By Michael Coglianese CPA, P.C.
The cryptocurrency asset class is here to stay and growing at warp speed. The stories are real. Some cryptocurrency traders have turned $100,000 into $1,000,000 in less than a year. Now those traders are creating cryptocurrency funds so they can trade on a multimillion dollar scale.
This article will focus on five things you should know before setting up your crypto fund. As a disclaimer I am not an attorney and I do not hold myself as one, therefore this article is not providing you with legal advice. If you need a legal advice, our firm can point you in the right direction. We are a CPA firm that specializes audit, tax, and compliance services for the alternative investment industry. Cryptocurrency is one of the investment classes that falls into our specialized wheelhouse.
- Regulations: Regulations concerning crypto are also being implemented at warp speed. The IRS, CFTC, and SEC are developing laws to regulate the crypto asset class on an ongoing basis. Since a cryptocurrency fund is partly defined as a pool of money from a number of unrelated investors certain SEC regulations do apply. If your crypto fund is also trading CME or CBOE futures contacts then it is likely that registration with CFTC and NFA may be required, depending on the situation. In all cases IRS reporting is required.
- Transactions are taxable: Understand the tax ramification of trading and tax reporting of crypto trading is a necessity.
Initial IRS guidance on crypto currency (IR 2014-36), treated all virtual currency as property, rather than currency, for U.S. tax purposes. The Treasury left several questions unanswered, including whether crypto currency is business property eligible for tax-free exchange under §1031 and whether crypto currency is required to be reported on Foreign Bank Account Report (“FBARs”) or other foreign asset disclosure forms such as Forms 8938. The Tax Cuts and Job Act of 2017 impacts the analysis with its limitation on like-kind exchanges for non-real property transactions.
The IRS issued a “John Doe” summons to Coinbase, perhaps the largest crypto currency exchange, seeking transactions from 2013 to 2015, suggesting the Service will pursue an aggressive enforcement position on crypto currency exchanges. On November 28, 2017, the Federal District Court for the Northern District of California entered an order requiring Coinbase to provide the IRS with data on many of its clients who engaged in transactions exceeding $20,000.
- Volatility: Trading crypto is currently highly volatile. A $20,000 Bitcoin value drops to $11,000 within days. A consideration may be to use the futures contracts offered by CBOE and CME in your portfolio to help manage risk and volatility. For example, trading in XBT℠ Bitcoin futures on CBOE Futures Exchange was introduced December 10, 2017. Since their introduction XBT futures have had a 45% high-to-low range intraday. The peak-to-trough range, if you evaluate January futures settlement data, is only 31%. At this point, it should be clear that the underlying market is volatile. Volatility yields both opportunity and risk.
- Custody: As more money moves into the crypto fund space, the lack of custody options is a temporary barrier to growth. That is because the SEC requires registered investors, those with more than $150,000,000 of gross assets, to employ qualified custodians to safeguard client funds and publicly traded securities. Currently custody services are available from a few exchanges and a few independent trust companies.
- Front and Back Office Structure: Properly structuring your front and back office is imperative to attract investors and to decrease the fund operator’s liabilities and risks. Before jumping into operating a crypto fund or any other fund, gain a good understanding of your risks and liabilities. Understand the legal and compliance aspects that makes crypto fund appealing to investors and at the same time a potential nightmare to the sponsor. It is crucial to have a solid accounting and performance infrastructure. At a minimum understand the regulator limitations and requirements in marketing a cryptocurrency fund.
If you are interested in adding digital currency to your portfolio or starting a cryptocurrency fund, please give us a call. Simply go to the CONTACT page in our website https://www.cogcpa.com/contact/ and request a 15-minute telephone consultation. Include your contact information as well as a few dates and times that work for your schedule.
For over 30 years our boutique CPA team at Michael Coglianese CPA, P.C. has provided exceptional value through fund audit, tax, and compliance services for the securities, futures, and hedge fund, industries. Our goal is to be your strategic partner by navigating you through the ever-changing regulatory requirements and risks. As experienced and specialized alternative investment accountants, you will receive responsive cost-sensitive help that is a perfect partner for small firms and start-ups.