We seem to be hearing more and more about cryptocurrency. Is it the money of the future? Is it a passing trend? And what do nonprofits need to know about cryptocurrency, the underlying blockchain technology, and the existing regulation?
What is Cryptocurrency?
There are four critical definitions required for understanding cryptocurrency: (1) cryptocurrency, (2) cryptography, (3) distributed ledger, and (4) blockchain.
According to Wikipedia:
A cryptocurrency (or crypto currency) is a digital asset designed to work as a medium of exchange that uses strong cryptography to secure financial transactions, control the creation of additional units, and verify the transfer of assets. Cryptocurrencies are a kind of alternative currency and digital currency (of which virtual currency is a subset). Cryptocurrencies use decentralized control as opposed to centralized digital currency and central banking systems.
According to Investopedia:
In principle, the cryptography guarantees the security of the transactions and the participants, independence of operations from a central authority, and protection from double spending. … Cryptography technology is used for multiple purposes – for securing the various transactions occurring on the network, for controlling the generation of new currency units, and for verification of the transfer of digital assets and tokens.
According to Towards Data Science:
A distributed ledger is a database that is spread across several nodes or computing devices. Each node replicates and saves an identical copy of the ledger. Each participant node of the network updates itself independently.
The groundbreaking feature of distributed ledger technology is that the ledger is not maintained by any central authority. Updates to the ledger are independently constructed and recorded by each node. The nodes then vote on these updates to ensure that the majority agrees with the conclusion reached. This voting and agreement on one copy of the ledger is called consensus, and is conducted automatically by a consensus algorithm. Once consensus has been reached, the distributed ledger updates itself and the latest, agreed-upon version of the ledger is saved on each node separately.
Distributed ledger technologies drastically reduce the cost of trust. The architectures and structures of distributed ledgers can help us mitigate our dependence on banks, governments, lawyers, notaries and regulatory compliance officers.
According to Blockchain.WTF:
A blockchain is a distributed ledger technology that forms a “chain of blocks.” Each block includes information and data that are bundled together and verified. These blocks are then validated and strung onto the chain of transactions and information in previous blocks. These blocks of transactions are permanently recorded in the distributed ledger that is the blockchain. … Blockchain is the platform which brings cryptocurrencies into play. The blockchain is the technology that is serves as the distributed ledger that forms the network. This network creates the means for transacting, and enables transferring of value and information.
How Much Money are We Talking About?
According to CNBC, as of November 23, 2018, the total market capitalization of cryptocurrencies was around $138.6 billion. CoinMarketCap tracks the top 100 cryptocurrencies by market capitalization. Currently, the top 3 are Bitcoin (over $74 billion), XRP ($16 billion), and Ethereum ($12 billion).
The market capitalization of cryptocurrencies has fallen more than 80 percent from its January peak of over $830 billion. The New York Times (11/21/18) explained why in 5 Reasons Cryptocurrency Prices Are Plunging Again:
- Relying on unregulated infrastructure and exchanges is risky.
- Regulators are cracking down.
- Cryptocurrencies are managed by communities of developers. That can get messy.
- Cryptocurrencies were going to solve all kinds of real-world problems. But the real world hasn’t had much use for cryptocurrencies.
- Governments could get into cryptocurrencies, and do a better job of managing them.
Can Nonprofits Accept Cryptocurrencies as Donations?
Generally, it is lawful for a nonprofit to accept a donation in the form of a cryptocurrency. However, this does not necessarily mean that it would be prudent for all nonprofits to do so. First, nonprofits must understand how cryptocurrency gifts work and what risks may be involved with taking and holding onto cryptocurrency.
How is Cryptocurrency Treated for Federal Tax Purposes?
According to the IRS Notice 2014-21:
- For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.
- For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.
- In order to get a deduction for noncash gifts of more than $500, donors must file Form 8283 and charities must sign the donee acknowledgment portion of the Form.
- If the value of the donated property exceeds $5,000, the general rule is that a donor must get a qualified appraisal for contributions of property (other than money or publicly traded securities). The recipient charity will not be considered a qualified appraiser for the purpose of valuing the donated property. Notwithstanding the foregoing, the Instructions to Form 8283 provide that a written appraisal is not required for certain securities considered to have market quotations readily available (see Treasury Regulations section 1.170A-13(c)(7)(xi)(B)). Currently it’s not settled whether appropriate market quotations are readily available for cryptocurrencies so it’s arguable whether a qualified appraisal is necessary for a cryptocurrency donation of over $5,000, but a conservative approach would be to get the appraisal. If an appraisal is required, one problem will be finding a qualified appraiser, particularly in the absence of a recognized professional appraiser organization for demonstrated competency in valuing the type of property being appraised.
- If the recipient charity receives charitable deduction property (including cryptocurrency if the donee organization signed an appraisal summary or Form 8283) and within 3 years sells, exchanges, or disposes of the property, it must file Form 8282 unless either (1) the property is valued at $500 or less, or (2) the property is consumed or distributed for charitable purposes.
- As for the donor’s charitable contribution deduction (and note that charities should not provide tax advice to their donors):
- If the the individual donor held the property for less than one year, she will be able to deduct the lesser of cost basis or fair market value up to 50% of adjusted gross income, assuming such donor can itemize her deductions.
- If the the individual donor held the property as a capital asset for more than one year, she will be able to deduct the fair market value of the gift up to 30% of adjusted gross income, assuming such donor can itemize her deductions.
- In addition, the individual donor will not have to pay capital gains tax on the appreciated portion of the gifted property. Accordingly, the donor and charity will generally both benefit more from a charitable gift of long-term appreciated cryptocurrency than a gift of after-tax proceeds of donor’s sale of the cryptocurrency. For example, if the gifted cryptocurrency cost $1,000 and appreciated to $10,000, the donor’s gift would result in $10,000 to the charity (less any transaction costs) and the donor may be able to get a charitable contribution deduction of $10,000. But if the donor first sold the cryptocurrency, she would need to pay capital gains tax on the $9,000 of appreciation which could be 20% or $1,800, leaving only $8,200 for the gift to charity (less any transaction costs) and the amount of the charitable contribution deduction.
Can Nonprofits Invest in Cryptocurrency?
Because of the very high volatility of the assets, cryptocurrencies are unlikely to be a substantial part of a nonprofit’s investment portfolio. If a nonprofit board wants to maintain cryptocurrency as part of its organization’s investment assets, it must carefully consider application of prudent investment laws (e.g., UPMIFA) and data security issues. Such laws and issues would probably preclude smaller nonprofits from holding onto significant amounts of cryptocurrency, but it’s reported that one of the largest charities in the country, the Silicon Valley Community Foundation, held a third of its US$13.5 billion investments – nearly $4.5 billion – in digital assets according to its annual financial statement.
How Can Nonprofits Liquidate Cryptocurrency?
Much more likely, a nonprofit will want to liquidate cryptocurrency gifts immediately upon receipt. Cryptocurrency it typically liquidated by nonprofits on an exchange like Coinbase and Bitpay. There are also direct trading platforms, peer-to-peer marketplaces, and offline selling, all of which you can read more about at Best Ways To Sell, Liquidate & Cash Out Your Bitcoin Crypto Holdings.
What are the Risks?
- Nonprofits may find it difficult to know the true source of a cryptocurrency gift, which could create issues for substantiating such gift.
- Cryptocurrency is generally not insurable so, if lost (which could result from a hack or even a lost password), it may be unrecoverable.
- Cryptocurrency gifts that originate from criminal activity may be subject to clawback risks (meaning that the nonprofit may need to give the gift to someone with greater rights to it).
- Many cryptocurrencies may become illiquid and/or otherwise worthless to the nonprofit.
- The laws regulating cryptocurrency still lack coordination and consistency among jurisdictions, raising uncertainty and compliance costs (e.g., could a recipient of cryptocurrency be violating anti-money-laundering laws?).
- Recipients of cryptocurrency may become higher risk targets for hackers, malware, ransomware, and fraudsters.
We’ll continue to build on this post as we learn more this year, including at the 2018 Western Conference on Tax Exempt Organizations in December.
Brave New World: How Cryptocurrencies and the Blockchain Are Changing Philanthropy (Inside Philanthropy)
Legal Alert: Issues Nonprofits Should Consider Before Accepting Cryptocurrency Donations (Lawyers Alliance for New York)