CRYPTO ASSETS AND THE PROBLEM OF TAX CLASSIFICATIONS.

• Author: Chason, Eric D.

Table of Contents Introduction I. Crypto Assets A. Introduction and Terminology B. Bitcoin C. Ethereum and Smart Contracts D. Tokens E. Ripple/XRP F. Stablecoins II. Existing IRS Guidance on the Taxation of Crypto Assets A. Internal Revenue Service 2014 Notice B. 2019 Frequently Asked Questions C. Other Guidance D. Categorization Beyond Current Guidance III. Crypto Assets as Securities for Tax Purposes A. Crypto Assets Under the Securities Laws B. Wash-Sale Rules 1. Statutory Restrictions on Loss Harvesting 2. Wash-Sale "Securities" 3. Crypto Assets and the Larger Purposes of the Wash-Sale Rules C. Information Returns 1. Returns of Brokers 2. Information with Respect to Foreign Financial Assets D. Investment Companies E. Code Provisions that Define "Securities" Narrowly 1. Character of Gain and Loss Realized by Dealers in Securities 2. Mark-to-Market Taxation for Securities Dealers and Traders 3. Worthless Securities 4. Retirement-Plan Distributions 5. Partnership Distributions of Marketable Securities IV. Categories Beyond Securities A. Money B. Foreign Currency C. Actively Traded Personal Property 1. Straddles 2. Passive Activity Loss Limitations 3. Application to Crypto Assets D. Commodities V. The Superiority of the Securities Classification VI. Beyond Securities: Asset-to-Asset Comparisons A. Introduction B. Like-Kind Exchanges C. Tumbler/Mixer Transactions D. "Wrapped" Coins 1. Moving Bitcoin to the Ethereum Blockchain 2. Realization Doctrine and Taxable Exchanges 3. Analyzing the BTC/WBTC Exchange VII. Solving Crypto's Tax Classification Problems A. Expanding "Securities" to Cover Actively Traded Crypto Asset B. Current Exceptions & Future Flexibility C. Other Determinations D. Exceptions for Taxpayer-Specific Determinations Conclusion Introduction

In 2014, the Internal Revenue Service (IRS) issued its first published guidance on cryptocurrencies. (1) The IRS was not the first regulator to take note of cryptocurrencies, (2) but it took a seemingly early start. Importantly, the IRS declared cryptocurrencies to be "property" and not "currency" for federal tax purposes. (3) Perhaps more importantly, the regulatory attention seemed to legitimize Bitcoin, (4) which suffered from an early taint with illegal activity such as the Silk Road black market. (5)

Over the intervening eight years, the IRS has lagged behind other crypto regulators, issuing a scant body of guidance. Much of its efforts have reminded recalcitrant taxpayers that they do indeed need to pay tax on their crypto gains. (6) The IRS has devoted less attention to answering more sophisticated questions, and when the IRS has spoken to those questions, its answers have often baffled observers. (7)

For the most part, however, the IRS has simply not spoken to the important issues. While its early classification of cryptocurrency as property answers many questions, (8) others remain. Various provisions of the Internal Revenue Code ("Code"), for example, apply special treatment to "securities." The wash-sale rules of section 1091(a) are such a provision, denying a deduction to taxpayers who sell securities at a loss and replace them within a thirty-day period. (9) Cryptocurrencies are arguably (but probably not) securities under the wash-sale rules, but the IRS has not offered any guidance on the question. (10)

Wash sales and other open issues of today seem multidimensional and daunting in comparison to the situation in 2014. Back then, the IRS could content itself and a handful of enthusiasts by answering a few questions about a quirky new asset called Bitcoin. From 2014 to 2022, cryptocurrencies and related assets ("crypto assets") (11) have skyrocketed both in number and in value. (12) Though many projects share similar traits, many are so different that they should have different tax treatments. Perhaps stymied by this complexity, the IRS has issued no regulations and little guidance on fundamental issues surrounding how to tax crypto assets.

Since the first law review article about Bitcoin was published in 2012, (13) there has been a steadily growing body of legal scholarship about it and other crypto assets. (14) Much of the tax scholarship has focused on novel problems like the taxation of hard forks (15) and enforcement. (16) Others have revisited the seminal issue of foreign-currency status (17) or have proposed more fundamental tax reforms to accommodate newly emerging crypto assets. (18)

This Article examines the interpretive issues of applying old categories in the Code to the new crypto assets. (19) Returning to the "securities" category, some authorities point to traditional categories like stocks and bonds. (20) Clearly, Bitcoin is neither stock nor bond, and it probably falls outside of the wash-sale rules as currently interpreted. In terms of purpose, the wash-sale rules seemingly use the term as a proxy for liquid, fungible investments. Bitcoin is liquid and fungible, and the wash-sale rules should apply as a normative matter.

Applying categories (securities, commodities, money, etc.) to crypto assets (Bitcoin, stablecoins, etc.) requires us to understand the text and purpose of the statute along with the nature of individual crypto assets. This Article analyzes key provisions of the Code, the categories they use, and how they apply to prominent crypto assets. After finishing this work, it concludes that most crypto assets should be classified as securities under the Code. Current law, however, often excludes crypto assets from the securities category because they are not corporate debt or equity. (21)

To facilitate the correct taxation of crypto assets, Congress should empower the IRS to classify them under various provisions of the Code. With this power, the IRS could classify crypto assets on a system-wide basis. Whether Bitcoin is a security or commodity does not ordinarily turn on taxpayer-specific facts like intention. If Bitcoin is a security in Alice's hands, it should be a security in Bob's. Ideally, the IRS would make these determinations by referencing specific crypto assets and specific Code provisions. (22)

Most crypto assets should be treated as securities under most provisions using that term. Some provisions in the Code, however, use the term securities without implicating the taxation of crypto assets. For example, the Code offers special incentives for retirement-plan distributions of employer securities. (23) Those provisions exist to encourage employee ownership rather than to tax income. (24) Also, as crypto assets evolve, they may fall into categories other than securities. For example, stablecoins--crypto assets pegged to the U.S. dollar--might be properly characterized as "money" in the future. (25) Thus, the IRS's power to classify crypto assets needs to accommodate present exceptions and future changes. (26)

The classification problem goes beyond asking whether one crypto asset falls within a category. We can also ask whether pairs of crypto assets share a relationship under the Code. As discussed below, the exchange of related crypto assets (like Bitcoin for "wrapped Bitcoin") may or may not be a realization event under current law. The determination does not turn on taxpayer-specific facts, and the IRS could clarify the issue with a pronouncement available to all taxpayers. (27)

1. CRYPTO ASSETS

   1. Introduction and Terminology

      This Article refers to cryptocurrencies and tokens collectively as crypto assets. Tokens are similar to cryptocurrencies in many ways, but they differ in how they relate to a blockchain. Cryptocurrencies are a native and inherent part of the blockchain; tokens are created and introduced by users and their smart contracts. (28) Confusion about the difference arguably led the IRS to issue problematic guidance. (29)

      Readers can equate the term crypto assets with the terms "virtual currency" and "digital assets" that regulators use. Despite this usage, their meaning can be problematic. The IRS has adopted the term "convertible virtual currency," which the Financial Crimes Enforcement Network (FinCEN) first used in 2013. (30) Virtual currencies, however, predate Bitcoin and include video-game currency like World of Warcraft Gold and Second Life Linden dollars. (31) The U.S. Securities and Exchange Commission (SEC) uses the term "digital asset." (32) Again, this term predates Bitcoin, and it includes a wide range of assets that predate Bitcoin such as computer image and music files, (33) which presumably are outside the scope of the SEC's attention.

   2. Bitcoin

      Created in late 2008 and early 2009 by the pseudonymous Satoshi Nakamoto, (34) Bitcoin is the oldest and largest cryptocurrency. In early February 2022, each unit of Bitcoin had a market price of around $42,000, and all Bitcoin in circulation had a value of roughly $800 billion. (35)

      Bitcoin exists solely as a computational data structure. Unlike shares in most corporations, units of Bitcoin are not backed by assets, money, or business projects. Bitcoin does not produce dividends, interest, rents, or royalties that we associate with traditional investment assets. (36) Bitcoin's value comes from markets where participants buy and sell. (37)

      Whether Bitcoin is a fundamentally sound asset or investment is irrelevant to this Article. It has endured for more than a dozen years and does not seem poised to recede in importance soon. Because it is a relatively new asset, Bitcoin presents difficult issues for tax classification. The IRS has asserted that Bitcoin is "property" and not "currency," (38) but numerous issues remain unresolved (e.g., whether Bitcoin is a "security" for tax purposes). Much of this Article is devoted to resolving these issues.

   3. Ethereum and Smart Contracts

      In broad terms, Ethereum reproduces many of the features of Bitcoin while adding new functionality. Ethereum has a cryptocurrency--Ether-that exists on a decentralized blockchain like Bitcoin does. Bitcoin and Ethereum have different blockchains...