Bitcoin Hedge Funds Caught in IRS Crypto Tax Crosshairs Amidst Unclear Regulations

Hedge Funds Are Struggling to Correctly Tax Crypto Holdings Amidst Unclear Regulations

According to US law, bitcoin and other cryptocurrencies are taxed like property – similar to real estate. Amidst unclear regulations, however, hedge funds are struggling to correctly pay their taxes, which is a problem because the IRS just announced a crackdown on crypto investors.

“Dozens of hedge funds investing billions of dollars in cryptocurrencies don’t know if they’re calculating their taxes correctly,” reported Bloomberg earlier today.

Despite the unclear regulations, the IRS has announced plans to increase scrutiny of virtual currencies. That means hedge funds – some of the world’s largest holders of cryptocurrencies – could come under fire despite their best efforts to report crypto taxes correctly.

“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.”

Meanwhile, just a few weeks ago, the Internal Revenue Service (IRS) announced that virtual currencies would be a focus of audits for its large business and international division. Crypto funds could face bigger tax bills or even penalties after an investigation from the IRS. The IRS even added virtual currencies to its list of “compliance campaigns” in July.

It’s still unclear how the IRS could clamp down on virtual currency. Some argue that the IRS will keep existing regulations in place, treating bitcoin and other cryptocurrencies like property while declaring some virtual assets securities. Others suggest the IRS could announce a whole wide-ranging set of cryptocurrency regulations.

Part of the complication comes from the government’s own regulatory agencies. The IRS, for example, treats bitcoin and other cryptocurrencies like property instead of currency. The Commodity Futures Trading Commission (CFTC), meanwhile, has declared cryptocurrencies as commodities. If the IRS agrees with the CFTC, then that could open crypto fund holders to some tax advantages.

The IRS Is Not Contemplating A Voluntary Disclosure Program

Faced with changing tax laws, the IRS periodically implements a voluntary disclosure program. Tax filers can report a transgression – like income they failed to report – and limit their criminal and civil liability for breaking the rules.

The IRS added virtual currencies to its list of compliance campaigns last month. At the same time, the agency suggested taxpayers with unreported transactions should correct their returns. Nevertheless, the IRS isn’t considering opening a voluntary disclosure program.

The IRS has treated bitcoin like property since 2014. If you have owned or traded bitcoin at any point between 2014 and today, then that trading activity needs to be listed on your taxes.

“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,” explains Bloomberg.

This made sense back in 2014 when bitcoin was a niche tool for techies. Today, however, things have changed. Bitcoin has a market cap of over $100 billion. Hedge funds are increasingly purchasing bitcoin.

“Morgan Stanley estimated that investment firms launched 84 cryptocurrency hedge funds in 2017, which hold about $2 billion-worth of virtual currencies,” mentions Bloomberg. These hedge funds are struggling to comply with tax laws regarding bitcoin.

Hedge Funds Are Buying Crypto Offshore To Limit Tax Liabilities

When taxes get too complicated or expensive, corporations and the wealthy take a different approach: they move their funds offshore to avoid US taxes.

Bloomberg claims a growing number of institutional crypto investors are buying crypto offshore in tax havens like the Cayman Islands.

“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.”

It’s not totally clear if a hedge fund investing in cryptocurrencies on behalf of foreign investors would need to file a US tax return. Hedge fund operators claim they don’t need to file a return. The IRS and US courts, meanwhile, haven’t declared one way or the other.

The unclear rules mean that, for today, offshore hedge funds can purchase cryptocurrency on behalf of a US-based investor while avoiding paying US taxes.

If Cryptocurrencies Are Declared Commodities, It Would Be Very Good News For Hedge Funds

The CFTC believes cryptocurrencies are commodities. The IRS has always treated bitcoin and other cryptocurrencies like property. If cryptocurrencies are declared commodities, then this would be huge news for hedge funds.

Many hedge funds structure their holdings and profits in a way to limit their taxes:

“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.”

Ultimately, we’re still waiting for further clarity on crypto taxes from the IRS and CFTC – and it’s unclear when that clarity will arrive.