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On November 2, 2023, Sam Bankman-Fried was found guilty on all counts in his federal criminal trial in the Southern District of New York.
The most recent superseding indictment was filed on August 14, 2023, and included seven criminal counts such as wire fraud, securities fraud, commodities fraud, and conspiracy counts related to those activities.
This post is part of CoinDesk's Tax Week, presented by TaxBit.
After a multi-week trial, SBF was found guilty on all counts. An appeal of this conviction is likely; plus, the sentencing phase of the prosecution is not scheduled to occur until early 2024. So the saga is not over yet.
But his conviction does provide, in its own way, some clarity for FTX customers waiting to figure out where they stand in the FTX bankruptcy proceeding and the tax treatment of any losses incurred.
The joint FTX bankruptcy
Since November 2022, the myriad of FTX affiliated companies, including Alameda Research, FTX,com (the offshore trading platform), and FTX.us (the U.S. trading platform), have been operating as debtors in bankruptcy.
Customers of both FTC.com and FTX.us have been in a holding pattern with little certainty as to whether they will receive any of their account holdings back either in fiat or crypto.
On July 31, 2023, the debtors filed a draft Plan of Reorganization under Chapter 11 of the bankruptcy code. The draft plan includes a number of upfront qualifiers alerting readers that it is likely to change over time as more information is uncovered, agreements are reached, and assets are discovered and moved back into the bankruptcy estate.
With that said, the draft plan does provide a framework for creditors holding claims against the debtors, including FTX.com and FTX.us customers. Importantly, this clearly indicates that customers will likely not be made whole and that any payout is almost certainly to be received in cash. There is a possibility for an alternate payout with respect to FTX.com customers, but that is only referenced in a footnote.
The draft plan segregates FTX.com and FTX.us customers into two distinct creditor pools, anticipating that funds to pay those pools will be based, at least initially, on fiat accounts or crypto wallets held in the names of each respective entity.
It also carves out creditors with claims based on FTT token or NFT holdings on the debtor exchanges. These creditors are treated separately from the generic FTX.com and FTX.us customer-claimants. Of course, a creditor may hold multiple claims.
Ultimately, creditors are still in a holding pattern as to when and how much of a payout they will receive in bankruptcy. Because creditors are likely not going to me made whole, customers subject to U.S. tax will have questions regarding what tax deductions may be available to mitigate the economic loss incurred.
As explained below, SBF’s conviction likely solidifies one of the most difficult hurdles to overcome for those looking to deduct any losses on their U.S. tax returns — the existence of a theft.
Claiming tax losses
It is important to note that the bankruptcy proceeding begun by FTX in November 2022 did nothing for tax purposes. At that time, nothing had actually been lost by any customer. The bankruptcy filing simply put all activities on pause until the administrators of the bankrupt debtors — FTX’s new management — could figure out what assets FTX and its affiliates held so a plan could be proposed on how to dissolve the companies and pay out as much value as possible to creditors.
Under the tax code, as it has existed since 2018, the amount of a loss can only be deducted in limited circumstances.
As it relates to crypto, a taxpayer could deduct a loss resulting from the bankruptcy if:
The taxpayer was in the trade or business of trading crypto; or
The taxpayer was engaged in the trading of crypto for the production of income and the loss stemmed from a theft.
Generally, the tax code has a pretty high standard for individual’s looking to characterize their trading activity as a trade or business. This avenue likely applies to only a few of FTX’s customers.
Most customers, however, would easily be able to show that their activity on FTX was directed at making the production of income. It is unlikely that the IRS would challenge this characterization since investing activities have traditionally been characterized as activities done for the production of income.
Until SBF’s conviction, the second part was uncertain. Since 2018, deductions for losses need to relate to both the production of income and be the result of a theft. Under the tax code, claiming that a loss is the result of a theft is much more difficult than just saying it was a theft. A taxpayer generally needs to show that a criminal theft occurred.
For the majority of customers-turned-creditors in the wave of crypto-related bankruptcies over the past year, many are grappling with whether their ultimate losses can be characterized as thefts. SBF’s conviction now provides certainty on this front. In light of his conviction and the evidence introduced during the trial, taxpayers are in a good position to claim that losses incurred on either FTX.com or FTX.us were the result of a theft.
Even with this step of the analysis resolved, taxpayers will still need to wait before deducting any losses because the losses are not deductible until there is reasonable certainty as to if or how much of a recovery will be made because that recovery reduces the amount of the loss that can be claimed.
As a closing thought, U.S. taxpayers who are creditors of FTX.com, rather than FTX.us, should speak to their tax advisors about any loss deductions being sought. U.S. individuals were not supposed to be using FTX.com as it was an offshore entity not subject to U.S. jurisdiction, which means activity on that exchange was technically not legal. Although no criminal charges are likely to be brought against U.S. individuals who improperly used FTX.com, the IRS may use the impropriety of that activity to deny any losses claimed.
Tax law in the U.S. has long recognized the government’s ability to deny a tax deduction on public policy grounds where the deduction arose in the context of illegal activity. The court opinions tackling these issues have some mixed outcomes generally based on the facts, but there are cases holding that theft losses incurred during the context of illegal activity are not deductible on public policy grounds.
It is not clear if the IRS would try to take such a position with respect to losses claimed by U.S. users of FTX.com but it is a question that should be discussed with your tax advisor before claiming such a loss.