Crypto After the Crash

Strategies for Resolving Litigation Disputes

The cryptocurrency market is down approximately 57 percent for the year as of the time of this writing. For many, this news may bring a feeling of JOMO (Joy of Missing Out). For practitioners involved with crypto-litigation, however, it just further complicates a complex subject matter. This article explores the considerations and strategies to help resolve these types of cases during times of uncertainty, including financial forensics, asset divisions, income, taxes, and other topics. Each of these are discussed below.

The cryptocurrency market is down approximately 57 percent for the year as of the time of this writing. For many, this news may bring a feeling of JOMO (Joy of Missing Out). For practitioners involved with crypto-litigation, however, it just further complicates a complex subject matter. This article explores the considerations and strategies to help resolve these types of cases during times of uncertainty, including financial forensics, asset divisions, income, taxes, and other topics. Each of these are discussed below.

Financial Forensics

Finding crypto data is just the beginning, and often involves a separate forensic engagement with qualified analysts to help identify transactions and remaining holdings. While the particulars of these investigations are beyond the scope of this article, the discovery process has improved through a combination of tax disclosures,[1] increasing number of exchanges,[2] and widespread acceptance.[3] Regardless, the tracing of these transactions may be expensive and ultimately unnecessary if the funds cannot be seized at the end of the day. This process may also uncover potential tax liabilities from prior transactions, which add to the complexity of the case (see further discussion below).

Often, forensic analysts will trace the transactions and prepare balance sheets, income statements, and “statements of crypto flows”.[4] These reports will help clients understand the flow of funds and remaining balance(s), location of the transactions, accounts receiving the funds, who controlled the assets, and more. Once prepared, the reports can then be used in conjunction with the other assets and liabilities in the case to facilitate a property settlement, assess the costs/risks of transferring the crypto assets,[5] and understand the recurring income (if any). The State/Federal jurisdictional rules can help practitioners navigate the division of assets or reimbursement claims.

There are ongoing changes within the crypto space which may further improve transparency. Examples include crypto 401(k)s and social media accounts connecting to crypto wallets.[6] The Infrastructure Investment and Jobs Act (IIJA) also expanded the reporting requirements for “brokers” to report Form 1099-B filings for transfers of digital assets and Form 8300 for crypto payments over $10,000.[7] 

Asset Division Strategies

After the forensic discovery, the next step in the analysis is to determine the value of the virtual assets. This process is straightforward if the assets are in parties’ custody though additional considerations may be required if the assets have been disposed. In addition to currencies, virtual assets may also take the form of a blockchain token, such as Nonfungible Tokens (NFTs). NFTs represents ownership in a unique digital item and have become popular Web3 investment vehicles, with an estimated $37 billion transacted in the first four months of 2022.[8] To illustrate, a CryptoPunk NFT sold for $24 million this year, more than double the previous record.[9]

Both cryptocurrency and NFT values are reported on major exchanges, though precision is required to accurately measure the value due to the continuous trading of the assets.[10] Note that the asset division should include any offshoots from the main currency that resulted from a “fork” in the blockchain (think Bitcoin Cash, Bitcoin SV, Ethereum Classic, etc.).[11] 

For crypto that has been disbursed or sold, the Court may face various dates from which to ascribe disputed asset values (time of transfer, conversion, separation date, trial, etc.). The selection of the measurement date and corresponding value may depend on the facts and circumstances of the case and the party who initiated the transaction may bear the burden to provide documentation to support their position for how the funds were used. This dilemma is compounded during times of uncertainty and illustrated in the following example.

Example 1

Prior to the pandemic, Party A purchased 10 Bitcoins at $10,000 each. In January 2021, the entire balance was transferred to an unknown account when the price was $35,000. Party B moves out and files for divorce in October 2021 when Bitcoin was $50,000. The trial took place in October 2022 when the price was $20,000. Which is the correct value to use for this disputed transaction for the property division (excluding tax considerations)? Party B may advocate for the higher value (separation date) though the reduced value (trial date) complicates the issue.

The Parties in the above example may look to the date other financial accounts (bank, investment, credit cards, etc.) are divided to resolve the situation. Party A’s actions (especially if intentional concealment) may be considered an advance to his/her portion of the marital estate, resulting in a disproportionate division of assets. If the actual transaction date is used, it may alleviate the need to address why Party B would have continued to participate in a high-risk investment despite significant price volatility.[12] 

Income Considerations

Determining historical income from virtual assets can be as simple as looking at the tax returns. However, the crypto “tax gap” is estimated to be $50 billion per year so a deeper investigation of the situation may be required.[13] There are no dividends or interest payments from cryptocurrencies; rather, the gains or losses are calculated when transacted.

The due diligence process for assessing historical/future income may include an understanding of the following:

• The account holder’s qualifications
• Unrealized capital gains
• Account addresses
• Transaction history
• Trading frequency
• Types of transaction activities (mining, NFTs, conversions, etc.)
• Assets received from hard forks
• Type of payment (gambling winnings, payroll, services rendered, etc.)
• Any “airdropped” tokens[14]
• Development history of digital assets

The practitioner can use these (and other) factors to assess the likelihood of recurring income from crypto-related activities. For example, a Bitcoin miner would be expected to have recurring revenue compared to a long-term investor with a one-time capital gain. Even so, mining Bitcoin offers diminishing returns going forward. There are roughly 2 million Bitcoins left to be mined compared to the 19 million currently in existence.[15] With fewer “coins” available to be mined and depressed prices in 2022, practitioners face increasing complexity with predicting income.

If the parties have developed digital assets such as NFT’s there may be a royalty component that affects the determination of future income. While estimating the royalties can be difficult, even for seasoned valuation analysts, the workaround may be to set up a mechanism whereby the parties periodically “settle up” if and when the digital asset generates income. There are other items affecting income if the parties are Influencers or receive funds from their YouTube or other social media accounts though beyond the scope of this article.

Tax Considerations

Virtual currencies and NFTs are taxed as personal property which may involve gains or losses. The IRS has issued some guidance on the taxation of digital currencies and “actively addressing potential noncompliance”.[16] As indicated above, the personal income tax forms require disclosure about virtual currency activities which, along with the return’s supporting schedules, can be used by practitioners to reconcile with the bank accounts, exchange activity reports, etc.

Unlike U.S. dollars, using cryptocurrency triggers a gain or loss on most transactions due to the price fluctuations. These transactions are subject to taxes (either ordinary income for short-term holdings or capital gains for long-term). Any unreported activity would likely face interest and penalties. Since Bitcoin has been around since 2009, there may be significant tax-related liabilities depending on the volume of transactions in the case. The blockchain maintains a record of all the transactions that have ever occurred on the platform and is often referred to “deferred prosecution” by law enforcement. If there is evidence to support unreported crypto-related activities, the case negotiations may shift to innocent spouse relief, quantifying/funding the tax liabilities and estimated penalties, amending tax returns, current year reporting, etc.

Example 2

Using a similar fact pattern from Example 1, Party C received 10 Bitcoins valued at $35,000 each in January 2021 for payment on an invoice. Party C then converts the currency to Ethereum in October 2021 when the value of Bitcoin was $50,000 (total of $500,000 transacted). The gain on the conversion was properly reported on the business return. In October 2022, the assets are scheduled to be divided with a business partner, Party D, when the account value was $200,000. How should the ($300,000) loss ($500k-$200k) be considered in the division? 

Assuming a combined Federal and State long-term capital rates of 20 percent, the value of the settlement could potentially be increased by $60,000 for the benefit of the unrealized loss deduction ($300k*20%). If the assets are not likely to be sold, this may be a negotiated point.

Other Practical Considerations

There are questions to be addressed in the court filings or final agreements. Practical questions to address include:

• Who owns the account?
• Where is the private key?
• What are the steps to ensure private key is protected?
• How do you take custody of virtual assets?
• How much of the holdings, passwords, data, etc. should be disclosed in the agreements?
• Should the assets be converted to USD?
• Is there any trading on margin?
• Any digital assets secured/pledged as collateral for loans?

Sometimes the line between business and personal transactions can be blurred. For example, a recent case by the author involved a personally owned Coinbase account but recorded in the business general ledger. Many of the issues identified above may also apply to business disputes though additional factors include:

• Should business holdings be discounted in a business valuation (DLOM, DLOC, etc.)?
• Does the business report gains/(losses) on appreciated/(depreciated) virtual assets when distributed?
• Should the virtual assets be sold/converted at the business level or personally?
• Are wages paid to employees and independent contractors using virtual currency taxable?
• Does statutory interest apply to damages?

These and other questions should be addressed in the litigation proceedings or settlement negotiations. For readers who are unfamiliar with crypto, utilizing a receiver may be a logical choice to ensure the assets are protected. In addition, there may be additional specialized consultants needed to successfully navigate the situation, including crypto forensic experts, tax specialists, valuation analysts, etc.

Summary and Conclusions

Digital assets are fast-moving targets and the factors involved are nuanced. This article gives readers some strategies and considerations to handle the complexities of litigation in the age of Web3. Dividing digital assets is an important outcome for cases but needs to be in context with the parties’ income, taxes, financial forensics, and other factors. The biggest risk faced in crypto cases is generally contingent tax liabilities—not the embedded gain/(loss) of the current holdings though that can be material, but the likelihood of unreported historical transactions triggering tax, penalties, interest, and other fees. Practitioners should be prepared to analyze the data, quantify taxes (past and present), and communicate the risks of continued investigations with benefits of settlement. Clients may face unfavorable outcomes for their positions absent compelling reasons and supporting documents, especially during times of uncertainty.

[1] Beginning with the 2020 Form 1040, the virtual currency question has appeared on the first page of the return. The 2022 Draft Form 1040 updates the language to: “At any time during 2022, did you: (a) receive crypto as a reward, award, or compensation; or (b) sell, exchange, gift, or otherwise dispose of a digital asset?”. See: https://www.irs.gov/pub/irs-dft/f1040–dft.pdf.

[2] At the time of this writing, there were 272 crypto currency exchanges. This is up almost 40 percent in the last four years. See https://coinmarketcap.com/rankings/exchanges/ and https://www.forbes.com/sites/sarahhansen/2018/06/20/forbes-guide-to-cryptocurrency-exchanges/?sh=31fdaffb2572.

[3] Half of men between the ages of 18 and 49 said they have dabbled in crypto. One in five Americans have invested in, traded, or used cryptocurrency. Source: Thomas Franck, NBC News poll, March 31, 2022.

[4] A phrase coined by Dorothy Haraminac, Director of Forensics, GreenVetsLLC. This is like a statement of cash flows but there is no cash on it.

[5] Cryptocurrency exchanges charge a fee for transactions. For example, Coinbase charges a flat 1 percent fee. In addition, the U.S. Government can impose crypto sanctions so the risks of transferring virtual assets should be considered. For example, in August 2022, the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) sanctioned Tornado Cash in a $7 billion money laundering scheme. See https://home.treasury.gov/news/press-releases/jy0916.

[6] Hayward, Andrew and Farren, Tom, Facebook, Instagram Users in US Can Now Share Ethereum, Flow and Polygon NFTs, Decrypt, September 29, 2022.

[7] See Section 80603 of the IIJA which amends IRC §6045(c)(1) and §6050I(d). The IIJA becomes effective for returns filed after December 31, 2023.

[8] Chainanalysis Website, NFT Transaction Activity Stabilizing in 2022 After Explosive Growth in 2021, May 5, 2022, https://blog.chainalysis.com/reports/chainalysis-web3-report-preview-nfts/. There were nearly 1 million unique addresses that bought or sold an NFT.

[9] Business Insider India Website, CryptoPunks NFT project has set another record for itself, this time worth $24 million, February 16, 2022, https://www.businessinsider.in/investment/news/cryptopunks-nft-project-has-set-another-record-for-itself-this-time-worth-24-million/articleshow/89606075.cms.

[10] Note that the crypto world runs on Coordinated Universal Time (UTC) so the exchange reports may need to be converted to your time zone.

[11] Hard forks are unique blockchains when they split off from the original cryptocurrency. From that point forward, the two currencies will trade under separate symbols, have their own transaction history, and develop unique values. See: Bennington, Ash, Why a Bitcoin Fork is Not a ‘Stock Split’, August 2, 2017, https://www.coindesk.com/markets/2017/08/02/why-a-bitcoin-fork-is-not-a-stock-split/.

[12] The historical price volatility for Bitcoin approximated 70–75 percent since 2014.

[13] Vega, Nicholas, The IRS may be missing out on $50 billion a year in unpaid crypto taxes-and a crackdown is underway, CNBC Website, May 18, 2022.

[14] Airdrops involve blockchain-based projects and developers sending out free tokens to members of their communities as part of a broader marketing initiative. Sergeenkov, Andrey, What is a Crypto Airdrop?, Coindesk.com Website: https://www.coindesk.com/learn/what-is-a-crypto-airdrop/.

[15] Tardi, Carla, How Many Bitcoins Are There?, Sofi Website, July 18, 2022: https://www.sofi.com/learn/content/how-many-bitcoins-are-left/#:~:text=As%20of%20June%202022%2C%20there,19%20million%20currently%20in%20existence.

[16] Internal Revenue Service Website: https://www.irs.gov/newsroom/virtual-currency-irs-issues-additional-guidance-on-tax-treatment-and-reminds-taxpayers-of-reporting-obligations. See also Notice 2014-21 and Revenue Ruling 2019-24 for hard forks. Note: minting NFTs is not a taxable event.

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Jason Pierce, CPA, CMA, CFM, CVA, MAFF, is a Senior Vice President in the Economic Damages and Valuations section of J.S. Held’s Forensic Accounting / Economics / Corporate Finance practice. He specializes in forensic accounting, business valuation, and consulting engagements. He brings more than 25 years of experience in various accounting and finance-related disciplines. Mr. Pierce works with clients on disputes, transactions, fraud, damages, family law, criminal, and estate planning engagements. He has testified as an expert witness in State courts, Federal courts, and in arbitration proceedings. A regular speaker at legal and professional organizations, He also serves as a lead instructor for NACVA’s Master Analyst in Financial Forensics (MAFF) certification program and other courses.

Mr. Pierce can be contacted at (857) 216-9775 or by e-mail to JPierce@jsheld.com.