2021 was an incredible year for crypto investors. Tokens such as Polygon ($MATIC), Sandbox ($SAND), Decentraland ($MANA) had incredible gains, with investors realizing returns in excess of 100% of their original investment. Yet, investors may be looking at a hefty tax bill for 2021, if they failed to plan accordingly.

Crypto investors were not the only category of persons to proser.  2021 was also a great year…for crypto-scams. Epic failures such as Squid Game ($SQUID) literally wiped millions of dollars, generating substantial losses to thousands of investors. Launched on October 26, SQUID went from a $0.01 to a peak of $2,862 in a week, before falling to $0.00 after the developers performed what is commonly known as a “rug pull” (meaning that the developers abandon the project by selling their tokens and taking the investors’ money – hence “pulling the rug out” under the investors’ money). In these cases, the investors holding the tokens sustain giant losses without further possibility of recovery.

One of these “rug pulls” was performed on the last day of 2021—in less than 6 hours. The $YEAR token was launched as a “year in review” of the user Ethereum transaction history. The scam prohibited the investors from selling because the token developer activated certain code – embedded within the token software – preventing the investors from selling their tokens and only allowing purchases. This caused the price to soar to 0.0009 ETH only to drop to 0.000118 ETH and then zero after the rug pull.

Investors should exercise caution and be aware of such scams in order to prevent monetary losses—but also to prevent unintended tax consequences, such as the limitations on deducting losses.

The Internal Revenue Code (IRC) provides two primary avenues to deduct losses. Section 162 allows taxpayers to deduct ordinary and necessary expenses incurred in carrying on a trade or business. I.R.C. § 162. Another provision that allows individuals to deduct losses is Section 165, which allows taxpayers to deduct losses sustained during the year and not compensated by insurance. I.R.C. 165(a).

The first question to properly determine the tax treatment of a loss in cases such as $SQUID and $YEAR, is to determine whether an individual is engaged in a trade or business. If “yes,” the individual may be able to deduct the loss incurred in his business. If not, the taxpayer must resort to Section 165 to deduct the loss. A recent tax case, Antonyan, et. al. v. Comm’r, T.C. Memo. 2021-138, provides an example of the requirements to deduct losses for a trade or business.

However, if the individual does not carry on a trade or business—but rather is an investor (like many crypto investors)—the individual may be required to utilize section 165(c) to deduct his losses.

Generally, Section 165(c) allows individuals to deduct losses incurred in a transaction entered into for profit, but not connected with a trade or business, and losses of property arising from casualty, including theft.

Theft may include other criminal activities, for example larceny, embezzlement and robbery.  Treas. Regs. 1.165-8(d). For example: robbery of tokens. In such cases, state law is controlling and the individual must prove that the theft occurred under the law of the jurisdiction wherein the alleged loss occurred, the amount of the loss, and the date that the loss was discovered. See Monteleone v. Comm’r, 34 T.C. 688, 692 (1960). These rules can be challenging given the various elements that must be proven. For example, in a recent tax case, the Tax Court denied theft losses because, under California law, certain elements of the theft definition were not found. See Ronnie S. Baum and Teresa K. Baum v. Comm’r, T.C. Memo 2021-46.

As seen, investors who are victims of rug pulls, such as SQUID or YEAR, would need to show the existence of “theft” under State law. Additionally, the amount of the loss and the specific date must be proven. Rug pulls present specific challenges because the investors acquired the tokens and thus, the definition of theft under the respective law may vary and may fail to include other cases such as embezzlement. Another challenge is determining the applicable law to characterize the theft when there are various jurisdictions involved.

A final option potentially available to investors to deduct theft losses is under the safe harbor provided by Revenue Procedure 2009-2020, which allows certain taxpayers to deduct losses from certain arrangements determined to be criminally fraudulent.

Under this Revenue Procedure, various elements must be met. For example, there must be a “specified fraudulent arrangement” (an arrangement in which the lead figure – the scammer – receives cash or property from investors or purports to earn income for the investors, among others) and a qualified loss (a loss derived from the specified fraudulent arrangement where the scammer is charged with an indictment, or is subject to a State or Federal criminal complaint alleging theft, among others).

Although the safe harbor reduces some of the complications that stem from Section 165(c), it presents challenges of its own—particularly in cases of rug pulls. For example, the “qualified loss” may not be met if there is no legal action by the government. In the case of SQUID, there has been no governmental legal action taken to date (as of the date of this post). In the case of YEAR, the fact that the token was embedded with code may present challenges to characterize the scam as theft under state law.

As can be seen, individuals investing in crypto tokens should be aware of the tax implications with respect to their losses. The ability to claim such losses may depend on various facts and circumstances. Proper tax and legal advice may be necessary to correctly report such losses and to prevent exposure to further liability, such as penalties, stemming from these “rug pulls”.

Have a question? Contact Fernando Juarez, Freeman Law.