Blockchain and the Law

IRS Issues New Guidance for Virtual Currency Donations

The U.S. Internal Revenue Service (IRS) quietly added two new questions and answers regarding virtual currency donations to its answers to Frequently Asked Questions on Virtual Currency Transactions (FAQs) on December 26, 2019.  The two new answers address the responsibilities of charitable organizations when accepting donations of virtual currency, including cryptocurrency.

The original FAQs, issued on October 9, 2019 in conjunction with a concurrently issued Revenue Ruling (Rev. Rul. 2019-24, 2019-44 I.R.B. 1) (together with the FAQs, the “October Guidance”), re-confirmed the IRS’s position, announced in Notice 2014-21, 2014-16 I.R.B. 938, that virtual currency is “property” for U.S. federal income tax purposes and provided direction on how the rules generally applicable to property transactions apply in the context of virtual currency.

We discussed the October Guidance, which addressed the taxation of a wide scope of virtual currency transactions, in an earlier post. The October Guidance was the first official guidance on the taxation of virtual currency transactions in more than five years and thus attracted significant attention. It specifically addressed the donor side of taxation related to virtual currency donations, and applied the general rules applicable to non-cash donations to donations of virtual currency.  In addition, the October Guidance also provided information concerning the tax consequences of cryptocurrency “hard forks” as well as acceptable methods of determining tax basis for virtual currency transactions.

Donor Acknowledgment Responsibilities

In order for a donor to properly claim a tax deduction of $250 or more for a donation of virtual currency, the charitable organization must provide the donor with a contemporaneous written acknowledgment.

In order for a donor to properly claim a tax deduction of more than $5,000 for a donation of virtual currency, the charitable organization must sign the donor’s Form 8283, Noncash Charitable Contributions, if the donor presents the Form 8283 to the organization for signature.  Form 8283 requires a qualified appraisal for donated property over $5,000.  The organization’s signature represents acknowledgement of receipt of the virtual currency on the date specified and that the organization understands the information reporting requirements imposed on dispositions of the donated property; it does not represent the organization’s agreement with the appraised value of the property.

IRS Reporting Requirements

For IRS reporting purposes, a charitable organization should treat a donation of virtual currency as a non-cash contribution.  The tax-exempt organization is responsible for reporting such a contribution on its Form 990 annual return (and the associated Schedule M, if applicable).  In addition, the tax-exempt organization must file (and provide the original donor a copy of) Form 8282, Donee Information Return, if it sells, exchanges or otherwise disposes of any portion of the donated virtual currency within three years of the date it originally received it.  This would include situations where the organization sells or exchanges the virtual currency for real currency.

Impact on Charitable Organizations

The acknowledgement by the IRS of the application of the tax rules generally applicable to donations of property to virtual currency donations could be viewed as a positive development for tax-exempt organizations, as it may open up potential new avenues for funding.  However, the implied appraisal requirement for donors making larger donations to be able to appropriately claim the related tax deduction may discourage donations of significant amounts.  Appraisals are not required for publicly traded securities, and the IRS could have taken the view that virtual currency is comparable to publicly traded securities for purposes of the appraisal requirements, but this new guidance shows that the IRS is taking a different view.  Potential donors will likely find it expensive and difficult to find a “qualified appraiser,” which the IRS requires to have earned a recognized appraiser designation (which does not yet exist for virtual currency), or meet certain minimum educational requirements and have two or more years of experience valuing the type of property being appraised (which will be difficult to meet as virtual currency is so new), among other requirements.  Whether this additional guidance will encourage donations of virtual currency to tax-exempt organizations remains to be seen.

Illinois Embraces Smart Contracts with New Blockchain Legislation

As we highlighted in our recent Practical Law Practice Note, Smart Contracts: Best Practices, various state lawmakers are paving the way for widespread use of blockchains and smart contracts in commerce. For example, on January 1, 2020, the Illinois Blockchain Technology Act (BTA) went into effect, resolving some legal uncertainties around the legal status of blockchains and smart contracts in Illinois.

“Smart Contracts,” as defined by the BTA, are contracts stored as electronic records which are verified by the use of a blockchain. Smart Contracts can be deployed in a variety of legal and non-legal contexts, ranging from car rentals to supply chain management. However, one question that has loomed over smart contracts is how courts will review their enforceability, given that smart contracts may not resemble typical, written agreements. Some legislatures, and now Illinois, have sought to address this issue head-on, rather than waiting for courts to decide.

The BTA provides four permitted uses for blockchain and smart contracts:

  1. A smart contract, record, or signature may not be denied legal effect or enforceability solely because a blockchain was used to create, store, or verify the smart contract, record, or signature.
  2. In a proceeding, evidence of a smart contract, record, or signature must not be excluded solely because a blockchain was used to create, store, or verify the smart contract, record, or signature.
  3. If a law requires a record to be in writing, submission of a blockchain which electronically contains the record satisfies the law.
  4. If a law requires a signature, submission of a blockchain which electronically contains the signature or verifies the intent of a person to provide the signature satisfies the law.

In effect, these permitted uses prevent a court from denying smart contracts contractual or evidentiary effect solely by virtue of their status as a smart contract or electronic record stored on a blockchain, though courts will still have to review on a case by case basis. Tennessee and Arizona, among other states, passed similar legislation regarding contractual enforceability of smart contracts. Vermont passed a similar law handling the evidentiary effect of digital records such as smart contracts. Wyoming has also been active in adopting regulations related to digital assets, smart contracts, and blockchains.
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SEC Swings Into 2020, Warning Investors of Initial Exchange Offerings

The SEC’s Office of Investor Education and Advocacy issued an alert on January 14, 2020, warning investors of initial exchange offerings and the potential for fraud. This follows the 2020 examination priorities the SEC released at the beginning of the year, which touched on virtual currencies and digital assets, and signals continued monitoring of market and technological developments in the digital asset space.

Initial exchange offerings (IEOs) are token sales conducted on online trading platforms, where companies outsource most of the work of a token sale to the platform. While the purpose remains the same as initial coin offerings (ICOs) – to raise capital – platforms perform the work of marketing and selling the tokens, due diligence on the companies requesting an IEO on their platform, and AML and KYC diligence on customers – all for a fee, of course. IEOs gained popularity in 2019 as the new favored form of raising capital in the crypto community following multiple actions by the SEC against companies engaged in ICOs and fraudulent ICOs.

In its alert, the SEC highlighted several ways in which IEOs may clash with federal securities laws, including:

  1. Potential registration requirements under federal securities laws governing offerings and sales of securities. The SEC’s previously released framework for analyzing digital assets applies to this analysis.
  2. If an IEO involves securities, the online trading platform involved may need to register as an exchange (or qualify for, and operate under, an exemption such as an alternative trading system) and comply with certain regulations.
  3. The online trading platform may be acting as a broker or dealer in an IEO. Brokers and dealers are (also) subject to additional legal and regulatory requirements.

While the SEC’s alert is late for certain investors, it should also serve as a word of warning to companies considering, and trading platforms engaged in, IEOs. As noted above, certain laws and regulations continue to apply to IEOs, as they did to ICOs. Whether the SEC intends to take action against IEOs remains to be seen, but companies should be wary of potential actions down the road and should focus on structuring IEOs and any token trading platform they operate to be compliant with applicable laws and regulations.

Among an Array of 2020 Examination Priorities, SEC Signals Continued Interest in Cryptocurrency

On January 7, 2020, the Securities and Exchange Commission (SEC)’s Office of Compliance Inspections and Examinations (OCIE) released its 2020 examination priorities. The majority of OCIE’s priorities for the coming year involved financial regulatory issues that do not directly involve cryptocurrency – for a more detailed review of those priorities, please see the Client Alert posted on our firm’s website.

Tucked away in the SEC’s 22-page document, OCIE identified two examination priorities concerning virtual currencies and digital assets:

  • First, OCIE advised that it will continue to “examine SEC-registered market participants” engaged in cryptocurrency activities, specifically for: (1) investment suitability, (2) portfolio management and trading practices, (3) safety of client funds and assets, (4) pricing and valuation, (5) effectiveness of compliance programs and controls, and (6) supervision of employee outside business activities.  OCIE stated that the rapid growth of digital assets presents various risks, including “for retail investors who may not adequately understand the differences between these assets and more traditional products.”
  • Second, OCIE will continue to examine the core functions of transfer agents involved in the settlement of securities transactions and their role in maintaining proper records and safeguarding funds and securities. Specifically, OCIE noted: “Examination candidates will include transfer agents that serve as paying agents for issuers, transfer agents developing blockchain technology, and transfer agents that provide services to issuers of microcap securities, private offerings, crowdfunded securities, or digital assets.”

OCIE’s sustained interest in the risks associated with cryptocurrency is certainly not surprising, as evidenced by the SEC enforcement activity in the latter half of 2019 (which included, among other things, attempts to halt what it deemed non-compliant token distributions). Indeed, looking ahead, other regulators such as the IRS, FinCEN and CFTC are also watching the cryptocurrency space closely.  Thus, regulated entities engaged with blockchain and digital currency should understand the OCIE’s 2020 examination priorities in maintaining policies addressing regulatory compliance concerns.

IRS Officials Discuss Promotional Airdrops, Pre-2018 Crypto-for-Crypto Exchanges, and Other Issues Not Addressed in Recent Tax Guidance

In October of 2019, the U.S. Internal Revenue Service issued the first new guidance on the taxation of cryptocurrency transactions in over five years (the “Guidance”).  The Guidance comprising a revenue ruling (Rev. Rul. 2019-24) and answers to frequently asked questions on the taxation of cryptocurrency transactions published on the IRS’s website.

This post discusses recent news reports of statements by officials with the IRS and the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) concerning issues not explicitly addressed in the Guidance.

Please refer to our earlier post for complete coverage of the Guidance.

  1. Tax treatment of promotional airdrops remains uncertain

Revenue Ruling 2019-24 indicated that cryptocurrency received in a hard fork would be taxable to the owner at the moment the new units of cryptocurrency issued in connection with the hard fork are “received” by the holder of the legacy cryptocurrency, which is generally the moment the units of the new cryptocurrency are “airdropped” to the legacy holder’s wallet, provided the holder is able to exercise “dominion and control” over the units at that time.

Because the facts of the ruling involved a hard fork (i.e., a change in the protocol of a cryptocurrency’s blockchain causing the creation of a new blockchain and, therefore, a new cryptocurrency), it was not clear whether the same rule would apply to airdrops of cryptocurrency received in other contexts.  Airdrops may occur for promotional or marketing purposes by blockchain-focused startups in order to generate interest in the startup in connection with an upcoming ICO or to encourage mass adoption of the cryptocurrency.  The coins may be distributed for free to holders of existing cryptocurrencies (such as Bitcoin or Ethereum), or may be “earned” by posting to social media or referring the cryptocurrency to other users.

An attorney in the IRS Office of the Associate Chief Counsel clarified in recent comments that promotional airdrops are not within the scope of Revenue Ruling 2019-24, but also noted that the IRS had not yet reached a decision on the tax treatment of these airdrops

  1. Valuation and receipt issues for airdropped coins

If coins of a new cryptocurrency are “received” for tax purposes, the owner of the cryptocurrency is required to include in its taxable income the fair market value—generally, the trading price—of the cryptocurrency at the moment of its receipt.  An attorney for the IRS speaking before a recent conference of the American Institute of CPAs (AICPA) in Washington, D.C., suggested that a limited market for new coins may affect their valuation and that a zero valuation may be appropriate for a cryptocurrency that cannot be disposed of at all.

The same attorney also noted that, depending on the specific facts, a taxpayer may be treated as actually or constructively receiving coins of the new cryptocurrency distributed in a hard fork even if it is necessary for the taxpayer to download new software or undertake some other ministerial-type action to accept (or later to transfer) the cryptocurrency.  Taxpayers cannot avoid or delay a taxable event simply by declining to accept the airdropped coins. Continue Reading

Smart Contracts: Best Practices

Proskauer authored an in-depth Practice Note published by Practical Law, which details best practices for the use of smart contracts on blockchains. It discusses functional and legal considerations for both standalone smart contracts and smart contracts used in conjunction with traditional written contracts (hybrid smart contracts) and explores the extent to which smart contracts can independently be legally binding.

The full text of our Practice Note is available here: Smart Contracts: Best Practices


CFTC, FinCEN, and SEC Warn of Crypto AML Enforcement

Based on a recent regulatory statement, entities involved with cryptocurrency or digital assets should revisit their anti-money laundering and countering the financing of terrorism obligations (AML/CFT) compliance under the Bank Secrecy Act (BSA).

On October 11, the leaders of the Commodity Futures Trading Commission (CFTC), the Financial Crimes Enforcement Network (FinCEN), and the Securities and Exchange Commission (SEC) issued a joint statement (the “Joint Statement”) regarding the application of the BSA to activities involving digital assets. The Joint Statement “reminds” those involved with such activities of their AML/CFT obligations and specifically calls out those entities that would be subject to such obligations: futures commission merchants and introducing brokers (regulated by the CFTC), money services businesses (regulated by FinCEN), and broker-dealers and mutual funds (regulated by the SEC).

Potentially indicating a key concern of the regulators going forward, the Joint Statement notes that the applicability of AML/CFT obligations is not dependent on the terminology surrounding the applicable assets, but rather the nature of the assets themselves: “Regardless of the label or terminology that market participants may use, or the level or type of technology employed, it is the facts and circumstances underlying an asset, activity or service, including its economic reality and use (whether intended or organically developed or repurposed), that determines the general categorization of an asset, the specific regulatory treatment of the activity involving the asset, and whether the persons involved are “financial institutions” for purposes of the BSA.” Thus, while market participants refer to digital assets in many different ways, how assets are referred to should not have a bearing on BSA compliance. By way of example, the Joint Statement offers that “something referred to as an ‘exchange’ in a market for digital assets may or may not also qualify as an ‘exchange’ as that term is used under the federal securities laws.”

Following the general statement, each leader provides additional comments, which should guide entities subject to each applicable regulator’s review. Heath Tarbert (Chairman, CFTC) notes that introducing brokers and futures commission merchants are required to report suspicious activity and implement reasonably-designed AML programs, regardless of whether the digital assets qualify as commodities or are used as derivatives. Kenneth A. Blanco (Director, FinCEN) advises those handling digital assets to review FinCEN’s May 2019 interpretive guidance, under which FinCEN makes clear that many digital asset activities would qualify a person as a money services business subject to AML/CFT obligations (unless the person is registered with and functionally regulated and examined by the SEC or CFTC, whereby they would be subject to the BSA obligations of those regulators).  Jay Clayton (Chairman, SEC) reminds persons engaged in activities involving digital assets as securities that they remain subject to federal securities laws, but certain rules also apply regardless of whether the assets are securities, such as broker-dealer financial responsibility rules. Continue Reading