How Web3 companies resolve tax disputes: FTX and MicroStrategy as examples

Author: TaxDAO

1. Introduction

With the rapid rise of crypto assets, crypto assets have become a core component of the global financial sector. However, their unique decentralization and anonymity have also brought unprecedented tax challenges. As a global leader in financial technology, the United States has established a strict system for the tax management of crypto assets. According to the regulations of the U.S. Internal Revenue Service (IRS), cryptocurrencies are regarded as property, so their purchase, exchange and trading may trigger capital gains or losses, which must be reported according to capital gains tax. In addition, income from mining, airdrops and hard forks must also be taxed. However, due to the rapid iteration of crypto asset technology and the lag in tax supervision, taxpayers and tax authorities often have disputes over the amount of tax payable or tax liability in this emerging field. At this time, tax settlement provides both parties with an efficient and effective solution. Through negotiation and consultation, taxpayers can reach an agreement with the tax authorities to end the dispute and avoid more severe penalties.  

2. Overview of the US Tax Settlement System 

2.1 Development of the US Tax Settlement System 

The US tax settlement system is rooted in the Taxpayer Bill of Rights. According to US law, taxpayers are protected by the Taxpayer Bill of Rights while assuming their tax obligations, and enjoy ten rights, including the right to know, the right to enjoy quality service, the right to finality, the right to confidentiality, the right to question the IRS's position and appeal. One of them is the "right to a fair and equitable tax system", which clarifies that taxpayers have the right to require the tax system to consider facts and circumstances that may affect their potential liabilities, ability to pay, or ability to provide information in a timely manner. If taxpayers encounter financial difficulties or the Internal Revenue Service (IRS) does not properly and promptly resolve taxpayers' tax issues through its normal channels, taxpayers have the right to receive assistance from the Taxpayer Advocate Service (TAS). Under this right protection, in certain circumstances (for example, taxpayers cannot pay their tax debts in full, or paying their tax debts in full will cause financial difficulties), they can submit an Offer in Compromise to reduce the amount of unpaid taxes to ensure that taxpayers can afford basic living expenses.  

2.2 Implementation conditions of the US tax settlement system 

The tax settlement system is a way to resolve disputes through non-litigation when taxpayers and officials (such as the IRS, state governments, etc.) encounter tax disputes, but encounter difficulties in determining the amount of tax payable during the tax audit process. In the United States, alternative dispute resolution (ADR) was introduced into the field of administrative procedures in the 1990s and was later established as a permanent law by Congress, encouraging federal administrative agencies to apply other informal procedures such as mediation and negotiation, and settlement is the most commonly used means.  

The U.S. Internal Revenue Service (IRS)'s tax settlement (Offers in Compromise) system refers to the situation where taxpayers and the IRS reach a binding agreement based on administrative and criminal liabilities (including penalties, interest and other tax surcharges) and the amount of tax payable when the taxpayer is unable to fulfill his or her tax obligations, so that the taxpayer can resolve his or her tax problem with an amount lower than the amount owed. However, this agreement is subject to the taxpayer completing an application and meeting certain conditions: 

a. The IRS may accept a settlement when there is a dispute about the existence or amount of a debt. 

b. The IRS may accept a settlement when there is a concern about whether the full amount owed can be collected, that is, when the taxpayer's assets and income are less than the full amount of the tax debt.  

c. The IRS may accept a settlement when the taxes are legally owed and can be collected in full, but full payment would cause a financial hardship to the taxpayer or would result in an injustice under the circumstances.  

In order to successfully reach a tax settlement (OIC) agreement with the IRS, individuals or companies need to go through the following specific steps to complete the application to the IRS and finally obtain approval: 

Step 1: Collect personal financial information (including cash, investments, personal assets, expenses, etc.) 

Step 5: Pay the first tax payment and the application fee of US$205 

Step 6: Send the application to the IRS 

Step 7: If the application fails, the taxpayer may appeal to the Independent Office of the IRS within 30 days.

In addition to OIC, the IRS also provides other alternative dispute resolution mechanisms (ADR), including Fast Track Mediation and Fast Track Settlement: When taxpayers cannot reach an agreement with the review authority on tax matters, the review authority should prepare Form 14717 and attach the problem statements and valuation reports of both parties to appeal. After the appeal department accepts the application, a mediator will be assigned to promote reconciliation between the two parties through a mediation meeting. If the two parties fail to reach an agreement in the appeal, they can enter into post-appeal mediation according to the circumstances, and the case will be assigned to another appeals office for retrial. 2.3 Characteristics of the US tax settlement system The United States is influenced to a certain extent by pragmatism and administrative democratization. Although there are certain provisions on the scope of application of settlement in legislation, the tax court encourages settlement. In the Administrative Dispute Resolution Act (ADAR) passed by the US Congress in 1990, the legislator also proposed "authorizing and encouraging federal administrative agencies to use mediation, negotiation, arbitration or other informal procedures to quickly deal with administrative disputes." In the field of tax administration, about 80% of small tax litigation cases can be settled out of court before the trial, thus ending the litigation process.  

3. Tax settlement example between FTX and MicroStrategy 

3.1 FTX tax settlement case

FTX was once a well-known global digital asset spot and derivatives (crypto assets) trading platform. It was founded in 2019 and became the world's second largest virtual currency trading platform in a short period of time. In 2022, FTX’s funding chain was broken due to financial fraud committed by Sam Bankman-Fried, former CEO of FTX, and Alameda Research, another trading company he founded, causing FTX, Alameda Research and more than 134 other subsidiaries to file for bankruptcy in the United States, causing investors to lose billions of dollars. During the bankruptcy process, the Internal Revenue Service (IRS) filed a preliminary tax claim of $44 billion against FTX and its subsidiaries (including FLX Trading ltd., Alameda Research, etc.), which was later revised to $24 billion, stating that it was related to income taxes, employment taxes and penalties owed during the period 2018-2022. However, FTX lawyers filed documents with the bankruptcy court in December 2023, objecting to the claims and requesting the IRS to provide relevant documents to confirm its claims against FTX and explain how to estimate the back taxes it should pay. In the document, FTX lawyers stated that FTX "never received any amount close to the IRS's $24 billion tax claim" and lost a lot of money, and refused to bear the income tax liability and employment tax liability of the so-called "embezzlement income" generated by Sam Bankman-Fried's misappropriation of FTX customer funds. At the same time, in the statement, FTX lawyers emphasized that "the only source of recovery by the IRS is the compensation taken from the victims." Based on this, FTX filed a settlement application and was willing to pay the IRS $200 million in priority tax claims and $685 million in lower priority claims. In June 2024, FTX and the Internal Revenue Service (IRS) finally reached a settlement agreement, and the IRS will receive a priority claim of $200 million in the FTX bankruptcy case and will pay it within 60 days after the company's proposed reorganization plan takes effect. In addition, the agency will receive $685 million in lower priority claims to pay customers and other creditors.   

3.2 MicroStrategy Tax Settlement Case

In 2022, Washington Attorney General Karl Racine filed charges against Michael Saylor, the founder of MicroStrategy and a cryptocurrency billionaire, accusing him and his company of "not paying income tax for at least 10 years while living in the District." His company MicroStrategy helped him evade more than $25 million in income tax in the District by filling out false W-2 form information. In the tax return, Saylor claimed that he lived in Florida, which does not impose personal income tax, but actually lived in a seaside apartment in Washington. At the same time, Saylor reduced the risk of tax evasion by receiving only $1 in salary plus a large number of welfare arrangements (such as private jet travel, the use of car drivers and security teams), and the company was responsible for the federal tax on the welfare. Because his address was in Florida, the welfare received by Saylor was not considered taxable remuneration. In August 2022, Saylor resigned as CEO of MicroStrategy due to this case and became executive chairman. This is the largest income tax fraud recovery case in the history of the District of Columbia and the first lawsuit after the district amended the False Claims Act, which encourages whistleblowers to file tax evasion charges against residents who allegedly concealed their actual place of residence. According to the allegation, anyone who intentionally submits or causes a false claim to be submitted to the government shall be liable for compensation three times the government's losses and a fine linked to inflation, so experts once believed that Saylor should be fined at least $75 million. However, in the face of the lawsuit, Saylor insisted that he moved from Virginia to Florida more than ten years ago and bought a house in Miami Beach. His life center is in Florida, where he lives, votes, and performs jury duties. MicroStrategy clarified that the company has no right to regulate and influence Saylor's personal tax issues, so it refused to assume responsibility for Saylor's "tax fraud". With each party insisting on its own words, both parties expressed the hope to avoid the time, cost and inconvenience required for any further litigation and resolve all disputes and potential legal claims based on covered behavior. Therefore, on June 3, 2024, Saylor and the Washington Attorney General reached a settlement of $40 million for tax fraud.  

4. Lessons from the US tax settlement system 

4.1 Lessons from the FTX case 

FTX, once the world's second largest virtual currency trading platform, collapsed, damaging the market's confidence in crypto assets. The tax settlement in this case not only involved the dispute between the IRS and FTX over the amount of tax, but also involved the bankruptcy of the FTX exchange and the compensation of victims of fraud. The settlement agreement avoids the debtor from spending a lot of time and money on litigation, helps institutions prioritize customer repayment issues in bankruptcy proceedings, and protects the rights and interests of multiple parties. Therefore, in the face of high debt claims, US companies have a certain opportunity to reach a settlement with the IRS at a relatively low claim cost through multi-angle appeals.  

4.2 Tax implications of the MicroStrategy case 

The United States implements a dual-track legal system of federal law and state law. Therefore, on the basis of understanding federal law, we must also always pay attention to changes in state law. The policy differences between different states do provide taxpayers with certain benefits (such as the Florida government exempting personal income tax) and reasonable tax avoidance space. However, the tax avoidance method of falsely reporting one's place of residence is risky, especially under certain strict laws and regulations. Therefore, companies should assist employees in reasonable tax planning in accordance with the law to ensure that tax behavior is compliant and transparent.  

At the same time, it is worth noting that in this case, Saylor avoided a fine of up to $75 million under the False Claims Act through tax settlement, and ended the Washington government's lawsuit at a cost of $40 million. It can be seen that tax settlement can avoid further litigation burdens, avoid lengthy and expensive legal proceedings, and can also help taxpayers minimize the burden of fines.  

5. Conclusion 

Due to the characteristics of decentralization, anonymity, and global liquidity, individuals or companies holding crypto assets have tax risks such as difficulty in supervision and difficulty in obtaining evidence for the tax bureau, which can easily become a tax loophole, and cryptocurrencies are inevitably a way to evade taxes.  

In the case discussed in this article, the IRS filed a claim for a high tax debt against FTX. In the face of FTX's questioning of the amount of its debt, the IRS was unable to conduct a more rigorous investigation of the crypto asset trading platform and provide rigorous evidence. Instead, it chose to accept the settlement plan of the FTX legal team and settled with FTX with a compensation that was nearly 100 times lower than the "US$24 billion" tax amount previously requested by the IRS. The tax evasion case of "cryptocurrency billionaire" Saylor did not go to the end through legal procedures, but compensated the Washington, DC government through tax settlement. Judging from the results of the two cases, the application of the tax settlement system in the crypto industry is feasible and effective. For the current relatively "immature" crypto industry and "imperfect" crypto asset tax policies, the tax settlement system is highly practical, which is conducive to improving tax administration, effectively resolving tax disputes, and reducing the pressure of tax audits. At the same time, it also provides taxpayers with an effective means to deal with tax compliance supervision and make up for tax errors.  

References

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[3]. Civil Division, (2024, February 23). The False Claims Act.

[4]. Helen, P. (2024, June 03). MicroStrategy and Michael Saylor reached a settlement in a tax case, claiming $40 million.

[5]. Internal Revenue Service. (n.d.), Taxpayer Bill of Rights 10: Right to a fair and equitable tax system.

[6].Internal Revenue Service. (n.d.), Topic no. 204, Offers in compromise.

[7].Internal Revenue Service. (n.d.), Taxpayer Bill of Rights. 

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