Crypto Hedge Funds Face Tough Choices on Tax Day

Like so much else in cryptocurrency taxation, the rules for crypto funds - pooled investment vehicles that seek above-market returns from digital asset investments - are far from straightforward.

U.S. investors in crypto funds will typically invest in domestic partnerships or LLCs. Onshore funds could stand alone but could also be part of larger structures, incorporating one or more entities accommodating tax-exempt and non-U.S. investors.

As partnerships, onshore crypto funds are generally not subject to tax, but rather their investors are taxed on the funds' profits.

Crypto funds should restrict withdrawal rights or limit the number of investors to avoid classification as publicly-traded partnerships, which are taxable as corporations.

If crypto funds allow investors to contribute cryptocurrency when subscribing for fund interests, investors may be required to recognize gain on the contribution.

If contributions in-kind can be made tax free, crypto funds must track the contributors' bases in the contributed cryptocurrency and allocate any pre-contribution gains or losses to such investors.

Crypto funds will be traders if their trading activities are substantial, seeking to profit from short-term market swings.

Classifying crypto funds as traders or investors affects whether expenses of the funds are deductible for U.S. federal income tax purposes.

Straddle rules might delay recognition of losses if crypto funds hold, for example, crypto long and crypto futures short.

Generally, offshore funds will not be treated as engaged in a U.S. trade or business if the funds only buy and sell stocks, securities and certain commodities for their own account.