At first glance, any fund formation attorney may think that a hedge fund or venture fund that invests in digital assets is structurally and functionally the same as any other fund. However, there are unique issues that managers of crypto-focused funds have to contend with.
Investment Company Act & Advisers Act Considerations
The SEC has taken the position that Bitcoin and Ethereum (in their current forms) are not considered “securities” under U.S. securities laws, in large part because the protocols are sufficiently decentralized with no person or company in control, thus failing the “from the efforts of others” prong of the Howey test. Tokens are generally categorized as either “utility tokens” – giving holders the right to use a digital application or service or participate in its ecosystem or “security tokens” – granting the holder an ownership interest or share of profits or losses. Nonetheless, utility tokens can still be considered securities if there is an expectation of profits in a common enterprise primarily from the efforts of others.
Accordingly, it is possible that a cryptocurrency fund investing only in BTC, ETH non-security tokens may not be considered an investment company, nor would its management be subject to federal (or state) regulation as an investment adviser. This would provide its manager reprieve from certain requirements, including an audit and limitations on charging performance fees to non-qualified clients. Although appealing, because of the regulatory uncertainty around determining which tokens are securities, it is a best practice for a crypto fund to adhere to exclusions from classification as an investment company and any applicable investment adviser requirements.
Moreover, the SEC has indicated that early-stage protocols probably are securities at the beginning, and then may cease to be securities as they mature and become more widely distributed (i.e., decentralized control). As a result, any U.S. fund manager that anticipates investing in early-stage tokens, including through Simple Agreements for Future Tokens (SAFTs), should comply with all regulations applicable to a similarly situated manager trading on the NYSE or NASDAQ, or investing in the equity of privately held companies.
It is worth noting that, notwithstanding the classification of a manager as an investment adviser, any manager of a private fund that trades in futures, swaps or other “commodity interests” will be subject to regulation under the Commodity Exchange Act unless an exemption or exclusion applies.
In-Kind Subscriptions & Distributions
Fund managers wanting to accept subscriptions in-kind via cryptocurrencies should be aware that such currencies are treated as personal property for tax purposes, not a traditional currency like the U.S. dollar. This means that when an investor transfers digital currency to a fund’s wallet in consideration for an interest in the fund, the investor should not initially be subject to income tax so long as the fund is a partnership.
However, the investor may be subject to additional tax allocation if the fund sells the contributed digital currency in the future. In addition, contribution of tokens will result in additional tax lot tracking, which must start upon contribution. On the other hand, distributions of digital currencies to partners of a fund are not taxable. The “sale” only occurs once the partner disposes of that token.
Any fund that participates in mining, staking, yield-farming or lending activity should consider the impact on any tax-exempt investors. UBTI, or unrelated business taxable income, is income from a trade or business regularly carried on by an exempt organization that is not substantially related to the organization’s exempt purpose. When tax-exempt investors receive UBTI, they are subject to tax on that income, whether they are retirement accounts (such as self-directed 401ks and IRAs), charities, educational instructions, and other nonprofit entities.
IRS guidance indicates that DeFi activity that rises to the level of a trade or business may generate trade or business income. Until the IRS (or the courts) provide more guidance, it is likely that staking income would be treated similarly to mining income, meaning that tax exempt investors may be subject to UBTI on their staking (or other DeFi) activity. A common approach many funds take is to establish two classes of interests in the fund – one that participates in staking and other DeFi-related income, and another class for tax-exempt investors that does not.
Accessing Non-U.S. Exchanges
Most major offshore cryptocurrency exchanges do not permit access by U.S. persons in order to avoid U.S. securities and commodities regulations. This can put U.S. crypto hedge funds at a disadvantage, as liquidity on U.S. exchanges tends to be lower (resulting in higher bid-ask spreads) and there is a lack of U.S. based exchanges that offer crypto derivatives trading (although there are a some, including FTX US). Simply trading from an offshore account will not suffice, as exchanges will look to the “ultimate beneficial owners” to determine whether there are U.S.-based investors.