Initial coin offerings (ICOs) have emerged as a popular method for raising money from the public. Even with Bitcoin well below highs above $19,000, investors have poured billions of dollars into ICOs in 2018. According to a Wall Street Journal analysis of 900 offerings listed on ICOBench.com, ICOs have raised $11.8 billion this year through May 2018, more than double the $5.5 billion such offerings raised in all of 2017.
Here are the five most important items an investor should address before using a self-directed IRA or 401(k) plan to invest in ICOs:
What exactly is an ICO?
ICOs can be best viewed as a mix of an Initial Public Offering (IPO) and a crowdfunding campaign. ICOs have become popular with cryptocurrency, digital asset, and blockchain start-up companies looking to raise funds from the public. For example, a cryptocurrency company looking to raise funds would create digital tokens with certain rights and sell them to the public. In general, Bitcoin or Ethereum is used to purchase the digital tokens – not fiat or U.S. dollars. In most cases, the digital tokens are often sold to the public before the company has even developed or sold a product.
What does the IRS Say?
The Internal Revenue Code does not say what you can invest in, only what you cannot invest in with your retirement plan. Internal Revenue Code Sections 408 & 4975 prohibit “disqualified persons” from engaging in certain types of transactions, such as collectibles, life insurance, and self-dealing and conflict of interest type transactions.
The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a number of related party scenarios, but usually includes the retirement account holder, any ancestors or lineal descendants of the retirement account holder, and entities in which the retirement account holder holds a controlling equity or management interest. Because the IRS treats digital assets, such as cryptocurrencies and ICOs, as a capital asset, such as stocks, a retirement account is permitted to buy, sell, or hold digital assets, subject to the prohibited transaction rules mentioned earlier.
Therefore, since an ICO is not a life insurance asset, a collectible, and so long as the ICO transaction does not involve any “disqualified persons,”,the ICO transaction should not violate the IRS prohibited transactions rules and may be purchased using retirement funds.
Risks & Rewards: The 2018 ICO market is still full of risk and uncertainty. The strong interest in ICOs has emerged against a growing backlash from regulators, such as the Securities & Exchange Commission (“SEC”), due to a number of highly publicized fraudulent schemes involving ICOs. In May 2018, the SEC launched a mock ICO to help educate investors about the potential risks of fraud in the ICO marketplace.
SEC Commissioner Robert Jackson has expressed criticism of ICOs, claiming that investors are having a hard time telling the difference between investments and fraud. Over the last year or so, there have been a number of high profile fraudulent schemes involving ICOs, such as Centra Tech, which raised $32 million from investors in 2017.
The main benefit of using retirement funds to purchase ICO digital tokens is that all the income and gains from the ICO investment would be exempt from immediate taxation or exempted completely in the case of a Roth IRA or Roth 401(k). According to IRS Notice 2014-21, for federal tax purposes, digital assets are treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency or digital assets. Whereas, if an investor used after-tax funds to purchase ICOs, any gains would, generally, be subject to the capital gains regime and would either be subject to short-term capital gains tax (ordinary income tax rates) or long-term capital gains tax (15% or 20% -if held over 12 months).
Using retirement funds to invest in ICOs does have considerable tax advantages, however, the risks of fraud remains very real.
Is it Regulated?
One of the first things one should do when researching an ICO investment is confirming whether the ICO has been registered with the SEC as a security offering or if it has satisfied an SEC registration exemption. If the ICO has not been registered with the SEC, the offering may only be available to accredited investors. An accredited investor is generally an investor whose net worth is in excess of $1 million or maintains certain annual income levels.
According to the SEC, one of the biggest factors in determining whether a token is a security is the role a central organizer plays in promoting the coin and increasing its value, especially if the central organizer holds a significant amount of the tokens. The SEC has not yet formally declared that ICOs should be treated as a security, which would impose SEC regulations on ICO offerings.
However, that seems to be where we are heading. In a statement by Chairman Jay Clayton on cryptocurrencies on December 11, 2017, Mr. Clayton was clear that the SEC has “interests and responsibilities” with respect to cryptocurrencies. Mr. Clayton was clear that if an ICO shared the same characteristics of a security then it must be subject to securities laws. Currently, almost all ICOs are unregistered and have not filed offering documentation with the SEC. In addition, ICOs are being sold to the general public on various exchange platforms.
Many of the ICO promoters have taken the position that a “utility token” is not a security and, thus, is not subject to SEC oversight. Whereas, some ICO promoters have attempted to satisfy the requirements of the 2012 JOBS Act, which introduced exemptions from registration in the Securities Act if certain elements were satisfied (i.e. limits on investment amount). While some ICOs, such as TZERO, have only been offered to accredited investors.
Whether the ICO has been registered with the SEC may or may not impact your decision to make the ICO investment, but it is a very relevant factor to consider. The chances for fraud are considerably higher for any unregulated investments.
Exit Strategy. Before investing in an ICO, it is good practice to consider an exit strategy for your ICO investment. You should research if and how the company will allow you to get your funds out of the investment. Will you be permitted to cash in tokens for a refund? Will there be any lock-up periods? Will you be able to sell your tokens on a secondary market? What, if any, utility, will you be able to derive from the token? These are all important questions that one should address before electing to use retirement funds to make an ICO investment.
The cryptocurrency and ICO industries are quickly evolving and continue to be a hot area for many investors. Both the marketplaces remain highly uncertain and extremely risky. Anyone looking to invest retirement funds into ICO investments should be careful and proceed with caution.