What Are the Legal Risks to Cryptocurrency Investors?

Along with the explosion of interest in digital currency and all of its implications for both new and traditional businesses, there is a growing need for clarity regarding the legal implications of these new technologies and currencies. As governments around the world, regulatory agencies, central banks, and other financial institutions are working to understand the nature and meaning of digital currencies, individual investors can make a great deal of money investing in this new space. On the other hand, investors assume certain legal risks when they buy and sell cryptocurrencies.

While digital currency might be easy to confuse for conventional electronic money, it is not the same; similarly, it is unlike conventional cash currencies because it cannot be physically owned and transferred between parties. Much of the murkiness of the legal standing of digital currency is due to the fact that the space has only recently become popular as compared with more traditional currency and payment systems. Below, we'll explore some of the emerging legal implications associated with investing in cryptocurrencies.

Key Takeaways

  • As cryptocurrency investing has become pervasive, it has brought up a variety of legal implications and risks that savvy investors need to be aware of.
  • In some countries, cryptocurrency is seen as currency, but in the U.S. it's seen as property and is therefore taxed as such. Investors in crypto will need to pay capital gains taxes regardless of where they bought the crypto.
  • Bitcoin and other cryptocurrencies are decentralized and are therefore not backed by a central authority, which can be both a boon and a risk for investors.
  • Businesses that accept crypto do not currently need to register or obtain a license to do so, but at some point, they might, including the right to operate in certain jurisdictions.
  • Because of the decentralized nature of crypto, there is a greater risk of fraud; there is also the reality that investors who have been defrauded will not have the same legal recourse as traditional fraud victims.

Cryptocurrencies as Property

One of the most critical legal considerations for any cryptocurrency investor has to do with the way that central authorities view cryptocurrency holdings. In the U.S., the IRS has defined cryptocurrencies as property rather than currencies. This means that individual investors are beholden to capital gains tax laws when it comes to reporting their cryptocurrency expenses and profits on their annual tax returns, regardless of where they purchased digital coins.

This aspect of the cryptocurrency space adds layers of confusion and complexity for U.S. taxpayers, but the difficulty does not end there. Indeed, it remains unclear whether digital currency investors who have purchased their holdings on foreign exchanges must face additional reporting measures come tax time. According to a report by CNBC, "anyone with more than $10,000 abroad usually needs to fill out the Report of Foreign Bank and Financial Accounts (FBAR)... with the Treasury Department each year. Another law—the Foreign Account Tax Compliance Act, or FATCA—requires certain U.S. taxpayers to describe their overseas accounts on Form 8938, when they file their taxes with the IRS."

Former federal tax prosecutor Kevin F. Sweeney offered a hint as to how foreign cryptocurrency exchanges could complicate tax matters for U.S. digital currency investors: "there probably is an FBAR requirement, but I wouldn't go as far as to say there is always one," he explained, adding that the lack of guidance from the IRS has created a "black hole" of uncertainty for investors and tax professionals alike. "It would seem awfully unfair if they would expect taxpayers to know that—and to then issue penalties for taxpayers who didn't do that—when practitioners can't even 100% figure out if there's an FBAR requirement," Sweeney added during his interview with CNBC.

All of this suggests that digital currency investors should take special precautions to follow the advice of tax professionals when it comes to reporting cryptocurrency profits and losses. Because the rules are constantly changing, what may have been legally permissible last year or even months ago may now be cause for legal concern.

Decentralized Status

One of the great draws of many digital currencies is also a potential risk factor for the individual investor. Bitcoin (BTC) has paved the way for other cryptocurrencies in that it is decentralized, meaning that it has no physical presence and is not backed by a central authority. While governments around the world have stepped in to assert their regulatory power in various ways, BTC and other digital currencies like it remain unattached to any jurisdiction or institution.

On one hand, this frees investors from being beholden to those institutions. On the other hand, however, this status could result in legal complications. The value of digital currencies is dependent entirely upon the value that other owners and investors ascribe to them; this is true across all currencies, digital or fiat. Without a central authority backing the value of a digital currency, investors may be left in the lurch should complications with transactions or ownership arise.

Another potential risk associated with cryptocurrencies as a result of their decentralized status has to do with the particulars of transactions. In most other transactions, currency with a physical presence changes hands. In the case of electronic money, a trusted financial institution is involved in creating and settling deposits and debt claims. Neither of these concepts applies to cryptocurrency transactions.

Because of this fundamental difference, legal confusion between parties in various types of digital currency transactions is a real possibility. Once again, because of the decentralized state of these currencies, the path of legal recourse in these situations can be difficult to assess.

Business Registrations and Licensing

A growing number of businesses are taking advantage of digital currencies as a form of payment. As in other financial areas, businesses may eventually be required to register and obtain licensure for particular jurisdictions and activities. However, due to digital currencies ' complex and evolving legal status, this area is significantly less clear for businesses operating in the crypto market.

Companies that only accept cryptocurrencies, for example, may not need to register or obtain licenses at all. On the other hand, they may be required to submit to special considerations depending upon their jurisdiction. The onus of responsibility falls on business owners and managers to ensure that they follow proper legal procedures for their operations at both the local and state levels.

For example, at the federal level, financial institutions must maintain certain protection activities against money laundering and fraud, the transmission of funds, and more. Considerations like these also apply to businesses dealing with digital currencies.

Fraud and Money Laundering

There is a widespread belief that cryptocurrencies provide criminal organizations with a new means of committing fraud, money laundering, and a host of other financial crimes. This may not directly impact most cryptocurrency investors who do not intend to use this new technology to commit such crimes. However, investors who find themselves in the unfortunate position of being a victim of financial crime do not likely have the same legal options as traditional victims of fraud.

This issue also relates to the decentralized status of digital currencies. When a cryptocurrency exchange is hacked and customers' holdings are stolen, for instance, there is frequently no standard practice for recovering the missing funds. Digital currency investors thus take on a certain amount of risk by purchasing and holding cryptocurrency assets.

It is for this reason that developers and startups related to digital currency have focused such a great deal of attention on creating secure means of holding digital coins and tokens. Still, while new types of wallets are being released all the time, and while cryptocurrency exchanges are always improving their security measures, investors have so far not been able to fully eliminate the legal risks associated with owning cryptocurrencies, and it's likely that they never will.

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. 

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. CNBC. "How cryptocurrency investors could find themselves behind bars." Accessed Oct. 24, 2021.