Navigating Crypto Regulation: United States

By Alex Paley

It’s the second installment in our crypto regulation mini-series and we’re kicking off with a guide to navigating crypto regulation in the United States.

If you are an individual or company in the US, and are 1) buying crypto (fiat-to-crypto); 2) issuing crypto; 3) trading crypto (crypto-to-crypto or crypto-to-fiat); and, 4) accounting for crypto-related gains or losses, you no doubt have a lot of questions — and you should. While we can’t cover everything in a single article, we’re going to walk you through what we consider the most important regulatory questions facing crypto businesses and individuals in the United States:

1. Am I issuing/buying a security? What does that mean?
2. Where can you trade crypto, and is it legal?
3. How can I sell my crypto for fiat?
4. Can I trade anonymously?
5. What is my tax liability?

Without further ado, let’s get this thing started.

😥 Am I issuing/buying a security? What does that mean?

Why do we care about securities law?

The United States Federal Securities Act of 1933 states that without a registration statement, it is unlawful for any person, directly or indirectly, to engage in the offer or sale of securities in interstate commerce. This applies to both U.S.-based companies or individuals, and any international companies or individuals offering unregistered securities to U.S. residents. In other jurisdictions, regulations are different and may have different consequences.

The consequences of selling unregistered securities to U.S. residents can be far-reaching and severe, including:

1. A requirement to re-purchase all issued crypto;
2. Heavy fines on the business;
3. Personal fines on company principals; and last but not least,
4. Jail time 💀

U.S. residents as individuals purchasing securities are not completely immune either. While most members of the public who are purchasing unregistered securities may be arguably and defensibly naïve to their actions, accredited investors who advertise or promote securities can be fined and criminally punished. So, whether you’re a business or an individual investor, it is important to understand what type of crypto you’re working with.

What is a security under U.S. Federal law?

Section 2(a)(1) of the Securities Act and Section 3(a)(1) of the Exchange Act, define a security as “an investment contract” where there is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. The test was created in SEC v. W.J. Howey Co., 328 U.S. 293, 301 (1946), and is more commonly called the Howey Test. Whether a crypto-asset is a security depends on whether it meets all four elements of the Howey Test, which we’ll break down below:

Howey Test

1. Investment of money: Actual cash does not need to be put up to satisfy this element of the test — any cryptocurrency or token as a “medium of payment” would be sufficient.
2. Common enterprise: A collection of people brought together would be sufficient to establish “common enterprise”; for example, an ICO started by an enterprise of developers.
3. Reasonable expectation of profits: The definition of profits includes dividends, other periodic payments, or the increased value of the investment. Most, if not all, ICO-issued tokens are bought with the expectation that they will rise in value. Only if a token is issued at a set value, with a complete utility, for a non-profit purpose, and without being traded on any exchange, will it then probably not satisfy this element and be able to escape being defined as a security.
4. Derived from the efforts of others: If the token has no value other than that derived from the development efforts of the ICO-issuer, or the exchanges that promote the token, profits are derived solely from the efforts of others. However, where a token has a completely independent utility that the token-holder can use to create value, such as Filecoin (holders can use tokens to store files) or Golem (holders can donate computer power or use other holders’ computer power in exchange for the token) there is a chance that it may not meet this final element.

To understand the application of the Howey test, we’ll look at two famous examples:

Do Bitcoin and Ether (2018) meet the elements of the Howey Test?

Is Bitcoin a security?

1. Investment of money — In SEC v. Shavers (cite: SEC v. Shavers, №4:13-CV-416 (E.D. Tex. Sept. 18 2014) a federal judge held that the fact that bitcoin is a measure of value, used as a form of payment and method of exchange, is sufficient to be considered ‘money’ for the purposes of this prong, even though it does not have legal tender status.Conclusion: Meets Howey Test

2. Common enterprise — bitcoin is not limited to a specific venture or common enterprise; there is no controlling entity.Conclusion: Does NOT meet Howey Test

3. Reasonable expectation of profits — considering bitcoin does not confer additional rights, such as a utility provided by smart contracts, the primary reason to purchase bitcoin is for an expectation of profits.Conclusion: Meets Howey Test

4. Derived from the efforts of others — there is no specific controlling entity or managerial staff working on the platform and driving profits.Conclusion: Does NOT meet Howey Test

Even though most people are buying bitcoin with an expectation of profits, the fact that no specific issuer is benefiting or driving the value means that the “common enterprise” and “efforts of others” prongs from the Howey Test cannot be satisfied. For this reason, bitcoin is not considered a security.

Is Ether a security?

1. Investment of money — Ether will be considered an investment in money under the Shavers analysisConclusion: Meets Howey Test

2. Common enterprise — in 2014 when Ether was issued, the Ethereum Foundation was a controlling entity. Today, however, the Ethereum Foundation is so distantly removed that anyone purchasing Ether would not be investing in a common enterpriseConclusion: Does NOT meet Howey Test

3. Reasonable expectation of profits — an argument exists that initial investors in Ether were purchasing smart contract functionality and were not purchasing Ether with an expectation of profits. Today, most investors will be purchasing Ether because of an expectation of profits.Conclusion: Meets Howey Test

4. Derived from the efforts of others — Unlike its situation in 2014, it is no longer controlled by a single specific entity.Conclusion: Does NOT meet Howey Test

Whether or not Ether was a security at the date of issuance, the cryptocurrency’s relationship with the Ethereum Foundation is now so distantly removed that anyone purchasing Ether would not be investing in a “common enterprise” driven by the “efforts of others”. Therefore, Ether in 2018 is not considered a security.

In June 2018, the SEC officially ruled that Bitcoin and Ether are not securities (to the relief of us all).

So, it appears cryptocurrencies can transition from a security to a utility/currency, and maybe even back again several times. This leads us to contemplate several unanswered questions:

1. If a token was once a security, can the SEC retroactively penalize the issuers even if they are no longer involved or actively driving profits?
2. How will crypto exchanges know whether they are listing security tokens when there is no bright line test?
3. If a crypto exchange lists a utility token that then becomes a security token, will they need to delist the token and how can this be actively managed?

If tokens are fluid and can be a security one month and then not the next, it will be impossible for issuers to adequately comply with the applicable regulation and it will be a huge administrative burden on the SEC to determine whether issuers are in active compliance.

How do I issue a security token?

So, you have just determined that your token is a security. How do you issue it? Do you have to go through an IPO? Fortunately, there are exemptions to security registration requirements and most ICO-issuers are currently taking advantage of the options under SEC Regulation D. Regulation D allows companies to raise an unlimited amount of money through the offer and sale of securities, and does not require any registration or disclosures. It does, however, require that:

1. Securities are only offered to “accredited investors”; and
2. The company needs to take reasonable steps to verify that the investors are accredited

So what is an “accredited investor”? It is a natural person who can prove that:

1. He/she earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year, OR;
2. He/she has a net worth over $1 million (excluding the value of the person’s primary residence) either alone or together with a spouse.

Any securities sold under this provision will need to be “locked-up” for at least 6 or 12 months to ensure that the accredited investors do not re-sell the securities to non-accredited investors. This means that trading will be limited and the issuer will not be able to apply to list the token on exchanges. Whether there are further limitations on advertising and offering depends on which exemption is used under Reg D, and which exemption to use will depend on the specifics of the ICO-issuing entity’s structure.

🇱🇷 Where can you trade crypto, and is it legal?

So, you have found a way to issue your token and you want to make it available for trading. Can you list the token on an exchange? Where can you buy security tokens?

Whether a crypto exchange can list your token depends on whether it is a utility or security token. Any crypto exchange can list a utility token, but any crypto exchange trading security tokens is in violation of the Securities Exchange Act if the site is not registered as a national exchange or an alternative trading system (ATS). How many operational exchanges are registered as a national exchange or ATS? None (although three are nearly operational -Templum, SharesPost and tZero).

Does this mean all operational exchanges are in violation of the Exchange Act? Maybe not.

What is an exchange under U.S. Federal Law?

The Exchange Act defines an ‘exchange’ as an organization, whether incorporated or unincorporated, that provides a marketplace for bringing together purchasers and sellers of securities, or performing functions commonly performed by a stock exchange. The test for whether or not an exchange meets this definition is as follows:

1. Does the organization bring together the orders for securities of multiple buyers and sellers; and,
2. Does the organization use established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and where buyers and sellers entering such orders agree to the terms of a trade?

Most centralized exchanges will undoubtedly meet this definition. This means that the centralized exchanges that are trading security tokens are probably operating illegally. A lot of popular US exchanges, such as Coinbase, are in communication with the SEC to remedy this by seeking regulation as an ATS.

How can a U.S. exchange become an ATS?

One of the reasons many U.S. exchanges haven’t already registered as an ATS is because it can be a lengthy and costly procedure. There are several steps required;

1. Step 1 — the exchange must register as a broker-dealer with the SEC
2. Step 2 — the exchange must register as a broker-dealer with FINRA
3. Step 3 — the exchange must file Form ATS to notify the SEC of trading activities
4. Step 4 — the ATS must comply with regular lengthy disclosure requirements

Each step requires filing fees that can be significant, and also requires principals of the exchange to; 1) disclose their residential/employment history; 2) provide fingerprints; 3) disclose criminal convictions and civil judicial judgments; 4) prepare detailed business plans; 5) disclose their sources of capital, and 6) undertake an oral examination with agents at FINRA.

While many exchanges are keen to move forward and work under regulation, the application process to become an ATS is lengthy, costly and difficult to meet for start-up exchanges working with minimal capital.

Where can I list or buy crypto?

If your token is a security and you want to list it on an exchange, you may not be able to until any of the three ATS’s mentioned above are operational. Most centralized exchanges, such as Bittrex, now require a legal token opinion on the utility status of a listing applicant’s token. Attorneys will not write an opinion stating that your token is a utility if it isn’t, so if you want to be listed on a centralized exchange you may be out of luck. But do not despair, in some instances decentralized exchanges may be in the market to offer both utility and security tokens.

In May 2018, Coinbase acquired decentralized exchange Paradex. In an interview with CNBC, Coinbase COO Asiff Hirji stated “we bought Paradex, which is the leading relay in the world… and this will allow you to trade literally hundreds and hundreds of tokens from your own wallet and we are actually going to make that compliant with the US rules.” When explaining how Coinbase plans to do this, Mr Hirji explained that they intend to use Paradex not as an exchange but as a bulletin board. Paradex will be completely decentralized, will allow users to trade from their own wallet, and instead of using a matching engine, it will use a bulletin board mechanism — the underlying logic of this mechanism, however, has not yet been specified.

Consequently, this decentralized “bulletin board” method will most likely not meet the definition of an exchange under the Exchange Act, which means they will be able to offer utility and security tokens without any requirement to register with the SEC. Once Coinbase’s bulletin board is operational, issuers can apply to list their security tokens on the site and public investors can buy security tokens from the site without accreditation requirements.

💵 How can I sell or buy crypto for fiat?

Money services businesses in the U.S.

Any exchanges acting as financial intermediaries, considered “money services businesses”, providing crypto-to-fiat or fiat-to-crypto transfers must hold a money services transmitter (MST) license. Most large exchanges in the US including Bittrex, BitFlyer, BitStamp, Coinbase, Gemini, itBit and Poloniex all possess MST licenses. Kraken is one of the only exchanges offering fiat transfers without an MST license.

Individuals can safely purchase from money services businesses and know that the businesses are accountable for any losses of funds. Exchanges or ICO-issuers seeking to offer transfers of crypto-to-fiat across the U.S. and to U.S. individuals must apply for an MST license in all states and territories which require it, which is 53. Obviously this is a lengthy process and it can take years to amass all 53 licenses. During this time, to ensure services aren’t being performed in contravention of the Bank Secrecy Act, money services businesses must use IP-identifying software to block any potential purchasers from states where they are not yet licensed.

Can U.S. residents purchase crypto (fiat-to-crypto) from foreign exchanges?

While there are no laws preventing U.S. residents from purchasing crypto from foreign exchanges, a lot of foreign exchanges, such as Bitfinex, that are unregistered in the U.S. have chosen not to accept trades from U.S. residents. The temperature of the regulatory water in the U.S. is heating up and a lot of exchanges have chosen to avoid investigation from the SEC by ceasing relationships with U.S. customers altogether. Many foreign-based exchanges are open to U.S. nationals, but if they are offering services to U.S. customers they should be registered as a national exchange or an ATS.

How much crypto can I withdraw?

Crypto-to-fiat sales are limited by the liquidity of an exchange. If a trader tries to sell $10M worth of crypto, the exchange can only process the transaction and make a payout if it has $10M in fiat available. Crypto exchanges are not subject to any specific liquidity requirements which means they do not need to keep a consistent minimum.

In the early 1900’s, when trust companies were created to serve as a cross between a bank, stock exchange and hedge fund, they were also completely unregulated and lacked reserve requirements. The lack of liquidity requirements ultimately resulted in a massive depositor’s run that wrecked many trust companies and led to the ‘Panic of 1907’. This could be a parallel of today’s crypto problems; crypto-exchanges take in fiat deposits and give out crypto, but what happens if larger companies make massive withdrawals? Cryptocurrencies are so volatile that one whale in the ocean making a large transaction can substantially change or even crash the market.

Exactly how much can be withdrawn from each exchange and the state of their liquidity is very unclear, especially considering many exchanges are massively overestimating their trading volume.

👀 Can I trade anonymously?

A lot of cryptocurrency supporters are loyal to the means of payment primarily because of its anonymity. Many exchanges and ICOs allow you to purchase tokens without any identification requirements other than an email address and password. While this feature is convenient and private, it does open up the industry to money-laundering.

Exchanges registered as money services businesses, such as those discussed above, are all subject to strict anti-money laundering and know-your-customer (AML and KYC) regulations that seek to prevent money-laundering and require businesses to flag suspicious transactions. The Bank Secrecy Act requires all money services businesses to record and report transactions by a single customer if they aggregate more than $10,000 in one day. In 2014, a criminal investigation was instigated by FinCEN against Ripple Labs Inc., for their failure to report suspicious transactions and for dealing with customers with prior felony convictions for dealing with explosive devices. In 2015, Ripple agreed to settle for a $700,000 civil penalty.

Many exchanges licensed as money transmitters are required to obtain photographic identification before they can allow any crypto-to-fiat trading to ensure they are following counter-terrorist-financing and AML regulation. Since identification is now also required by most ICOs issued only to accredited investors, it is becoming increasingly difficult to anonymously purchase and sell crypto for fiat.

As cryptocurrencies grow in popularity, the ability to trade completely anonymously will decrease because the US federal government will impose more stringent AML/KYC regulations. However, individuals seeking anonymity can still trade on most decentralized exchanges — these exchanges generally don’t require AML/KYC implementations because, as of yet, they are unregulated.

💰 How do I pay taxes on any gains or income?

How do I pay taxes when selling crypto for fiat?

In 2014, the IRS released a tax notice clarifying that for federal tax purposes, virtual currency is treated as property, not a currency capable of generating foreign currency gains or losses. The notice explained the several types of tax liability that may be incurred;

1. Ordinary income — taxpayers who receive virtual currency as payment for goods and services must include the amount received in their calculation of gross income.
2. Mining income — virtual currency earned through mining will be subject to income tax.
3. Capital gains — virtual currency will be treated as a capital asset unless it is being held to sell to customers. The capital gain subject to tax is the excess of the final sale price over the original cost basis of the asset.

The notice prescribes that all gains or income made from virtual currency transactions must be reported in U.S. dollars on all tax returns. The “fair market value” of the virtual currency must be calculated as of the date of purchase, receipt or payment, which is taken to mean the exchange rate listed on major (unspecified) exchanges. The IRS included this time sensitive requirement to compensate for the massive fluctuations in value of virtual currency. However, the consequence is that in order to calculate capital gains and losses, every single purchase and sale of virtual currency must be recorded. There is no de minimis exception to this gain or loss recognition, which means taxpayers must track their crypto basis continuously to report gains or losses, whether it is for 100 bitcoin or 0.000000001 bitcoin. For day-traders, swing-traders or those using virtual currency to pay for smaller services, as is becoming common, the feasibility of logging every single transaction is laughable.

Yet, despite the prevalence of cryptocurrency transactions and constant requests by taxpayers for clarification, the IRS has not released any further explanatory guidance since their 2014 notice.

How do I pay tax when selling crypto for crypto?

The 2014 IRS notice did not provide any guidance on whether crypto-to-crypto transactions are considered “like-kind” sales exempt from capital gains tax. A 1031 exchange is a swap of a like-kind business or investment asset for another. In the IRS’ 2014 guidance, they stated that cryptocurrency is property, not currency. As a consequence, most investors and businesses believed for many years that a sale of Bitcoin for Ether would not be a taxable event because it is exempt as a “like-kind” transaction.

Unfortunately, on December 22nd, 2017 the Tax Cut and Jobs Act was signed into law and amended the Section 1031 filing. The major change was a complete repeal of personal property exchanges, which means that the 1031 filing is now exclusively limited to real estate assets. The law states “an exception is provided for any exchange if the property disposed of by the taxpayer in the exchange is disposed of on or before December 31, 2017, or the property received by the taxpayer in the exchange is received on or before such date.” This effectively means that any like-kind crypto exchanges before December 31, 2017 may be exempt, but anything after that date is 100% taxable. In effect, any gains made through crypo-to-crypto trades are taxable even if gains haven’t been realized in fiat. This means that crypto may need to be converted to fiat in order to pay taxes, but tax liability will be realized on that sale… so crypto may need to be sold in order to pay that tax, but tax liability will be realized on that sale…and now we have Tax-ception!

We’re sure day-traders and swing-traders will have a great deal of fun preparing next year’s tax returns!

This article is legal information and should not be seen as legal advice. You should consult with an attorney before you rely on this information.

Originally published at tokenarcade.com on June 17, 2018.