Cryptocurrency holders often want to put their assets into an entity for a host of reasons, such as asset protection, arranging negotiated management rights and exit planning.  This post discusses basic federal income tax issues related to holding cryptocurrency inside a partnership (meaning any entity taxed under Subchapter K* of the Internal Revenue Code; the “Code’).

Partnership Investment Company Basics

The IRS treats cryptocurrency as a form of property, and generally the Code does not immediately tax property contributions to partnerships.  However, there are important exceptions to the nonrecognition rule, the most prominent of which is Code Section 721(b).  The foregoing exception states that the general nonrecognition rule does not apply for a transfer to a partnership that would be an “investment company” under Code Section 351.

The Treasury Regulations provide that a transfer of property is treated as a transfer to a partnership investment company if two conditions apply.  First, the transfer results in “diversification” of the transferor’s interests, and second, immediately after its receipt of property, more than 80% of the value of the partnership’s assets (excluding cash and nonconvertible debt obligations from consideration): (i) are held for investment purposes, and (ii) consist of readily marketable stocks or securities.  Diversification requires each investor to transfer different appreciated assets to the same partnership (contributing identical assets obviously provides no diversification).  With respect to the ultimate composition of contributed assets, a portfolio is considered diversified when not more than 25% of the total assets of the partnership are invested in the stock or securities of any one issuer, and not more than 50% of the value of total assets is invested in the stock and securities of five or fewer issuers.  Stated differently and simplistically, the diversification rule is one of the Code’s toll charges on attempts to use Subchapter K to create “mutual fund” type investments on a tax deferred basis.

If a cryptocurrency is classified as a “commodity” under the Code, it may avoid the partnership investment company rules, because commodities are not included in the definition of “stock or securities” on which such rules rely.  However, while unlikely, if a cryptocurrency is considered to be a form of financial contract, obligation to pay, or money (under the Code, “money” has classically been interpreted as the physical, electronic, or book representation of currency issued by the U.S. government), then the partnership investment company rules could be applicable.  Cryptocurrency holders would be wise to review any new guidance discussing cryptocurrency classification. Also, as new guidance is released the partnership rules must be reexamined to determine if any assumptions on treatment are still accurate. A partnership agreement, for example, may need to be amended to account for new guidance and memorialize any necessary changes.

General Allocation and Distribution Concerns

Cryptocurrency may have a tax basis different from its value.  That raises several partnership tax concerns.  First, contributors of appreciated property typically have to account for the built-in gain existing at the time of contribution whenever the partnership disposes of such an asset.  Second, if the partnership attempts to distribute appreciated cryptocurrency to a non-contributing partner, the Code’s mixing bowl rules may apply.  The mixing bowl rules attempt to prevent both (i) shifting pre-contribution gain to a non-contributing partner and (ii) exchanging non-like kind property on a tax-free basis.

In the case of partnership distributions, the Code treats the distribution of marketable securities as money instead of property.  When partnerships distribute money to partners in excess of the partners’ tax bases in the partnership, gain results (this does not apply if (a) property is returned to the contributor; (b) the partnership is an investment company; or (c) the partner is an “eligible partner”, which exceptions are beyond the scope of this post).  Thus, cryptocurrency classification again becomes important.   If the IRS issues future guidance indicating cryptocurrencies are monies, or courts issue rulings finding the same, partnerships that hold such assets will need to evaluate their distribution policy and partnership agreements.

Even more esoteric partnership accounting issues arise when considering “reverse section 704(c) allocations” for partnerships heavy on cryptocurrency assets.   Reverse section 704(c) allocations arise when a partnership “creates” a book-tax difference by booking up or down its assets (e.g. such as when a new partner joins a partnership).  The Treasury Regulations have special reverse section 704(c) rules for “securities partnerships”.  A securities partnership is one that is not registered under the Investment Company Act of 1940 and (i) makes book allocations relative to book capital accounts, excepting reasonable special allocations for management services; (ii) on each book-up/down date, the partnership holds qualified financial assets that comprise at least 90% of the fair market value of the partnership’s non-cash assets; and (iii) the partnership reasonably expects, as of the end of the first tax year in which the special rules are adopted, to revalue (book-up or down) at least annually.  The special rules essentially allow securities partnerships to aggregate gains and losses from qualified financial assets using any reasonable Code Section 704(c) method.  For these purposes, qualified financial assets are actively traded personal property.  Certain cryptocurrencies may well be considered qualified financial assets, so the securities partnership rules may come into play.  In such cases, partners should carefully review their partnership agreements to ensure they do not receive unwelcome allocation surprises.

*Partnership tax rules are very complex.  This post is neither exhaustive nor intended to provide a detailed discussion of how Subchapter K applies to cryptocurrency investors. Specific questions should be addressed based on the individual facts and circumstances of the transaction and taxpayers involved.