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FTX Tax Losses: The Land of Misfit Toys

Reportedly, there are over a million creditors in the bankruptcy of the cryptocurrency exchange FTX and its affiliated entities. A substantial number of these FTX creditors may include U.S. retail customers who held and traded digital assets (such as Bitcoin, Ether, and FTT (the native token of FTX)) through a bankrupt FTX entity. Their FTX accounts are now inaccessible, and whether the crypto assets nominally held in such accounts are even still held by the relevant FTX entity is in doubt. The exact amounts that retail customers might ultimately recoup is unknowable until new management ascertains the extent of FTX’s remaining assets, proposes a reorganization plan and the bankruptcy court rules on whether the assets associated with such retail customer accounts are assets of FTX or are directly held assets of the retail customers which would not be properly includable in FTX’s bankruptcy estate. While U.S. retail customers of FTX and its affiliates are likely to ultimately be able to deduct their losses attributable to FTX for tax purposes, the foregoing uncertainties significantly narrow the paths for currently claiming a deduction in 2022.

High-Level Overview on Loss Deductions in the Context of FTX’s Retail Customers

Loss deductions are allowed for losses incurred in any transaction entered into for profit that are both “sustained” during a taxable year and not otherwise compensated for such as by insurance. This “sustained” requirement hinges on the taxpayer proving that the loss has been crystalized by identifiable events (i.e., must be actually sustained, fixed by identifiable events, and evidenced by closed and completed transactions). It is possible that the mere filing of the bankruptcy coupled with the rapid decline in the value of FTX (as well as the indictment of its founder) may be sufficient for taxpayers to recognize loss upon the filing of bankruptcy. However, the lack of reliable information regarding FTX’s actual assets and the legal uncertainty regarding whether assets associated with retail customer accounts are properly includable in FTX’s bankruptcy estate may prevent a retail customer from claiming that they have a crystalized sustained loss. Generally, the IRS will challenge loss deductions when the taxpayer lacks reliable information on which to base the calculation of their asserted loss. Even for taxpayers asserting that their claim against FTX is currently wholly worthless, the lack of information ruling out future recoveries may preclude a current deduction based on complete worthlessness. In the FTX context, such information simply does not yet exist and may foreclose any tax loss by retail customers who hope to perhaps recoup some of their loss in the future. In any event, the loss here whenever claimed would generally be ordinary and therefore more valuable to a retail customer whose income consists primarily of wages or other ordinary income.

Similarly, while the Code allows deductions for worthless securities and for bad debts, these provisions may not apply to retail customers of FTX. In particular, a “security” for this purpose is essentially limited to shares of stock and bonds. Putting aside potential arguments that FTT tokens (the native cryptocurrency promoted by FTX) themselves might represent equity in FTX or a more remote argument that customer accounts themselves represent a form of equity in FTX, it is unlikely that a retail customer’s FTX account or the crypto assets contained therein represent securities (including bonds) for tax loss purposes. Additionally, even if a retail customer’s loss were attributable to a security, the security would need to be wholly worthless to allow a loss, and such loss would be capital in nature, and thus less valuable to the retail customer who would normally hope to utilize their FTX loss to shelter their wages or other ordinary income. Similarly, the bad debt deduction provisions do not permit partial bad debt deductions for non-business bad debts, and it is unlikely that an FTX account or the right to the crypto assets (e.g., Bitcoin or Ether) contained therein represent “debt” within the scope of the bad debt rules (which require the debt to arise from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money). Again, even if the retail customer’s loss were found to be in respect of a debt for these purposes, such a loss would be treated as a capital loss.

Of course, a retail customer might also attempt to claim a theft loss in connection with the FTX debacle. While theft losses can generally be claimed in the year that the theft is discovered, in the FTX context it is currently unclear whether these losses were the result of theft or merely represent gross negligence or something else that falls short of an intentional theft. In light of the recent arrest and indictment of FTX founder Sam Bankman-Fried, the predicates for claiming a 2022 theft loss may now be present, although the uncertainty as to the amount of loss as well as the lack of a conviction or court ruling would weigh against a current deduction. Importantly, if a theft loss were ultimately allowed, such loss would typically be ordinary in character due to the lack of any sale or exchange (and thus represent more value to the retail customer as a potential offset to their wages and other ordinary income).

Other Avenues for Claiming a Loss Deduction in 2022

Despite the above, if a retail FTX customer is determined to claim a tax loss in 2022, at least two potential paths may remain, although both face their own practical complications and require the taxpayer to forfeit any future recovery they might ultimately have received as part of the bankruptcy proceedings.

The typical method for a creditor (e.g., a stockholder or a lender) of a bankrupt company to obtain an immediate tax loss for their claim (e.g., the stock or loan) is to simply sell the claim to a third party. Such a sale will clearly fix the loss of the seller in the year of the sale. Of course, this method has the tax downside that the sale will result in a capital loss, if the claim was a capital asset, while the taxpayer would likely have received ordinary treatment for their loss if they waited for the bankruptcy process to play out. However, this approach also presents some practical problems in the FTX context. First, unlike a share of stock in a bankrupt company which has a clear existence as an item of saleable property, the mechanics of how an FTX account and its associated bankruptcy claim would be sold are less clear. FTX customers are currently locked out of their FTX accounts and cannot sell the underlying assets therein. So, to “sell” their claim a retail customer would have to “sell” their FTX account (including their potential bankruptcy claim) or their right to the digital assets “held” in such account, more amorphous types of property for which there may be non-tax legal limits on transferability (e.g., possible non-assignment clauses in the account documentation). While there have been some reported sales in the range of six cents on the dollar, the dearth of reliable information about FTX’s finances may give many would-be speculators pause regarding whether a credible profit potential currently exists from buying claims against FTX.

If an actual sale of a customer’s FTX account (or its right to the digital assets “held” in such account) is not practical, an alternative would be to pursue an abandonment of the FTX account and associated bankruptcy claim. Generally, abandonment requires the taxpayer to demonstrate an intent to abandon, an affirmative act of abandonment, and a communication of that intent and act to all interested parties. As a practical matter, it is not clear what might be required as an affirmative act of abandonment in the context of digital assets or a customer’s FTX account. Potentially, a claim to a digital asset could be transferred to a null address to document the abandonment, but if the relevant asset here is likely the FTX account itself and its associated claim in bankruptcy, it is not clear a digital asset exists to send into the void. However, by analogy to other areas, a customer’s formal relinquishment of its rights in letters delivered to FTX and the bankruptcy court would appear to meet the requirements for an abandonment loss. Normally an abandonment loss is ordinary in character since an abandonment does not involve any sale or exchange (i.e., no consideration is received for the abandoned property). While the IRS might try to argue, as they did in Pilgrim’s Pride Corp. v. Comm’r, 779 F.3d 311 (5th Cir. 2015), that section 1234A requires an abandonment to be treated as a capital loss since the customer’s FTX account arguably represents a contractual right with respect to a capital asset, the abandoning customer’s claim for ordinary treatment would still succeed as long as the abandonment is not viewed as a cancellation, lapse, exercise or other termination of the FTX account.

Under either current loss method (i.e., sale or abandonment) the retail customer would be giving up on future recoveries in the FTX bankruptcy. Given the reported multibillion dollar insolvency of FTX, it might seem that there is not much potential upside being forgone, although retail customers have an argument that the assets in their FTX accounts should be released from the FTX bankruptcy estate and returned to them. In particular, the FTX terms of service governing ownership of digital assets explicitly states that any digital asset in an FTX account is the direct property of the customer and is not an asset of FTX. While many commentators expect the bankruptcy court to nevertheless treat FTX as owning these “customer” assets (akin to a typical brokerage account), if the court were to respect the terms of service, then the degree of FTX’s insolvency would be irrelevant with respect to any customer assets remaining under FTX’s control. Consequently, there is an element of non-tax legal uncertainty which a taxpayer must weigh in deciding to pursue a current tax loss in 2022.

In summary, U.S. taxpayers who held assets through the bankrupt FTX have the upcoming holiday season to discuss with their tax advisors how best to treat their lumps of crypto coal. Should they wait to see how the bankruptcy plays out with the potential for some future recovery and a later year ordinary loss that could offset normal wage income or should they conclude that an immediate loss is preferable to waiting for the chimera of a future recovery and take proactive steps now to either abandon their FTX claim and assert they have sustained an ordinary loss or formally sell their claim against FTX to a speculator and claim a certain capital loss in 2022?

Key Contacts

Linda Z. Swartz
Partner
T. +1 212 504 6062
linda.swartz@cwt.com

 

Adam Blakemore
Partner
T. +44 (0) 20 7170 8697
adam.blakemore@cwt.com

Jon Brose
Partner
T. +1 212 504 6376
jon.brose@cwt.com

Andrew Carlon
Partner
T. +1 212 504 6378
andrew.carlon@cwt.com

Mark P. Howe
Partner
T. +1 202 862 2236
mark.howe@cwt.com

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