When Bankruptcy and Fraud Affect Your Crypto Portfolio: Considerations for Valuation and Tax

Considerations for Valuation

Despite the uncertainty surrounding the value of tokens purchased from defunct crypto exchanges, like FTX, investment fund managers still need to mark their portfolios at fair value and issue financial statements to their investors. Whether these tokens are now worthless and should be written down to $0, if a discount should be applied, and how a discount would be supported have been questions on everyone’s mind since the collapse back in November.

Unfortunately, there is still no consensus on the correct course of action to take, and a path forward will ultimately depend on what can be supported and what is observable to market participants. With the level of uncertainty that remains around FTX, it is difficult, if not impossible, to provide enough evidence to support a specific discount. Another scenario investment fund managers need to consider when valuing these assets is the effect of a potential claw back related to future bankruptcy proceedings. This not only affects funds with assets in FTX during the collapse, but it can also affect funds that liquidated their positions before the FTX collapse.

Recently, industry circles have discussed trade claims on these positions, potentially trading at heavy discounts. There have also been recent reports about assets being recovered during SEC investigations. These are undoubtedly positive indicators that there may be a certain degree of recovery for FTX account holders, but the question remains to what extent and when.

From a U.S. GAAP valuation standpoint, with the high uncertainty around the future outcome, most managers have been marking their FTX exposure down to $0, side-pocketing the investment, and not charging a management fee on this segment of their investment portfolio. As mentioned above, this is a common option as it retains the percentage ownership of the positions by the Fund investors at that point in time and is segregated from the other assets in the general portfolio. If new investors were subsequently admitted to the Fund, they would not participate in these FTX positions, which were previously placed in a side pocket. If, at a future date, accounts become unfrozen and proceeds are received, they would be allocated to the original side-pocket investors only.

While this appears to be the widely accepted approach initially, as more information is uncovered over the coming months and years, the process will continue to evolve. With a lack of liquidity and minimal visibility for market participants into any actual activity, supporting a value on these investments is challenging.

Considerations for Income Tax Treatment

Once valuation of assets has been determined, the treatment for tax purposes should be considered.

There are different tax treatment considerations that arise when dealing with the bankruptcy of an exchange or a token that has become worthless. For tax purposes these two things do not necessarily trigger a taxable event. Bankruptcy proceedings are ongoing and the potential for recovery is not yet clear. It is difficult to meet all the criteria for worthlessness to realize losses for income tax purposes because an asset generally needs to be completely worthless. Abandonment of cryptocurrency is treated similarly to worthlessness. The mere intention alone to abandon is not sufficient to accomplish abandonment for tax purposes. If the taxpayer continues to exert dominion and control, a loss cannot be taken.

Some partnerships may consider distributing the asset to its partners. Partners are not necessarily able to recognize the loss in this scenario, but they can independently decide what to do with the asset. Many accounts remain frozen on FTX so this may prove difficult to do logistically. The loss would not be recognized until either the bankruptcy is finalized, or the partner is able to transfer the assets to a third party.

Some taxpayers may consider selling the investment to a third party. A sale or exchange would trigger a taxable event allowing the taxpayer to realize the loss. However, using FTX as the example, you would need to have access to your FTX account to transfer the asset as part of a sale.

For now, the taxpayers should stay up to date on the latest industry news and consult with your service providers, tax professionals, auditors, and valuation specialists. Keeping an open dialogue with key industry players is critical as we wait for more information to become available.

Contact Us

For more information on this topic, please contact a member of Withum’s Financial Services Team.