Bitcoin Investing Is Creating Tax Predicaments for Hedge FundsDozens of hedge funds investing billions of dollars in cryptocurrencies don't know if they're calculating their taxes correctly, which may be a problem now that U.S. authorities have said they're going to be scrutinizing virtual currencies.
Just like individual taxpayers, institutional investors that have plunged into Bitcoin, Ether and other digital currencies are finding there are few guidelines governing their holdings, and those that exist are murky. As a result, many funds have tried to minimize their liabilities without really knowing what the rules are.
That could all come to a head later this year, following an announcement by the Internal Revenue Service in July that virtual currencies would be a focus of audits for its large business and international division. The new batch of crypto funds could face bigger tax bills, or even penalties.
"There is still a lot of uncertainty about how the IRS will come down on virtual currency," said Clay Littlefield, a tax attorney for Alston & Bird in Charlotte, North Carolina. "There are some good arguments for why this analogy or that analogy should apply, but there's not a lot there."
Part of the problem stems from how slow regulators have been to define their views of virtual currencies. The IRS considers them to be property rather than currency. The Commodity Futures Trading Commission says they're commodities, which could open up some tax advantages if the IRS agrees.
When the IRS added virtual currencies to its list of "compliance campaigns" last month, it said taxpayers with unreported transactions should correct their returns but that it wasn't contemplating a voluntary disclosure program, which lets taxpayers limit their criminal and civil liabilities for breaking the rules.
In 2014, the IRS said virtual currencies would generally be treated as property for tax purposes. Investors who traded Bitcoin would need to report gains and losses the same way they would other property, as would cryptocurrency "miners" and others who got paid with it.
At that time, most Bitcoin trading was done by small investors. In the past two years, more hedge funds have started trading cryptocurrencies, creating a new set of issues that the IRS has still left unaddressed.
Even after plunging 55 percent this year, Bitcoin has a market capitalization of $111.5 billion. Morgan Stanley estimated that investment firms launched 84 cryptocurrency hedge funds in 2017, which hold about $2 billion-worth of virtual currencies.
The burgeoning interest is leading some tax firms to devote increasing resources to sorting out the tax issues created when a hedge fund buys virtual currencies.
Seward & Kissel, a New York law firm that focuses on hedge funds, started a cryptocurrency practice last year and now advises more than two dozen crypto funds, said Brett Cotler, one of the firm's tax attorneys.
Many hedge funds hope that the CFTC's view that many virtual currencies are commodities prevails. Some federal judges have also reinforced that the currencies should be treated as commodities over the last couple of years.
Funds often set up offshore vehicles in the Cayman Islands or other low-tax jurisdictions for investors who don't live in the U.S. If the fund is operated correctly, income from trading commodities, stocks or other securities won't trigger the need for a U.S. tax return or for foreign investors to pay U.S. taxes.
Funds that invest in cryptocurrencies on behalf of foreign investors are now acting as if that means they can avoid filing a U.S. tax return, but the IRS or courts haven't confirmed that position, Cotler said.
Other investment firms try to structure their funds so that they're not taxed at the corporate level. One of the requirements of the exemption is that at least 90 percent of the funds' earnings come from certain kinds of income. While some kinds of trading don't qualify, trading in commodities generally passes the test.
Tax experts have urged federal officials to provide clarity over the past year, and some guidance may be coming soon. Karl Walli, senior counsel at the Treasury Department's office of tax policy, told a gathering of tax professionals in June that the IRS understood there's a "long list" of issues to address, and that Treasury could release some details as soon as this year.
Still, he said the implementation of the new tax law would limit the resources needed to answer all outstanding questions.
"There's no way in this environment that we're going to be able to put out guidance on the majority of those issues," Walli said.
Funds could end up owing more taxes if their guesswork runs afoul of what the IRS ultimately decides. But as long as their assumption was reasonable, the agency is unlikely to pursue penalties beyond taxes and interest, said David Shakow, professor emeritus at the University of Pennsylvania Law School.
"The fact that they haven't issued guidance will certainly give a defense for whatever position you take," Shakow said.