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A Tax Glimmer of Hope for FTX Crypto-Fraud Victims

By William Stromsem, J.D., CPA
Department of Accountancy
George Washington University School of Business

The cryptocurrency collapse of FTX left many investors with only a limited potential to recover their losses. Although the financial condition of FTX is still being evaluated, its new CEO has said, “We’re not going to be able to recover all the losses here.”

That may be a gross understatement with total losses estimated at up to $10 billion for its 1 million investors. There is no federal insurance for cryptocurrency like for bank or brokerage accounts, so it is just lost. There may be a partial recovery in bankruptcy, but crypto investor claims are likely to be behind those of a lot of other secured and general creditors, and any recovery may take years to resolve. There may be some potential for a partial recovery from tax deductions as described below.

Capital Loss?

Deductible capital losses are limited to capital gains plus up to $3,000 of ordinary income, so unless the investor has big gains, a large crypto loss could result in capital loss carryovers that could take decades to use. If the investor’s portfolio has gains, they should consider selling those investments in the year the FTX crypto losses are recognized or later. One problem with selling FTX crypto now is sales are frozen until the government can determine where the company really stands from its apparently murky books, so selling likely cannot happen until at least 2023. A sale will be required because these losses do not qualify to be written off as worthless while there is still a potential for some recovery. You might also seek to claim the loss as a non-business bad debt, but this depends on how the initial payment to FTX is classified, and in any case, the worthless stock or business bad debt approaches would yield short-term capital losses that can only be used to offset capital gains plus up to $3,000 per year with potentially long-deferred tax benefits from carryovers.

Theft Loss?

There is a glimmer of hope for a theft loss deduction, depending on the interaction of a provision in the Tax Cuts and Jobs Act of 2017 (TCJA) and a 2009 revenue ruling. The TCJA made personal casualty and theft losses deductible only to the extent they were attributable to a federally declared disaster, and FTX losses were not related to any disaster. The Act did not similarly stigmatize business theft losses, and that is where the 2009 revenue ruling comes in.

Revenue Ruling 2009-9 may provide an exception to the requirement to have a declared disaster for a theft loss from investment fraud. After Bernie Madoff’s $65-billion 2008 Ponzi scheme, the IRS published rulings, including Rev. Rul. 2009-9 and safe harbor Rev. Proc. 2009-20 to clarify tax compliance requirements for Madoff’s victims. Rev. Rul. 2009-9 said that if a taxpayer put money into an investment account with the intent to make a profit and the scheme was fraudulent, losses could be considered business theft losses that were not subject to the personal theft loss reductions of 10% of AGI, plus $100 per theft. Thus, arguably the FTX losses could be characterized as business theft losses and not cut off by the disaster requirement of the TCJA for personal theft losses. This argument has been made in other, much smaller crypto-fraud cases recently. Also, if a crypto loss is considered a business loss, this could allow the taxpayer to claim a net operating loss that could be carried forward and used to reduce taxable future income. Rev. Rul. 2009-20 relates to timing, amounts and other issues involving investment fraud deductions. If the Rev. Rul. 2009-9 is found not to apply, the investor might still have a personal theft loss recovery by waiting for the disaster requirement of TCJA to sunset after 2025 – and the bankruptcy and criminal proceedings may take that long.

The FTX losses may meet the requirement of Rev. Rul. 2009-9, with the Justice Department charging Sam Bankman-Fried, founder and former CEO of FTX, with fraud and various other crimes. However, it may take years for the courts to decide whether Bankman-Fried had the requisite intent to defraud or was just in over his head and incompetent. This is sometimes called the “stupid defense,” claiming that the defendant was innocent by virtue of having been ignorant of facts and requisite intent to defraud, but just mismanaged assets and lost a lot of money – which is not a crime. Some regulators and courts may feel little sympathy for investors in FTX for not exercising diligence in investing and sometimes seeming to relish the opportunity for a fast profit in an adventurous unregulated investment.

Another hurdle for the use of Rev. Rul. 2009-9 is the requirement that the money was deposited in an account; the issue is whether crypto investments were a deposit in an account with the crypto wallet like a savings account passbook or whether they were a purchase of assets. This distinction must be clarified by federal regulators.

The question of whether the theft loss will be deductible may depend on whether the courts see the TCJA limit on personal theft losses as having greater hierarchy of authority than the earlier IRS revenue ruling that gave investors more ability to claim theft losses. With 1 million individuals, many with large losses, possibly the IRS will issue some rulings to help clarify the situation.

Hey, IRS are you reading this?!

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