The IRS Is Changing Crypto Bankruptcy With $44 Billion Of Claims Against FTX: Considerations For Investors

As if the fallout from FTX had not harmed crypto enough, the IRS seeking to prioritize billions in claims is making things even more painful.

The saga of the dramatic rise and fall of FTX has been covered extensively in financial markets the world over, but the reality is that the unraveling of the over 130 entities connected to FTX via the bankruptcy courts is going to take years. While some investors, notably those with funds on deposit at FTX Japan, have been able to access and withdraw funds since February, U.S. investors are stuck waiting for the bankruptcy proceedings to eventually unfold. As if the regulation-by-edict approach of the Securities and Exchange Commission was not enough, the IRS is further contributing to the uncertainty, ambiguity, and anxiety for investors.

The IRS has filed 45 claims totaling $44 billion against FTX and its affiliated entities, including a pair of claims – $20.7 billion and $7.9 billion – against Alameda Research that are specifically related to unpaid partnership taxes. Worryingly for investors and depositors, the IRS has labeled these claims as administrative priorities, which enables these claims to supersede those of unsecured creditors. As of April 2023, the legal team from Sullivan & Cromwell had recovered $7.3 billion in liquid assets, and FTX CEO John Ray is still considering a potential relaunch.

That is all well and good, and hopefully will allow investors and depositors to recover these funds, but the IRS claims 1) going to prove a significant challenge for the bankrupt exchange to cover, and 2) have the potential to redefine the planning and tax strategies that crypto organizations will need to discuss going forward. Given the fact that the IRS, generally speaking, does not take such an active role in bankruptcy cases, there are several implications that investors and crypto developers should take note of as these actions continue to unfold.

Reasserting Regulatory Leadership

It is no secret that the U.S. regulatory landscape for crypto continues to be murky, ambiguous, and increasingly antagonistic. With the SEC continuing to state that most crypto should be registered as a security without providing criteria to do so, Congress unable to pass (much less bring for a vote) legislative solutions, and the accounting standard setters only slowing getting into the game, the IRS looks set to reassert itself in the regulatory conversation.

Specific items that investors and depositors should keep an eye are that 1) crypto exchanges and entities are not treated as unique items under U.S. tax law, which forms the foundation of several claims levied by the IRS against Alameda, 2) entrepreneurs and investors who found and invest in companies headquartered overseas, but who are U.S. citizens, are still subject to the totality of U.S. tax laws, and 3) that the IRS continues to look upon crypto as a revenue raising opportunity.

All About Customers

The IRS has been active in obtaining customer lists from firms such as Coinbase, Kraken, and others including Circle; this serves a dual purpose. Firstly, this provides the IRS with an active listing of customers of exchanges, trading history, and helps the Service put together an audit trail in order to assess and collect taxes owed from both the individual and institution. Building on the regulatory focus that has continued to shift toward more of a regulation-by-edict and aggressive approach, the IRS has not been shy in pursuing collection of crypto liabilities. Collecting and assembling these customer lists will only facilitate the ability of the IRS to track, assess, and collect taxes owed by U.S. taxpayers.

Given the regulatory turmoil that has surrounded the collapse and bankruptcy of FTX, including the controversy around the political contributions made on behalf of both FTX and Samuel Bankman-Fried, it makes sense that the IRS would be interested in these customer lists. One of the most commonly cited concerns about crypto repeated by policymakers is that there is a lack of transparency and accountability for crypto traders and investors.

By inserting itself prominently into the bankruptcy proceeding, the IRS is also putting itself in a prime position to get even more information on the customers of FTX and other exchanges.

More Token Delistings

An additional effect of this IRS scrutiny is that, combined with the crackdown coming out of the SEC, is that the crypto marketplace is in the middle of a massive reset. With the number frauds, as well as the financial costs of these frauds, causing billions in economic damages, it makes sense that regulators will take a much harder look at the tokens themselves. As several prominent tokens have been delisted, including by U.S. exchanges like Coinbase, the increased interest and scrutiny being shown the IRS seems set to only further amplify this trend.

It makes sense from a business and reputational perspective. If the IRS is investigating an exchange or issuer for compliance matters, seeking customer lists and trading information, and is sharing this data with other regulators, specific tokens will invariably find themselves under higher levels of pressure. Such an event is good for the space, and will improve the quality and transparency of tokens moving forward, but will lead to short-term dislocations and volatility. Either way, the IRS is going to have many more questions for every entity and individual involved with the crypto sector.

The IRS has taken an unusually strong interest in the FTX bankruptcy, and this will have implications for the entire crypto space moving forward.

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