Discussion of Tax Principles Used to Prepare IRS Form 1099-Bs
1. General comments
a. This document discusses tax principles used to prepare IRS Form 1099-Bs for products traded on LedgerX’s exchange. Nothing in this document is intended to be tax advice by LedgerX to its customers, or by Lukka to Ledger X and/or LedgerX’s customers.
b. If a LedgerX customer desires advice on the application of the U.S. tax rules to their particular transactions, the customer should speak with a tax professional. In addition, there are aspects of a particular customer’s tax position that may be unknown to LedgerX and which could impact the tax consequences of transactions occurring on the LedgerX exchange. Some examples include the impact of mark-to-market election under section 475(f) of the Internal Revenue Code of 1986, as amended,1 and the application of straddle rules under Section 1092. Taxpayers should make their tax advisor aware of all aspects of their tax positions, applicable elections, and other facts relevant to their virtual currency trading activities.
c. It is also important to note that factors specific to each virtual currency exchange or other trading venue can change the tax treatment of transactions and products that have the same name but are traded on different exchanges. Thus, customers should not assume that the tax treatment of all of their investment products across all exchanges or venues on which they trade is the same.
d. LedgerX’s platform provides access to three types of bitcoin-related products: options, swaps, and futures. Below is a summary of the tax treatment of these products on the LedgerX exchange. The tax treatment of these products may differ on other exchanges based on the way those other exchanges structure their products.
- i. The U.S. tax law does not provide for uniform tax treatment of all futures contracts simply because they are called a futures contract by the relevant exchange.
- ii. There are special rules under Section 1256 that apply to “regulated futures” Regulated futures contracts are defined under Section 1256 as a contract (a) with respect to which the amount required to be deposited and the amount which may be withdrawn depends on a system of marking to market, and (b) which is traded on or subject to the rules of a “qualified board or exchange.”2 A qualified board or exchange includes a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission.3
- iii. LedgerX believes it is a qualified board or exchange based on the approvals it has received. However, futures contracts available in 2020 on the LedgerX exchange do not tie the amount which is required to be deposited or which may be withdrawn on a marking to market system. Accordingly, LedgerX believes the tax treatment of the futures contracts it made available in 2020 are not governed by Section 1256. Consequently, the futures contracts available in 2020 on the LedgerX exchange would be taxed in a manner similar to forward contracts.
b. Acquisition of bitcoin under a LedgerX futures contract
- i. A customer’s acquisition of bitcoin under a LedgerX futures contract is treated as a purchase of bitcoin at the date, time, and price expressed in the futures contract.
- ii. The basis of bitcoin acquired is equal to the amount paid under the LedgerX future, plus any premiums or fees paid.
c. Selling bitcoin under a LedgerX futures contract
- i. A customer’s sale of bitcoin under a LedgerX futures contract is treated as sale of bitcoin at the date, time, and price expressed in the futures contract, less any fees paid to effect the sale.
- ii. Gain or loss on the bitcoin sold under the futures contract is measured as the difference between the net sales proceeds from the sale and the basis of the bitcoin sold. The basis of bitcoin sold is determined by reference to the basis of bitcoin the customer holds on the LedgerX exchange at the time of the sale under a first-in, first-out (FIFO) methodology.
- i. Like futures, the U.S. tax law does not provide a uniform treatment to all swap contracts simply because the contracts are called swaps.
- ii. The U.S. tax law defines a swap (or formally called a “notional principal contract” under the U.S. tax regulations) as “a financial instrument that provides for the payment of amounts by one party to another at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specific consideration or a promise to pay similar amounts."4
- iii. LedgerX believes that its swap contracts are not classified as notional principal contracts under U.S. tax law, because they do not provide for payments at specified intervals by reference to a specified index upon a notional principal amount. Rather, LedgerX believes its swaps are taxed in a manner similar to forward contracts.
b. Acquisition of bitcoin under a LedgerX swap
- i. A customer’s acquisition of bitcoin under a LedgerX swap contract is treated as a purchase of bitcoin at the date, time, and price expressed in the swap contract.
- ii. The basis of bitcoin acquired is equal to the amount paid under the Ledger X swap contract, plus any premiums or fees paid.
c. Selling bitcoin under a LedgerX swap contract
- i. A customer’s sale of bitcoin under a LedgerX swap contract is treated as sale of bitcoin at the date, time, and price expressed in the swap contract, less any fees paid to effect the sale.
- ii. Gain or loss on the bitcoin sold under the swap contract is measured as the difference between the net sales proceeds from the sale and the basis of the bitcoin sold. The basis of bitcoin sold is determined by reference to the basis of bitcoin the customer holds on the LedgerX exchange at the time of the sale under a first-in, first-out (FIFO) methodology.
- i. Like futures contracts, the U.S. tax law does not provide for uniform treatment of all option contracts simply because a contract is called an option contract.
- ii. A call option is a contract that grants one party (the holder) of the option contract the right (but not the obligation) to purchase an asset from a counterparty (the writer) of the contract at a predetermined price.
Conversely, a put option is a contract that grants one party (the holder) the right (but not the obligation) to sell an asset to the counterparty (the writer) of the contract at a predetermined price. LedgerX believes its option contracts qualify as option contracts for U.S. tax purposes.
- iii. Special rules apply to option contracts that are treated as “Section 1256 contracts” under Section 1256. An option is a Section 1256 contract when it qualifies as a “nonequity option.”5 A nonequity option is any “listed option” that is not an “equity option.”6 Listed options are options that are traded on a “qualified board or exchange.”7 Equity options are options to buy or sell stock, or options whose value is determined by reference to the value of any stock or any narrow-based security index.8
- iv. LedgerX believes its option contracts qualify as Section 1256 contracts because LedgerX is a qualified board or exchange and bitcoin is not treated as stock for U.S. tax purposes. Accordingly, LedgerX believes the rules under Section 1256 apply to determine gain or loss from transactions involving its options.9
b. Taxation of LedgerX option contracts
- i. Gain or loss is determined by reference to the value of a LedgerX option contract at settlement (including physical delivery). Gain or loss on the contract is the difference between the contract price and the fair market value of the contract at time of exercise.10 Gain is reduced by any premium paid by the holder of an option. Gain is increased for any premium received by the writer of an option.
- ii. Any bitcoin acquired under a LedgerX call option has a current fair market value price at time of settlement / termination.
- iii. If bitcoin is transferred to settle a Section 1256 contract providing for delivery, gain / loss is measured on the contract in addition to the gain / loss measurement on the bitcoin transferred to settle the contract.11 This additional gain or loss is subject to generally applicable rules relating to character, holding period, etc.
- iv. If a LedgerX option contract is open at year end, then the contract is deemed to be sold and gain or loss recognized.12 Gain is reduced by any premium paid by the holder of an option. Gain is increased by a premium received by a writer of an option. Tax basis is reset to that fair market value on the mark.13
- v. Any gain or loss recognized on a LedgerX option is treated as 60% long term and 40% short term capital gain or loss.
c. Reporting Section1256 gains and losses on LedgerX options
- i. Gains and losses from LedgerX options are summarized in the materials provided to LedgerX customers. The line number on the form LedgerX provided relates to lines on IRS Form 1099-B. Reporting of summary Section 1256 figures is permitted under IRS guidance.14
- ii. For put options that a taxpayer wrote and which were physically settled, the date on which the put option was written is reported in Box 1(c) (Date Sold), while the date on which the put option was exercised is reported in Box 1(b) (Date Acquired). As noted above, gain or loss was determined by reference to the difference between the strike price and the fair market of the LedgerX option contract.
- iii. Details on the Form 2020-B Proceeds from Broker and Barter Transactions do not show a mark to market of LedgerX’s options for transactions that were not settled during 2020. Unrealized gains or losses that are marked to market on LedgerX options are only reflected on the Summary Page.
a. Withdrawals of bitcoin from the LedgerX exchange incur fees. These fees are subtracted from the bitcoin withdrawn. Gain or loss on payment of fees in bitcoin is equal to the fair market value of the amount bitcoin used to pay the fee at time of payment, minus the basis in the bitcoin used to pay the fee.
b. Proceeds from these transactions are reported in Box (1d).
6. Other aspects of the 2020 1099-B
a. Many aspects of the standard Form 1099-B instructions contained in materials LedgerX provided to customers do not apply to LedgerX’s products. The IRS instructions are general in nature and have not been edited by LedgerX in order to excise generally applicable text.
b. LedgerX has not reported basis to the IRS for any transactions occurring on its exchange, even though LedgerX is reporting this basis to its customers. This is because basis reporting to the IRS is only required for “covered securities” and “specified securities,” while bitcoin and derivatives therein are neither.15 In addition, there are instances where LedgerX customers transfer bitcoin to the exchange. In these instances, LedgerX has no way of knowing what the basis of the transferred bitcoins are. Thus, reporting basis and net gains to the IRS could result in an adverse IRS reaction.
c. Taxable gains and losses were measured as the difference between the cost basis of assets and fair market value of proceeds on disposition. For purposes of determining which bitcoin was sold, a first-in, first out (“FIFO”) methodology was used.
1 Any reference to a “Section” is to a section of the Internal Revenue Code of 1986, as amended.
2 Section 1256(g)(1).
3 Section 1256(g)(7)(B).
4 Treas. Reg. § 1.446-3(c)(1).
5 Section 1256(b)(1)(C).
6 Section 1256(g)(3).
7 Section 1256(g)(5).
8 Section 1256(g)(6).
9 LedgerX believes that section 1601 of the Dodd Frank Act (enacting Section 1256(b)(2)(B)) does not change this conclusion.
10 Sections 1234(c), 1256(c).
11 Under Treas. Reg. § 1.6045-1(a)(9), similar treatment exists for regulated futures contracts under Section 1256(b)(1)(A) where a closing transaction involves making or taking delivery. Under this regulation, there are two sales, one resulting in profit or loss on the contract, and a separate sale on the delivery.
12 Sections 1256(a).
13 Sections 1256(a), (c).
14 See https://www.irs.gov/pub/irs-prior/i1099b--2020.pdf (page 2).
15 See https://www.irs.gov/pub/irs-prior/i1099b--2020.pdf (p. 8); T.D. 9616, 78 FR 23116 (2013) (“Because commodities and foreign currency are not specified securities, basis reporting by a broker for an option on foreign currency or an option on a commodity is not currently required under section 6045”).