By Steven Singer CPA
In my previous articles, I covered how cryptocurrency is taxed, hard and soft forks, and minimizing the tax effects of cryptocurrency transactions. This article addresses how you can diversify risk by contributing your cryptocurrency to a partnership or corporation in exchange for an interest in the entity.
In the future, I will be covering the following topics:
• If I want to donate cryptocurrency, what are the appropriate steps, and what should I look out for?
• How do I protect my cryptocurrency from being stolen?
• What is the best way to incorporate these alternative assets within my estate planning?
• What do I need to tell my CPA and my estate attorney regarding where I hold them?
Many of our highly successful entrepreneurs and family office clients who invest in startup companies constantly challenge me for ideas on how to diversify their risk profile, while generating higher returns and pay less taxes. Due to the way their investment portfolios are constructed, many of them are able to invest directly or through different entities in startup companies, and hold their investments in these companies for years, until they can realize an above market rate of return.
Did you know, if done properly, you can contribute your appreciated cryptocurrency tax-free to a partnership or corporation?
By doing so, you can effectively convert your appreciated cryptocurrency into corporate stock and defer paying taxes on the appreciation until a later date.
CONTRIBUTING CRYPTOCURRENCY TO A CORPORATION TAX-FREE
Exchanging your appreciated cryptocurrency solely for corporate stock can result in tax-free treatment to both the corporation and you as the investor. There are just a couple of items that you need to know so you do not inadvertently realize a gain on contributing your cryptocurrency.
To obtain tax-free treatment you, together with all other persons who transferred property as part of the same transaction for the corporate stock, must own 80% of the voting power and non-voting stock of the corporation immediately after your transfer. This is not hard to accomplish if one of the persons is the founder of the company and is an early stage company or at a later round with other significant investors.
Additionally, you must do your due diligence to make sure that the company you are contributing your cryptocurrency to is not considered an investment company. An investment company is a company that holds at least 80% of its assets (by value) in stocks, securities, cash, notes, options, foreign currency, certain financial instruments, precious metals, interests in REITs, and ownership in entities holding such assets. Usually startup technology companies do not qualify as investment companies as their most important asset is the technology they are contributing or already own.
Lastly, even if you inadvertently contribute your cryptocurrency to an investment company, you could still get tax-free treatment if your contribution does not result in diversification of your contributed cryptocurrency. To result in diversification, two or more persons must transfer nonidentical assets to a corporation in exchange for stock and the transfer of your cryptocurrency must be significant. To be insignificant, your transfer of appreciated cryptocurrency must be 5% or less of the total value of the assets transferred. If you are concerned about this rule, you could always find another investor who has the same type of cryptocurrency so you both are contributing the identical type of cryptocurrency. There is no diversification issue if all the assets contributed are the same type of cryptocurrency.
If you try to contribute cryptocurrency that you could sell at a loss, the above strategy is not for you. You would be better off if you sold the cryptocurrency and recognize the loss and contribute the cash. Tax-free exchanges of assets for stock which the investor’s cost basis is below the fair market value results in the investor forever losing the benefit of the loss on contribution or on ultimate sale of the stock you received.
In the end, you may be lucky enough that the Company has a big liquidity event. As a result, you may be eligible to exclude up to $10 million of the gain if the Company qualifies for qualified small business stock treatment.
To learn more about how to qualify for this benefit, please visit our website at www.groco.com and search for qualified small business stock (QSBS).
CONTRIBUTING CRYPTOCURRENCY TO A PARTNERSHIP TAX-FREE
Another strategy for diversifying your ownership in appreciated cryptocurrency is exchanging your cryptocurrency for an interest in a partnership. Just like an exchange of cryptocurrency for corporate stock, this can also result in tax-free treatment.
Obtaining tax-free treatment for contributing appreciated cryptocurrency to a partnership is much easier than exchanging directly for corporation stock because the 80% Corporate ownership rule above is not applicable to transfers to partnerships. Other than that, you would follow the same steps (which I outlined above) as you do as if you were contributing your cryptocurrency to a Corporation in exchange for stock.
Instead of looking at Corporate entity for the determination of whether it is an investment company, you would look to the partnership you are contributing to in determining if it is an investment partnership. The definition of an investment partnership and investment company are the same for determining if the entity is an investment entity.
One additional strategy we use with partnership entities and avoid the classification of an investment partnership, is contributing appreciated real estate to the entity before contributing your appreciated cryptocurrency. If the value of the real estate constitutes more than 20% of the value of the partnership before the time of transfer, the partnership is not considered an investment partnership. We recommend waiting a while before transferring your cryptocurrency to the partnership if you have recently transferred appreciated real estate.
One downside aspect of contributing appreciated cryptocurrency to a partnership is if the partnership decides to sell it. If you contribute appreciated cryptocurrency to a partnership, and that partnership should sell it as well, you as the contributing partner will be allocated the gain up to the amount of the appreciation at the time of transfer to the partnership. Any gain in excess of the appreciation at the time of transfer is split between the partners. This is unlike contributing cryptocurrency to a Corporate entity where the Corporate entity (if it is not an S Corporation) pays the tax.
Contribution of unappreciated cryptocurrency to a partnership is not recommended. You should sell your cryptocurrency at a loss and then contribute cash to the partnership so you can personally utilize the loss.
The strategy of contributing your appreciated cryptocurrency to a Corporation in exchange for stock also works well with a partnership entity. If the partnership exchanges the appreciated cryptocurrency you contributed for stock of another corporation, you and your partners will get the same benefits as that of an individual who invests directly in a Corporation.
Finally, in addition to the tax-free benefit of exchanging cryptocurrency, forming a family partnership is one way for our family office clients to get the younger generation involved in the decision and investment- making process. We have found that the younger generation likes investing in cryptocurrency and in many cases are better at understanding these concepts then their older counterparts. It is another way that they feel they can contribute without competing with their parents.
I act as a lifestyle advisor and collaborator for our high net worth families. By assisting them in preserving their wealth, and effectively transferring that wealth to the next generation, we educate the family and their children on how to achieve their family objectives. If their objective is achieving social development goals through impact investing, we can recommend and monitor their wealth advisors.
Let us know how we can assist you and your family.
My next article will address how to safeguard your cryptocurrency. If you enjoyed or found this, or any of my articles helpful, please feel free to share them with your friends and colleagues.