This is an excerpt from the white paper Tokens of Affection and Disaffection: Taxation in the Age of Bitcoin, Altcoins and Crypto Tokens. To down load the full white paper click here.

A Poorly Fitted Shoe

Over the past few years, the popularity of cryptocurrencies and related digital assets (crypto tokens) built on top of blockchain technology has grown exponentially. Bitcoin’s dramatic 1,300% price surge in 2017 alone imprinted cryptocurrencies in the popular imagination, not only as potential alternative mediums of exchange, but as investable digital assets.

If you count bitcoin, all the alternative cryptocurrencies spawned from the same blockchain technology (so-called altcoins) and crypto tokens (more about them later), these virtual currencies and tokens now number in the thousands. The website itself listed over 2,000 cryptocurrencies and tokens as of October 2018.

Though created for a different purpose than virtual currencies but using the same technology (blockchain’s distributed ledger), crypto tokens and their offerings (referred to as initial coin offerings or ICOs) in particular have surged in 2017 and 2018. These tokens, often used by start-ups to obtain funds to develop their services or products, generally reside on an established blockchain platform (e.g., Etherium) rather than operating as separate blockchains and are intended to provide their holders the future use of the service or product the start-up is planning to develop. Coindesk’s ICO Tracker shows some 343 ICOs in 2017, in total raising in excess of $5 billion. As of October 2018, there were according to the tracker some 460 ICOs for 2018, raising in aggregate approximately $14 billion.

The rapid growth of these virtual currencies and tokens has resulted in a two-fold dilemma for regulators and U.S. tax regulators in particular: on the one hand, the size of this activity and the dollar amounts are too large to ignore, and on the other, the speed at which virtual currencies and tokens have entered financial markets have left regulators little time to build a governance framework.

From a U.S. tax perspective, this has meant that taxpayers acquiring, holding and selling these digital assets and institutions facilitating such activity have been warned repeatedly to comply with tax requirements applicable to such assets, while, at the same time, requirements applicable to such assets remain uncertain or unwritten. It evokes the image of a person walking in poorly fitted-shoes, forced to wear the shoes for fear there are glass shards underfoot.

For institutions such as exchanges facilitating trading in virtual currencies and tokens, tax compliance may require building or acquiring systems that are able to sift through internal platform data to produce required tax reporting to customers and the IRS, with enough flexibility to be updated as new tax guidance is issued. But perhaps another driver for such systems may be customer demand. Whether the tax rules are poorly fitted or not (or perhaps because they are so poorly fitted), customers trading virtual currencies and tokens may increasingly demand that the platforms they trade on assist them in complying with the tax rules. This might mean systems that are able to identify relevant tax data points not only as needed for the institution’s own tax reporting but ultimately all data points existing on the platform that may be relevant for a customer filing a tax return.

For a further discussion of  U.S. tax considerations and challenges for taxpayers trading in virtual currencies and tokens and for the institutions that facilitate such trades, click here to download the full whitepaper: Tokens of Affection and Disaffection: Taxation in the Age of Bitcoin, Altcoins and Crypto Tokens.