Regardless of whether you are an emerging fund manager or possess extensive experience, a frequently asked question among virtual currency fund managers is the possibility of contributing appreciated virtual currency assets to pooled investment partnerships or hedge funds, as well as the associated tax implications. Allowing contributions in-kind of virtual currencies could be a way of raising capital within the fund, but there are potential tax implications that need to be considered.
Current IRS Treatment of Virtual Currency
While virtual currencies are thought of by many as cash or currency, they are viewed by the Internal Revenue Service more similarly to securities, specifically property, and are therefore generally subject to capital gain and loss tax treatment. Until further guidance is provided, Notice 2014-21 is the standard for the treatment of virtual currencies. In the notice, the IRS noted that Bitcoin and other virtual currencies are to be treated as property for tax purposes, and as such, general tax principles associated with the sale or exchange of property apply to all virtual currencies. It is also specifically noted that virtual currency is not defined as “foreign currency”.
In-Kind Contributions and Tax Treatment
Applying the guidance set forth in Notice 2014-24, the initial tax effects of contributing virtual currency directly to hedge funds follow the rules for contributing other types of property under IRC §721(a). Generally, under IRC §721(a) there is no gain recognized on the transfer of property in exchange for a partnership interest. However, there is one exception that pertains to hedge funds and other similar vehicles which, based on its nature, could target a large number of unsuspecting virtual currency funds due to their often undiversified nature. If a property contribution is made to an “investment company” that results in the “diversification” of the contributor’s assets, then the contribution event is taxable related to unrealized gain positions, not loss, upon contribution. For further information regarding diversification rules, please refer to our most recent insights available here.
Nuances in Virtual Asset Contributions
Adding virtual assets comes with important details to consider. You must carefully record the original cost, fair market value, quantity, and acquisition date for each asset at the time of contribution. This information should be promptly shared with your administrator and tax advisors. This recordkeeping is crucial because you’ll need to identify and track specific coins within your wallet when they’re sold. Given that virtual currencies are often transacted in fractions, keeping precise records is essential for accurate gain calculations and holding period determination when the coins are eventually sold. Failing to properly track this information could have adverse tax consequences for the contributor. If the in-kind assets are unidentifiable amongst the portfolio, the transaction may be deemed to be taxable to the contributor on the date of contribution.
Importance of Diligent Tax Planning
As is often the case with tax, there are exceptions to the exceptions, and careful tax planning should take place when considering any transaction, especially those that could cause unsuspecting taxable events. As with all tax matters, exceptions may arise, making comprehensive planning essential to mitigate potential risks. It is advisable to consult with a qualified tax advisor or a Richey May specialist to ensure proper application of these rules.
If you need more help understanding the tax impact of contributing virtual currency in-kind to hedge funds, please reach out to Steve Vlasak, Business Development Partner for Alternative Investments Practice.
