Celsius Bankruptcy Update: Making Sense of the Court’s Recent Ruling On Earn Accounts

The Court’s Ruling

On January 4, 2023, the judge in the bankruptcy proceeding issued a ruling on the issue, holding that the crypto units held in Earn Accounts were the property of Celsius when the bankruptcy was initiated and therefore became part of the bankruptcy estate.  This holding means Celsius customers that had Earn Accounts now become unsecured creditors in the bankruptcy proceeding.

The court’s ruling has a massive impact on customers with Earn Accounts, so it is likely the ruling will be appealed to the district court for review. For now, though, customers with Earn Accounts are unsecured creditors, which means they will share in any payout from Celsius’s assets with other similarly situated unsecured creditors. This almost ensures that these account holders will not be made whole.

As unnerving as this holding is for those affected, the holding is relatively sound. The court’s analysis relied primarily on the plain language of the Terms of Use agreement governing those accounts. That language explicitly said that any crypto deposited into an Earn Account became the property of Celsius and that in the event of Celsius’s bankruptcy such crypto might not be recoverable other than as a creditor of Celsius.      

In reaching his conclusion, the judge also reviewed records from Celsius indicating that 99% of Earn Account holders had digitally accepted the Terms of Use agreement.  

What Else Can Be Done?

As noted, the ruling will likely be appealed because of the economic significance of its impact. Separately, the judge did include one qualifier on the scope of his ruling, that the ruling is premised on the notion that a specific customer accepted and entered into a contract with Celsius based on the Terms of Use agreement. 

An Earn Account customer who can prove that they never accepted or agreed to the Terms of Use contract may be able to get different treatment on the theory that no contract was ever formed governing that customer’s account.  But, proving that is likely near impossible for a multitude of legal reasons.  

First, it is unlikely a customer can show that they never accepted the Terms of Use agreement.  Second, even if that was feasible, there are a number of other legal items that arise that likely would show that a contract existed. For example, whether that same customer actually made deposits in the Earn Account and received rewards in return for those deposits.  

Legally, it is difficult to disclaim that a contract existed when everyone is doing what they were supposed to be doing on that contract. Ultimately, the ruling is likely to stand, and therefore Earn Account holders should start planning their next steps. Individually, those customers have little sway but if they can coordinate and assemble a class of unsecured creditors they may be able to argue for a larger piece of the pie than they would get if they acted individually. 

Should I Expect the Same Treatment in Other Pending Bankruptcy Cases?

It is important to note that the ruling in this bankruptcy case is not binding in any of the other pending bankruptcy proceedings for entities such as FTX, BlockFi, and Voyager, or even other account types at Celsius such as Custodial accounts.  

To the extent necessary, the judges presiding over those proceedings will need to make independent rulings in those cases.  However, to the extent the Terms of Use or User Agreements for those customers mirror the language of the Earn Account agreement used by Celsius, the outcome would likely be the same.  

In this regard, FTX.US’s User Agreement seems to be an outlier, and its language may provide some hope for customers of that platform.  The FTX.US User Agreement has language that states the opposite of the Earn Account language—it indicates that ownership of all customer deposits would remain at all times with the customer and never transfer to FTX.US.  

Although that language is promising, the FTX.US situation is further complicated by the fact that FTX.US appears to have violated those terms and misappropriated customer deposits.  So even if the deposits should legally belong to the customers, it is likely that those deposits simply no longer exist because they were improperly taken from customer accounts. This added wrinkle is possibly the most troubling piece of the FTX bankruptcy proceedings.

What Does This Mean For My Taxes?

On the tax front, this ruling has a few interesting and possibly unexpected implications.  It is important to note that the actual tax treatment is uncertain as the IRS has not issued any guidance on these issues and some of them are fairly novel.  For those customers caught up in this situation, it is recommended that you seek professional tax advice.  Plus, it is entirely possible the IRS may issue some special guidance on these issues that customers will want to make sure they are aware of.  With that said, general tax provisions may likely be applied as outlined below.

Are Deposits into Earn Accounts Taxable Events?

The ruling likely impacts how transfers of crypto into Earn Accounts should be treated for tax purposes. The IRS has never issued guidance on how lending arrangements like the Earn Accounts are taxed, and most individuals seem to treat them as non-taxable under the premise that the deposit of units into an Earn Account is not a sale or disposition of those units for tax purposes.  The court’s ruling, however, may very likely have changed that.

Under the tax code, you do not recognize any gain or loss on an asset until you sell or otherwise dispose of it.  A disposition is commonly seen as the relinquishment of both legal title and beneficial ownership or control of an asset. The court’s ruling with respect to ownership of assets in Earn Accounts is basically a determination that the transfer of units into those accounts constituted a complete transfer of ownership from the customer to Celsius.  In tax terms, that is almost certainly a taxable disposition.  

From a tax reporting standpoint, this means that gain or loss would be recognized whenever any units were transferred into an Earn Account.  That gain or loss would be calculated based on the acquisition cost basis of the transferred units measured against the value received at the time of the transfer.  The value received at the time of the transfer is likely just the fair market value of the transferred units at that same time – but this is where things are a little murky.  

When units are transferred into an Earn Account the customer does not seem to get anything specific in return, but economically Celsius is getting ownership of the deposited units and the customer is getting an agreement from Celsius to return to the customer those same units at a future date.  That agreement is a contract that has value and represents the value received at the time of the deposit.

For example, if 1 crypto unit that was purchased for $5,000 is transferred into an Earn Account with a value of $20,000, the value received would be $20,000.  For tax purposes that $20,000 would be measured against the $5,000 purchase price, resulting in a taxable gain of $15,000.  

For tax purposes, the customer no longer owns the 1 crypto, the customer now owns the contractual agreement from Celsius to receive the return of 1 crypto at some future date. The customer’s acquisition cost basis of that contract is $20,000 – the value at the moment of the transfer. This point will be important when calculating any deduction resulting from losses caused by the bankruptcy.

Do I Get to Claim a Loss From the Bankruptcy?

As discussed here, it is likely that at some point customers will be able to claim a tax deduction associated with any loss suffered from the bankruptcy.  Because of the court’s ruling and Earn Account customers’ now being treated as unsecured creditors, it is almost certain that they will not be made whole.  However, the amount of the loss needs to be determined with reasonable certainty before any deduction can be taken.  

The loss rules generally require an individual to know the amount of the loss and then offset that loss by any recovery made through insurance or otherwise.  Because of the requirement to offset the loss by any recovery, you cannot claim a deduction until that recovery is known with reasonable certainty.  

Here, the court’s ruling helps individuals know the initial amount of their loss. As explained above, after a transfer into an Earn Account a customer no longer owns the actual crypto but rather owns a contract for the return of that crypto. It is this contract, or more specifically its value, that the customer is losing in the bankruptcy rather than the crypto itself. 

The loss rules limit the amount of a loss to the acquisition cost of the lost property. If the lost property is the contract, the acquisition cost of that contract is going to be equal to the value of the crypto given up to get the contract – the value of the crypto transferred into the Earn Account. In the example above, that would be $20,000.  

Customers, however, will not be able to claim a loss using that amount because they will need to see what recovery or payout they receive from the bankruptcy.  Any recovery will reduce the amount of the loss.  For example, if the customer from the example above ultimately receives $9,000 from the bankruptcy, the loss deduction will be limited to $11,000 ($20,000 initial loss less $9,000 recovery).

Is My Loss Deduction Considered a Capital Loss?   

Once a customer is eligible to claim a loss deduction and knows the deductible amount, the last question is what the character of that loss deduction is — i.e. capital or ordinary. Under the tax code, loss deductions are generally considered ordinary losses meaning that they can be used to offset any income such as business or wage income, and not just limited to offsetting capital gain (with a max of $3,000 able to be used to offset ordinary income). 

The tax code generally puts losses into three categories: 

1. Related to a trade or business;

2. Related to a transaction entered into for profit that is not a trade or business; or 

3. Related to a casualty event or theft.

Given the bankruptcy court’s ruling about the Earn Accounts, it is likely that customers can argue that the loss relates to a transaction entered into for profit – the purpose of the Earn Account was to lend out crypto to Celsius and earn some yield in return.  This is likely better and easier than trying to categorize the loss as a theft, which some individuals may want to do.

Categorizing a loss as a theft loss under the tax code is somewhat difficult because the taxpayer needs to be able to show that a theft occurred under the law of the relevant state.  That is not always as easy as just saying it was a theft.  The New York Attorney General recently filed a lawsuit against the CEO of Celsius, Alex Mashinsky, alleging various fraud and misrepresentation causes of actions, but this lawsuit is a civil lawsuit rather than a criminal one. 

Separately, even if a theft can be shown, since 2018, theft losses are not deductible by individuals on their tax returns unless they relate to a federally-declared disaster. At this point, no such declaration has been made and it is unlikely one will be made. 

What's Next?

Unfortunately, Celsius customers are still in a holding pattern with respect to any tax losses.  The court’s ruling however does provide some initial clarity for Earn Account holders and should provide some insight on what approach to take when filing 2022 taxes and what to be thinking about or what discussions to be having with a tax professional in regard to deducting losses arising from the bankruptcy in the future. 

How TaxBit Can Help

At TaxBit, we are building the industry-leading solutions for digital asset compliance. Our technology is trusted by some of the world’s largest regulatory agencies, accounting firms, and Fortune 500 companies with features such as:

• Scalability to handle tens of millions of transactions

• A controlled environment to support robust control frameworks such as ISO 27001 or SOC 1 & 2

• Audit support that is built with your auditors in mind

• Leading expertise from our team of IRS, AICPA, and Big-4 alumni

Contact us to learn more, explore partnership opportunities, or schedule a demo of our enterprise solutions.

Please note: TaxBit content is for informational purposes only; you shouldn’t construe any information as legal, tax, investment, or financial advice. For those affected by the Celsius situation or other bankruptcy proceedings, it is recommended that you seek professional tax advice.