as well as other nations remains stable. The major step in recent history is the classification of some crypto assets as securities. When an asset or contract is considered a security, the ramifications involve the mandatory compliance of the respective sovereign state. For our purposes, we will be examining the United States.

What is a security? While the official US legal definition is 145 words, with multiple pages defining each significant word, we will choose to use a simplified and still applicable definition:

“A security is an investment contract where an investment of money is made in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”

To understand the precedent for how the SEC defines securities, we must travel all the way back to a Floridian citrus farm in 1946, run by The Howey Company. This farming company decided to lease half of the land under its ownership to several businessmen “attracted by the expectation of substantial profits.” The enterprise consisted of the businessmen providing investment money while The Howey Company provided the farming and the land. The businessmen provided the “capital,” and The Howey Company provided the “work and management of the land.” The businessmen had an expectation of “return” from The Howey Company under a lease contract. Seems fair enough, right?

It was fair, but fraught with risk.

The Howey Company litigation became known officially as the SEC v. W. J. Howey Co., 328 U.S. 293 case. The court ruled The Howey Company was a security because of the design of the investment contract. This is where the courts created what would eventually be known as the infamous “Howey Test.” The test of whether a transaction, asset, or ambiguous stand-in is an “investment contract” (a security) under the Securities Act is whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others. Anything that holds the label of “security” has an entire set of rules and regulations that must be followed in order to protect investors. It is expensive and is why being identified as a security is such a big deal.

If the “investment contract” test is satisfied, the next step of the Howey Test is concerned with if the contract is immaterial or material, speculative or nonspeculative, and whether a sale of property with or without intrinsic value goes on. That is to say, if a contract involves an investment in which you do nothing, with the expectation set in advance that a certain return will be given to you based purely on capital, then you have entered into the territory of said contract being classified as a security.

This is where things get tricky. Currency is not a security. Currency is a medium of exchange, not a generator of return based on management by a third party. This sentiment was backed up by the SEC Chairman in 2018, who confirmed in a CNBC exclusive interview that cryptocurrencies such as Bitcoin are not securities. This is because cryptocurrencies have the properties of a currency and do not contractually promise a certain return, in contrast to a traditionally defined security. In addition, while the “speculative” portion of the Howey Test is satisfied, because blockchain is decentralized, no managerial efforts of a single party can be pointed to by the SEC or any regulatory body. This is unprecedented. It’s a deep space wormhole that pulls investor money in, without the possibility of reaching the center of it all, because there is no centrality. No single party.

Caution is still due. No official statement concerning Bitcoin as a security has been released by the SEC (an interview does not count as an official statement). This by and large remains one of the greatest risks many cryptocurrencies face—regulations and the impact of the law on investors who own Bitcoin could be heavy.

SEC Clamps Down

Has the SEC given up its ability to go after cryptocurrencies? Absolutely not.

Enigma began in 2015 at the MIT Media Lab. It started off as a humble white paper focused on creating the privacy layer for the decentralized web. Enigma raised $45 million during its ICO in return for “ENG,” the cryptocurrency of the Enigma blockchain. As one of the oldest projects, it was one of the first blockchain protocols to lead the charge. The team touted a long-term vision, regular development updates, and a soon-to-be-live testnet. Enigma MPC was based in San Francisco and Israel, with team members from all over the globe.

On February 19, 2020, the SEC announced it settled charges against blockchain technology startup “Enigma MPC” for conducting an unregistered offering of securities. Enigma agreed to return funds to harmed investors via a claims process, register ENG digital tokens as securities, and file periodic reports with the SEC. Finally, Enigma MPC paid a hefty charge of $500,000. Remember when risks were discussed earlier? This is a perfect manifestation of a risk that was qualitatively predictable.

While the SEC didn’t outline the exact reasons for why ENG was classified as a security while Bitcoin was not, it boils down to a very basic concept. When investors purchased the digital asset ENG, they had an expectation that the management of the protocol by Enigma MPC would yield a certain amount of return. Because the protocol was not decentralized in its ownership and design, the agency of the protocol was firmly attached to Enigma MPC the company. Combine that with speculation and an immaterial contract, and suddenly you’ve passed the Howey Test. This is not so for other blockchain protocols that are decentralized by design with decentralized control of the protocol such that no single party has the burden of needing to provide a certain return.

Hope for a blockchain protocol such as Enigma exists, but litigation is a huge setback. Enigma is now establishing a new truly decentralized network not controlled by Enigma MPC. The token on the network is called SCRT (Secret Token) and will not be classified as a security by the SEC because the network is properly decentralized and therefore falls into the same unclassified/decentralized category as Bitcoin. Enigma may see a future in which its protocol is widely developed, extended, and used by hundreds of different use cases. For now, the future remains shrouded in risk.

What are the ramifications of this type of event? Investors lose trust, developers move to sustainable platforms, and price drops off a cliff. In Enigma’s case, ENG lost 80 percent of its value in just under 30 days after the SEC announcement, a humble reminder of the volatility and unknowns of the Wild West that is cryptocurrency. This is the power of the SEC on display—not all projects will have the liquidity and capital to survive a long-standing litigation with the SEC.

Figure 27: Enigma SEC Price Drop

Enigma was not the first ICO-turned-SEC litigation, nor will it be the last. While protection of the consumer is cited on many occasions, the truth is that a lot is at stake. Anything that would threaten the hegemony of the United States and the power of the dollar as the de facto global currency is immediately under intense suspicion. Congressmen have on multiple occasions called for a complete ban on cryptocurrencies under this very basis. Donald Trump has openly stated on Twitter, “I am not a fan of Bitcoin and other Cryptocurrencies, which are not money, and whose value is highly volatile and based on thin air.” He has also stated there is only one real currency in the United States, the United States Dollar. This is ironic considering a survey by HSB revealed 36 percent of small to medium businesses in the US accept Bitcoin. Major companies that accept Bitcoin are AT&T, Expedia, Microsoft, and everyone’s favorite data silo, Wikipedia. Clearly bankers are concerned, and you can’t blame them. Decentralized technology is the exact antithesis of those who believe in the central control of technology and monetary policy.

“An awful lot of our international power comes from the fact that the US dollar is the standard unit of international finance and transactions. Clearing through the New York Fed is critical for major oil and other transactions. It is the announced purpose of the supporters of cryptocurrency to take that power away from us, to put us in a position where the most significant sanctions we have against Iran, for example, would become irrelevant.”

—Congressman Brad Sherman

Fear not, one representative’s negative view of cryptocurrency is not universally accepted. Utah has put favorable regulations in place to help encourage blockchain innovation within their own borders. The “Blockchain Technology Act” (Bill 0213) excludes blockchain businesses from money transmitter compliance standards—a problem that is stifling innovation in other states. Other states have also begun toying around with state legislation outlining rules specifically for cryptocurrency and blockchain technology. Andrew Yang, a 2020 presidential candidate, is known for wanting to bring clarity in the regulatory space from a federal standpoint.

“Right now we’re stuck with this hodgepodge of state-by-state treatments and it’s bad for everybody: it’s bad for innovators who want to invest in this space. So that would be my priority is clear and transparent rules so that everyone knows where they can head in the future and that we can maintain competitiveness.”

—Andrew Yang

Classification

The Crypto-Currency Act of 2020 proposed by Arizona Congressman Paul Gosar aims to classify crypto assets. This regulatory clarity is one of the first comprehensive pieces to be written up in the United States and will more than likely be a guiding piece of legislation for future proposals. Important regulatory oversights were the classification of cryptocurrency into three different categories. This is where language is beginning to evolve in the regulatory space. While this book took a broad swing at pinning down legislative intent as it pertains to semantics, language will continue to evolve as regulatory frameworks are established to classify and regulate the various crypto asset classifications.

•Crypto-commodities—regulated solely by The Commodity Futures Trading Commission

•Crypto-currencies—regulated by FinCen and the Treasury

•Crypto-securities—regulated solely by the SEC (discussed earlier in this chapter)

Crypto-commodities (as defined by this bill) are economic goods or services that have full or substantial fungibility, rest on a blockchain or decentralized cryptographic ledger, and are treated by the market with no regard to who produced the good or service. In what way is a commodity different from a currency? A commodity is an object with use value and can be exchanged. A commodity also can experience a deviation in price based on market expectation of future supply and demand. Grain, precious metals, electricity, oil, and beef are all classical examples of commodities.

Take electricity as an example: electricity is used for commercial, residential, industrial, and transportation purposes. Electricity’s value fluctuates based on how much electricity is demanded and supplied on any given day. After a hurricane, many different oil and gas refineries (located along the Gulf Coast between Houston and Louisiana as an example) are negatively impacted. When operations shut down for repairs post storm, less supply is available, increasing the price of electricity. Generally, we don’t care where the electricity comes from, as long as our phone is able to be charged, the lights turn on, and the computer boots up. Because electricity can be traded, exchanged, speculated on, and used, we are able to confidently define it as a commodity and regulate it as such.

But wait a moment, isn’t Bitcoin a cryptocurrency? Isn’t that the assumption we have run under?

Doesn’t Bitcoin sound a lot like a crypto-commodity? First, let’s return to the bill’s definition of a crypto-currency.

A crypto-currency in this proposed bill is defined as:

“Representations of United States currency or synthetic derivatives resting on a blockchain or decentralized cryptographic ledger. Such representations are reserve-backed digital assets that are fully collateralized in a correspondent banking account such as stablecoins. Synthetic derivatives are determined by decentralized oracles or smart contracts and are collateralized by crypto-commodities, crpyto-currencies, or crypto-securities.”

Facebook’s Libra was shoved into national attention in 2019 and is an example of a crypto-currency by this legislation’s definition. Libra was a “stablecoin” designed to be a one-to-one equivalent with the US dollar, backed by Facebook’s bank account. This is what makes a stablecoin; a digital asset that is guaranteed to be a one to one equivalent with another currency.

Why did Facebook want to create this currency? According to Mark Zuckerberg, Libra would make sending money “as simple as sending photos.” You would quite literally be able to “text” currency in terms of functionality. In addition, over 1.7 billion adults without bank accounts (but with access to Facebook) would be able to use Libra as a means of exchange. The Libra Association is a consortium of companies aiming to launch a cryptocurrency shared on multiple different platforms. While Facebook is technically not the direct owner of the to-be Libra blockchain, Facebook has a significant amount of clout in decision-making.

In the end, legislators attacked Libra as an attempt to usurp US dollar dominance. Seven of the original twenty-eight founding members dropped out before the Libra Association’s inaugural meeting in Geneva on October 14, 2019. These members that dropped out included PayPal, eBay, Stripe, Visa, and MasterCard. Essentially, the industry giants got cold feet. You can’t blame them, either—no centralized group of entities wants to go toe-to-toe with the full force of the US regulatory system. It is not to be messed with.

Cryptocurrency is the universally accepted term (as of now) for a digital token that holds and represents value—hosted on the blockchain and exchangeable between mutually distrustful parties. While this piece of literature used this as the working definition, regulators are heading in a direction where, for all intents and purposes, the cryptocurrencies that you can invest in and see a return on are considered to be either a crypto-commodity (Bitcoin) or a crypto-security by the regulatory space.

Now that we have a better understanding of the classification of cryptocurrency, how does regulation manifest itself with your dollars? It comes forth in the form of a power as old and strong as death itself.

“In this world nothing can be said to be certain, except death and taxes.”

—Benjamin Franklin

Taxation

Taxes. Love them or hate them, the civilization you exist within depends on the fair contribution of citizens paying back into the sovereign nation in order to maintain the public good—to create a stable society enabled by the unspoken agreement we all play by. This is made possible by your labor in tandem with the collective whole of society. You are legally obliged to follow the law to the best of your ability. The walk-through I have given and will proceed with should always be triple checked. This is not financial advice; all financial decision-making is your own. Taxation and the law are ever changing. Always be weary of what you read from the past and always fact-check with the most current reality.

Disclaimer: This section is informational and should not be construed as a placeholder for tax or investment advice. Please speak to your own CPA, tax attorney, or tax expert on how you should treat taxation of digital currencies and digital assets.

As of the tax laws valid for January 1, 2020, cryptocurrencies of all ambiguous forms are considered property as it pertains to taxes. Because of this, you are subject to the rules surrounding capital gains and capital losses.

What is a capital gain? It is the rise of value of a capital asset (property-like assets) that gives it a higher worth than the purchase price. If I purchase an asset for $100 and then turn around and sell it for $200, I have just made a capital gain. The inverse is true for a capital loss.

What is a taxable event for crypto-commodities and crypto-securities? Is it if I purchase coffee with Bitcoin? What if I gift a friend Ethereum or buy some cryptocurrency from an exchange?

Fortunately, the IRS took action in 2014 and outlined precisely what the rules are in a six-page document titled “Notice 2104-21.” I would encourage you to look this up and read from the horse’s mouth. Despite the fact that definitions from a regulatory perspective are consistently shifting, we can confidently follow the following rules as of the time this book was published.

A taxable event for crypto (for which tax reporting is a requirement) are the following:

•Earning crypto as income

•Using crypto for goods and services

•Trading crypto for a different crypto

•Trading crypto to fiat currency (such as the US dollar)

A taxable event for crypto does not include the following:

•Buying crypto with USD

•A transfer from one digital wallet to another

•Giving crypto as a gift—a transfer of property for less than its full value (as defined by the IRS)

People are fighting for the ability to purchase items with cryptocurrency without triggering a capital loss or capital gain. I fully believe that in the future, as stablecoins are adopted in their many hybrid forms, legislation will reflect this needed change.

You must have a record of all your taxable events, as you need to submit an IRS form 8949 as well as a 1040 Schedule D on a yearly basis. Services such as TurboTax help with the submission of the form, but you need to be able to provide the inputs. If you are wondering the exact mechanics of recording a taxable crypto event, plenty of online videos that are up to date can walk you through the series of steps. It would be worth starting a spreadsheet containing a consistently updated log of the following required 8949 entries:

•The amount of property (such as five Bitcoin)

•Cost basis in USD (what rate you bought the crypto for, including fees)

•The date of purchase

•Fair market value in USD (what rate you sold the crypto for, as well as the amount sold)

•The date of sale

•Gains and losses in USD

At the end of the tax year you will summate all your taxable events, resulting in either a net positive or negative situation. Your investment log is an objective view into your crypto investments, and as a side effect can simultaneously be the basis for tracking the entries that are the basis for filling your 8949 and 1040.

After your overall capital gains or losses have been determined at the end of the year, How is the rate the capital gains are taxed determined? In layman’s terms, “What is the tax rate on my overall profit (or loss)?” It depends on if either short-term capital gains or long-term capital gains apply to you, as well as your income bracket. Short-term capital gains are if the sale of the property (in this case crypto) has been less than or greater than twelve months since the original purchase. If the sale is under twelve months from the original purchase, short-term capital gains apply. If the sale is over twelve months from the original purchase, long-term capital gains apply. Listed below is the 2020 tax brackets in the United States.

Figure 28: Short Term Capital Gains

This is in stark contrast to an individual who sells a crypto asset after the twelve-month period. Long-term tax rates are significantly lower and reward individuals who have patience and conviction about their investment. This is why picking your time horizon as mentioned earlier in the book is so important. It can be the difference between a small gain and a large gain because of capital gains tax. Listed below are the long-term capital gains brackets for 2020.

Figure 29: Long Term Capital Gains

Because of the perceived lack of regulation from the SEC and other regulatory bodies, some investors have taken it upon themselves to not pay taxes, not record their transactions, and to not follow the law. In order to onboard your fiat into cryptocurrency, you need to go through an exchange that transacts with banks. Those exchanges are compliant with the US authorities, and therefore are held responsible by Know Your Customer standards. Right off the bat, you are “in the system” when you send your cryptocurrency to a different wallet from your exchange wallet. Your real-world identity could conceivably get attached to that digital wallet.

Because the majority of large public blockchains are entirely transparent, the chain of transactions from the wallet receiving the funds (from the exchange) to any other wallets is visible. By design, public blockchains are accessible to everyone in the world—anyone can see the entire set of transactions on a blockchain all the way back to the very first transaction. This is what makes a blockchain immutable and auditable.

This is to say that even if you are transacting with decentralized exchanges or smart contracts separate from an exchange, you are not immune or invisible from the government. Your public wallet address may be 0xc02aaa39b223fe8d0a0e5c4f27ead9083c756cc2 and completely “anonymous” to 99 percent of the individuals using the blockchain, but if an exchange has somehow attached your Know Your Customer exchange identity to this wallet, then you are no longer outside of the system.

You are responsible for your financial transactions.

“Mixers” are considered some of the most dangerous technologies by regulators. Mixers aim to obfuscate transactions by having groups of wallets swap hundreds of different denominated amounts between wallets, making it difficult to track a sender and receiver. The funds will eventually reach their intended target but will arrive at the wallet from multiple different wallets, confusing any sort of tracking algorithm trying to detect which wallet was the original sender and even who was the intended receiver. This is an arms race of technology, and you can count on the fact that the IRS or FinCen have some of their best software engineers designing programs to track wallets through these various obfuscation services.

At the end of the day, you must do your due diligence. Track your transactions to improve yourself as an investor and to also pay your taxes properly. Always be on the lookout for legislation and regulation that will impact your investment vehicle. Be aware of the risks of not properly following the law, even unintentionally. As John Marshall, a lawyer and politician from the early 1800s, stated, “The power to tax is the power to destroy.”

Don’t end up on the wrong side of the fence.

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