How Web3 Enterprises Resolve Tax Disputes: FTX and MicroStrategy as Examples

Author: TaxDAO

1. Introduction

With the rapid rise of encryption assets, encryption assets have become a core component of the global financial sector. However, their unique decentralization and anonymity also bring unprecedented tax challenges. As a global leader in financial technology, the United States has established a strict system for the taxation of encryption assets. According to the regulations of the Internal Revenue Service (IRS), cryptocurrency is treated as property, so its buying, selling, exchanging, and trading may trigger capital gains or losses, which need to be reported in accordance with capital gains tax. In addition, income from mining, airdrops, and hard forks must also be taxed.

However, due to the rapid iteration of encryption asset technology, there is a lag in tax supervision. In this emerging field, taxpayers and tax authorities often have disputes over tax payments or tax responsibilities. At this time, tax reconciliation provides both parties with an efficient solution. Through negotiation and consultation, taxpayers can reach an agreement with the tax authorities, thereby ending the dispute and avoiding harsher penalties.

2. Overview of the U.S. Tax and Settlement System

2.1 Development Process of the US Tax and 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 fulfilling their tax obligations, including the rights to be informed, receive quality service, finality, confidentiality, question the IRS’s position, and appeal. One of these rights is the right to a fair and just tax system, which explicitly states that taxpayers have the right to request the tax system to consider facts and circumstances that may affect their potential liability, ability to pay, or timely provision of information. If taxpayers encounter financial difficulties or the IRS fails to resolve their tax issues through normal channels, taxpayers have the right to assistance from the Taxpayer Advocate Service (TAS). Under this right, in specific situations (such as when taxpayers are unable to fully repay tax debts or full repayment would cause economic hardship), taxpayers can reduce the unpaid tax amount by submitting an Offer in Compromise (OIC) protocol to ensure that they can afford basic living expenses.

2.2 Conditions for the Implementation of the U.S. Tax Settlement System

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

The tax and compromise system of the Internal Revenue Service (IRS) in the United States refers to a binding protocol reached between taxpayers and the IRS when taxpayers cannot fulfill their tax obligations, including administrative and criminal responsibilities (including penalties, interest, and other tax supplements), and the amount of tax due, enabling taxpayers to settle their tax issues for less than the amount owed. However, the premise of this protocol is that the taxpayer completes the application and meets specific conditions:

a. When there is a dispute about the existence or amount of the debt, the IRS can accept a compromise.

b. If taxpayers are concerned about whether the amount owed can be fully recovered, i.e. if their assets and income are lower than their tax debt, the IRS may accept a settlement.

c. When taxes are legally due but can be fully recovered, but full payment would cause economic hardship for taxpayers, or result in unfairness in special circumstances, the IRS may accept a settlement.

To successfully reach a tax compromise (OIC) protocol with the national tax authority, individuals or companies need to complete the following specific steps to apply to the national tax authority and ultimately obtain approval:

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

Step 2: If it’s an individual, fill out Form 433-A; if it’s a company, fill out Form 433-B and calculate the reasonable tax bill.

Step 3: Attach relevant document copies to support the content of forms 433-A/433-B.

Step 4: Fill out Form 656, select a tax resolution plan, and ensure that the tax amount under this plan is greater than or equal to the calculation result on Form 433.

Step 5: Submit the first tax payment and a $205 application fee

Step 6: Mail the application to the National Tax Bureau

Step 7: If the application fails, taxpayers may appeal to the independent office of the State Taxation Administration within 30 days.

In addition to OIC, the tax bureau also provides other alternative dispute resolution (ADR) mechanisms, including Fast Track Mediation and Fast Track Settlement: When taxpayers cannot reach an agreement with the reviewing authority on tax matters, the reviewing authority shall prepare Form 14717 and attach the statement of issues and the appraisal report of both parties for appeal. After the appeals department accepts it, a mediator will be assigned to facilitate reconciliation through mediation meetings. If the two parties fail to reach an agreement in the appeal, they may enter into post-appeal mediation depending on the situation, and the case will be assigned to another appeals office for re-examination.

2.3 Characteristics of the U.S. Tax Settlement System

To a certain extent, the United States is influenced by the trend of pragmatism and administrative democratization. Although there are certain provisions for the application of reconciliation in legislation, the tax court encourages reconciliation. In the Administrative Dispute Resolution Act (ADAR) passed by the U.S. Congress in 1990, legislators also propose to “authorize and encourage federal administrative agencies to use mediation, negotiation, arbitration, or other informal procedures for the prompt resolution of administrative disputes.” When implemented in the field of tax administration, about 80% of small tax litigation cases can be settled out of court before trial, thereby ending the litigation process.

3. Example of FTX and MicroStrategy’s Tax Settlement

3.1 FTX Tax and Settlement Cases

FTX was once a well-known global Spot and Derivatives (encryption assets) trading platform, founded in 2019, and quickly became the world’s second largest Virtual Money trading platform.

In 2022, due to financial fraud committed by Sam Bankman-Fried, former CEO of FTX, in conjunction with his other trading company Alameda Research, the fund chain of FTX was broken, leading to FTX, Alameda Research, and over 134 other affiliated companies filing for bankruptcy in the United States, causing investors to lose billions of dollars.

In the bankruptcy process, the IRS has filed initial tax claims against FTX and its subsidiaries (including FLX Trading ltd., Alameda Research, etc.) for a total of 44 billion USD, which was later revised to 24 billion USD, related to income taxes, employment taxes, and penalties owed between 2018 and 2022. However, FTX lawyers submitted documents to the bankruptcy court in December 2023, objecting to the claims and requesting the IRS to provide corresponding documents to substantiate its claims against FTX and explain how it estimated the additional tax payments. In the documents, FTX lawyers stated that FTX has never received any amount close to the 24 billion USD tax claim by the IRS and has incurred substantial losses. They also refuse to assume the income tax liability for the so-called “embezzled income” resulting from Sam Bankman-Fried’s misappropriation of FTX customer funds and the employment tax liability for compensation. Furthermore, FTX lawyers emphasized in the statement that the only source of recovery for the IRS is the compensation taken from the victims. Based on this, FTX has filed a settlement application and is willing to pay 200 million USD in priority tax claims to the IRS, as well as 685 million USD in lower-priority claims.

In June 2024, FTX reached a final settlement with the Internal Revenue Service (IRS) protocol, with the IRS receiving a priority claim of $200 million in the FTX bankruptcy case and paying within 60 days after the company’s proposed restructuring plan takes effect. In addition, the agency will also receive a lower priority claim of $685 million to pay customers and other creditors.

3.2 Microstrategy Taxation and Settlement Case Studies

In 2022, Washington, D.C. Attorney General Karl Racine filed charges against Michael Saylor, the founder of MicroStrategy and a billionaire in the cryptocurrency industry, accusing him and his company of ‘failing to pay income tax for at least 10 years while residing in the District.’ MicroStrategy, through the submission of false W-2 forms, helped Saylor evade over $25 million in income tax owed to the District. In his tax filings, Saylor claimed to reside in Florida, a state that does not impose personal income tax, but he actually lived in a waterfront apartment in Washington, D.C. Additionally, Saylor mitigated his tax risk by receiving only a $1 salary along with numerous benefits (such as private jet travel, chauffeur, and security team), allowing the company to cover federal taxes on those benefits, which were not considered taxable compensation due to his Florida address. In August 2022, Saylor resigned as CEO of MicroStrategy as a result of this case and assumed the role of Executive Chairman.

It was the largest income tax fraud recovery case ever in the District of Colombia and the first lawsuit in the district since the False Claims Act was amended, which encouraged whistleblowers to file tax evasion charges against residents who allegedly concealed their actual residence. According to the allegations, anyone who knowingly submits or causes to be filed a false claim to the government is liable for three times the amount of damages lost by the government, as well as a fine linked to Inflation, so experts have held that Saylor should be fined at least $75 million. In the face of the lawsuit, however, Saylor insisted that he moved from Virginia to Florida more than a decade ago, bought a house in Miami Beach, and lived in Florida, where he lived, voted and performed jury duty. MicroStrategy clarified that the company does not have the authority to regulate and influence Saylor’s personal tax issues, and therefore refuses to take responsibility for Saylor’s “tax fraud” problem. In the event that both parties disagree, each party expresses its desire to avoid the time, expense, and inconvenience required for any further litigation and to resolve all disputes and potential legal claims based on the Covered Conduct. As a result, on June 3, 2024, Saylor settled with the Washington Attorney General for $40 million in tax fraud.

4. Insights into the U.S. Tax and Settlement System

4.1 Tax Implications of the FTX Case

As the former second-largest exchange in the world, FTX’s collapse has damaged market confidence in encryption assets. The tax settlement in this case involves not only the tax dispute between the national tax bureau and FTX, but also the bankruptcy of FTX exchange and the compensation of defrauded victims. The settlement protocol 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 longer. Therefore, facing high debt claims, American companies have a certain opportunity to reach a settlement with the national tax bureau through multi-faceted appeals at relatively low claim costs.

4.2 Tax Implications of the MicroStrategy Case

The United States implements a legal system of dual tracks of federal law and state law. Therefore, in addition to understanding federal law, it is also necessary to follow the changes of state law at all times. The policy differences among different states do provide taxpayers with certain Favourable Information (such as the Florida government’s exemption from personal income tax) and space for reasonable tax avoidance. However, there is a high risk in the tax avoidance method of falsely reporting one’s place of residence, especially under specific and strict legal regulations. Therefore, companies should assist their employees in reasonable tax planning based on legal compliance to ensure that their tax behaviors are compliant and transparent.

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

5. Conclusion

Due to the characteristics of Crypto Assets such as Decentralization, Anonymity, and global Liquidity, individuals or companies holding encryption assets pose difficult tax supervision and evidence collection risks for tax authorities, making them susceptible to tax loopholes. Consequently, Cryptocurrency has inevitably become a means of tax avoidance.

In the case discussed in this article, the IRS initiated a high tax debt claim against FTX, and in the face of FTX’s questioning of the debt amount, the IRS did not conduct a more rigorous investigation of this encryption asset trading platform and provide rigorous evidence, but chose to accept a settlement solution from FTX’s legal team, with compensation nearly 100 times lower than the “24 billion USD” tax amount previously demanded by the IRS, and reached a settlement with FTX. The case of “Cryptocurrency billionaire” Saylor’s tax evasion also did not go through the legal process, but instead reached a settlement with the Washington, D.C. government through tax compensation. From the results of the two cases, the application of the tax settlement system in the encryption industry is feasible and effective. For the current “immature” encryption industry and “imperfect” encryption asset tax policies, the tax settlement system is highly practical, conducive to improving tax administration, effectively resolving tax disputes, alleviating the pressure of tax inspection, and also providing taxpayers with effective means to address tax compliance oversight.

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