Deductibility of Cryptocurrency Losses: Active Trade or Business Analysis

By: Matthew E. Foreman, Esq., LL.M. and Samuel J. Brady, Esq.[1]

A question of burning relevance to certain taxpayers and their advisors is whether losses incurred in cryptocurrency trading can (a) be deducted generally and (b) can be deducted in excess of gains from the same activities.

Section 162(a) of the Internal Revenue Code of 1986 as amended (the “Code”) states that a taxpayer is permitted to deduct ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. Nearly every word of Code section 162(a) has been extensively clarified by regulations, caselaw, and subregulatory guidance. The requirements for deducting expenses are explored in this article, but the crux of the analysis in determining whether cryptocurrency losses in excess of gains from the same activities can be properly deducted by an individual taxpayer hinges on whether the taxpayer’s cryptocurrency activities in the tax year in question constitute a “trade or business.”[2] Section I of this article explores the general requirements of Code section 162(a) deductions, Section II explores the general requirements for an individual to be active in a trade or business under Code section 469, Section III explores and applies the key requirements of Code sections 162(a) and 469 to the context of cryptocurrency trading, and Section IV provides a conclusion to summarize the considerations.

Trade or Business Expenses under Code Section 162[3]

As stated above, for any expense to be deductible under Code section 162, it must meet each of the four requirements:

1. The expense must be related to a trade or business;
2. The expense must be ordinary and necessary;
3. The expense must have been incurred in the carrying on of the trade or business; and
4. The expense must have been paid or incurred during the tax year it is being deducted.

The “Trade or Business” Requirement

The term “trade or business” is intentionally not defined in the Code or the Treasury Regulations, as Congress, the Department of the Treasury (the “Treasury”), and the Internal Revenue Service (the “IRS”) prefer to use the lack of a formal definition as a way to prevent taxpayers from literally meeting requirements without substance. As such, courts have sought to define “trade or business,” with the seminal case being Groetzinger,[4] which held that for there to be a trade or business, there must be a profit motive, which can be shown through the activities of the employees, agents, and owners of the business. While there must be a profit motive, the reasonableness of the belief that profit can be made is not relevant, provided the belief is beyond mere hope, particularly if it will take a long time for the business to become profitable.[5] A taxpayer does not have to hold themselves out as being in that trade or business, for example Mr. Groetzinger literally gambled on dog races, but the key is that the trade or business must be intended to be a source of livelihood.[6]

It is necessary for the taxpayer to undertake the business on a “considerable, regular, and continuous” basis,[7] though a single taxpayer can have multiple trades or businesses,[8] leading to questions regarding how considerable, regular, or continuous each trade or business must be. Further, a group of businesses can be a “unified business enterprise", which could allow for certain deductions that would not otherwise be permitted due to the lack of a trade or business, provided there is a larger business enterprise.[9]

In Groetzinger, Mr. Groetzinger “devoted 60 to 80 hours per week” to gambling on dog races with the intention of earning a living from those activities.[10] Mr. Groetzinger generated gross winnings of $70,0000 with $72,032 of expenses and declared a net loss for the tax year of $2,032.[11] On audit, the IRS determined that Mr. Groetzinger’s losses were sustained in the “trade or business of gambling” and disallowed the deduction. The Supreme Court disagreed with the IRS, reasoning that to be engaged in a “trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify” and that the ultimate determination would require a fact-specific examination without a bright-line test.[12] The Court held that Mr. Groetzinger’s activities were undertaken with the requisite profit motive, with sufficient continuity and regularity, and were, therefore, a trade or business within the ordinary meaning of such term in the tax code. Accordingly, his deduction was allowed.

The “Ordinary” and “Necessary” Requirements

Expenses must be both ordinary and necessary to be deductible,[13] In Welch, the Supreme Court analyzed the deductibility of payments made to the creditors of a bankrupt corporation that the taxpayer was not statutorily required to make but made in an attempt to repair his standing in the business community and to repair his credit in an attempt to launch a new business venture.[14] In grappling with whether such a deduction was ordinary, the Supreme Court reasoned that the situation may be “unique in the life of the individual affected, but not in the life of the group, the community of which he is a part.” The Court held that whether a deduction is ordinary depends on whether similarly situated people from the taxpayer’s community would act similarly, i.e., whether a similar business would normally have this as an expense.[15] This is determined by the time, place, and circumstances[16] of the expense, as well as how regularly, commonly, or frequently these expenses occur for this kind of business.[17]

In addition to being ordinary, for an expense to be deductible, it must also be necessary. For an expense to be necessary, it must be “appropriate and helpful,” though not absolutely essential,[18] but the expense must be reasonable.[19] An expense can be necessary even if there are other ways to reach the same result,[20] for example if there are more economical and practical means of attaining the same result, the expense is not reasonable.[21] In Jenkins v. Comm’r,[22] the Tax Court reasoned that whether a deduction is appropriately necessary depends on the intention of the taxpayer in making the expense. The Tax Court held in Jenkins that a business expense was in furtherance of his trade or business and therefore deductible because the taxpayer paid the debts of his investors to avoid negative publicity as a Country performer.[23]

The “Carrying On” Requirement

For a deduction to be permitted, the expense must be made in carrying on an ongoing trade or business within the tax year.[24] The key determination for whether commercial activity is an ongoing trade or business is whether economic activity has commenced and the business is functioning as a going concern.[25] Preparation and start-up costs,[26] as well as having a business that is a mere expectation is not the carrying on of a trade or business.[27] In order to have a trade or business, common factors that indicate the existence of carrying on a trade or business are investors, sales, a plan, facilities, contracts, activities, the performance of services, customers.[28]

Further, the expense must be related to carrying on a specific trade or business. There are numerous examples of the lack of the relationship between an expense and a trade or business--with common examples being people who deduct personal expenses, such as cars and travel, that frequently come before various courts.[29]

Paid or Incurred During the Tax Year Requirement

The trade or business deduction must be for an expense made within the tax year, as opposed to permanent improvements or improvements made to increase the value of any property or estate.[30] Cash basis taxpayers may only deduct expenses in the year the expense was paid,[31] and accrual basis taxpayers may only deduct expenses in the year in which they are incurred.[32]

Active in a Trade or Business under Code Section 469

Prior to 1986, taxpayers generally could deduct losses in full, from rental activities and trades or businesses, without regard to their level of participation.[33] Following the Tax Reform Act of 1986,[34] a loss from a passive activity can only be used to offset passive income.[35]  In essence, Code section 469 creates three baskets, (i) Active, (ii) Passive, and (iii) Portfolio. Income is in the active basket if the taxpayer materially participates, which requires “regular, continuous, and substantial” activity.[36] To the extent losses from an activity are not active, the losses are categorized as passive and cannot offset income from an active trade or business.[37]

A taxpayer’s involvement in an activity can be considered regular, continuous, and substantial under a variety of tests.[38] The tests, only one of which needs to be met for the taxpayer’s activities to be considered regular, continuous, and substantial, are as follows:

• The individual participates in the activity for more than 500 hours during the tax year;[39]
• The individual’s participation constitutes substantially all of the activities for all individuals (including owners and no-owners) for the tax year;[40]
• The individual participates for more than 100 hours during the tax year and is not less than any other individual participant;[41]
• The taxpayer spends at least 100 hours in each of a variety of different activities and, together, the individual’s participation in the larger group of activities exceeds 500 hours;[42]
• The individually materially participated in this activity for at least five of the past ten years, though not necessarily consecutively;[43]
• The activity is a personal service activity and the individual materially participated in at least three years preceding the current tax year, though not necessarily consecutively;[44] or
• Based on all the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the current tax year.[45]

Establishing a "Trade or Business" in the Cryptocurrency Trading Space

Accordingly, the threshold question for a trade or business deduction in cryptocurrency trading is whether the taxpayer’s activities in the relevant tax year can be viewed as undertaking a “trade or business.” The next question will be whether the deduction can be said to be undertaken actively or passively. Finally, the recent and convoluted Excess Business Loss Limitation rules, which impose severe limits on the deductibility of certain losses from business activities, renders the question, “whether business losses may be established” moot.

Determining Whether Cryptocurrency Trading is a Trade or Business

Presently, there is no case law or guidance directly on point to determine whether cryptocurrency trading is a trade or business. Therefore, any analysis must begin by discussing the general trading of goods; the most on point is the trade of securities. An individual who purchases and sells securities does not have a default classification, as they can be a trader, a dealer, or an investor.[46] A dealer purchases and sells for the account of others, which is inapplicable here. A trader sells for their own account and their income is derived by fluctuations in price in the short-term.[47] Meanwhile, an investor derives income from long-term appreciation or distributions.[48] Managing a portfolio of investments is not a trade or business,[49] as a taxpayer must engage in substantial trading activity to be considered in the business of trading cryptocurrency.[50] One recent case that is favorable to individuals seeking to have their cryptocurrency activities classified as a trade or business is YA Global,[51] in which the taxpayer provided funding in various forms, because the general partner structured the investments and performed due diligence, the general partner’s activities, and therefore YA Global’s activities, were sufficiently continuous and regular to have YA Global be categorized as a trade or business.

Certain activities, which can be considered sufficient to characterize cryptocurrency trading as a trade or business when the activity is viewed on the whole, can also exist in a variety of forms, including literally buying and selling various digital assets; staking;[52] wrapping and unwrapping tokens; and researching new technologies, protocols, and digital assets. However, it’s important to remember that the activities must be undertaken on a considerable, regular, and continuous basis.

Determining Whether Cryptocurrency Trading is Active or Passive

In many ways, the determination of whether cryptocurrency trading is active or passive is simpler than determining whether cryptocurrency trading is a trade or business, if only because of the myriad of tests, particularly those with mechanical hours requirements.  The time spent trading, staking, etc., are not the only time considered when determining if the activity is active or passive. Rather, the time that must be considered includes time spent reading whitepapers, reviewing new features on various blockchains, and attending seminars, conferences, and webinars. As a result, recordkeeping can be especially important to be able to substantiate the time and effort spent in case of an audit by the IRS or a state tax authority.[53] Merely showing a list of trades, in absence of thousands of trades in a brief period of time, is unlikely to be sufficient to show that cryptocurrency trading was active.

Excess Business Loss Limitation

Section 465 of the Code limits losses to the amount at risk.[54] Under the 2017 legislation commonly referred to as the Tax Cuts and Jobs Act,[55] noncorporate taxpayers[56] were disallowed from taking deductions of “excess” business losses for tax years beginning in 2018.[57] The Inflation Reduction Act of 2022 extended the business loss limitation through 2028. [58] As such, excess business losses are defined as the excess of aggregate deductions of the taxpayer attributable to a taxpayer’s trade and business activities less the sum of gross income from that trade or business beyond a threshold amount.

In effect, businesses that are not corporations are prohibited from taking losses that exceed the loss limitation threshold (i.e., more than $305,000 for 2024) in the year of the loss. Losses are carried forward to the next year indefinitely. The excess amount is determined by netting the “aggregate deductions attributable to trades or businesses” of a taxpayer in a tax year and the “aggregate gross income or gain . . . attributable to such trades or businesses.”[59] Accordingly, if the facts and circumstances permit a cryptocurrency trading taxpayer to take such a deduction, the loss limitation under Code section 465(l) may limit the taxpayer from using losses to offset income from other sources.

Case Study, Establishing Trade or Business in Crypto Trading Applying Groetzinger

Over a few tax years, the taxpayer (the “Crypto Trader”) engaged in significant activities with the goal of profit. The Crypto Trader spent significant time researching various digital assets and blockchains, reading whitepapers, attending webinars and in-person events, and connecting with well-known enthusiasts and market participants. The Crypto Trader researched new technologies and read research by other enthusiasts prior to engaging in trades and other transactions, such as staking. As was common, given overall market trends in the industry, the Crypto Trader did very well in 2020 and 2021, but lost considerable sums of money in 2022, leading to a significant loss in 2022. 

Trade or Business under Code Section 162

While the Crypto Trader was enthused about digital assets generally, there was a profit motive behind their actions.  The Crypto Trader spent many of their waking hours reading, analyzing, and discussing various aspects of digital assets and blockchains, which was clearly a considerable, regular, and continuous basis.  The expenses were costs related to various trades and positions, as well as webinars and books about the industry, which are both ordinary and necessary in the industry.  The activities undertaken by the Crypto Trader were done to carry on the business of trading in cryptocurrencies, and the expenses were all paid during the tax year.

Active in a Trade or Business under Code Section 469

The Crypto Trader spent significantly more than 500 hours during the tax year, and the sheer volume of activities, including emails, attendance at seminars and webinars, and trades can be used to substantiate these claims.  The Crypto Trader can likely meet a significant number of the mechanical tests, and there is even an argument that the Crypto Trader meets the facts and circumstances test given the sheer amount of time and effort during the year, which they estimated at 12-16 hours per day, every day including weekends, for a period of nearly three years.

Conclusion

Being permitted to take deductions for expenses relating to a trade or business for cryptocurrency trading, especially one where the activities result in losses depends heavily on the facts and circumstances of a given situation.  The taxpayer will need to ensure that their activities rise to the level of carrying on a trade or business, and that they, as individuals, are active in the trade or business itself.  Further, as was the case here, even if they meet both requirements, the ability to take the losses may be limited by the excess business loss rules.  As such, it is imperative that any taxpayer seeking to take deductions or losses consult an experienced tax advisor before taking a position.

[1] Matthew E. Foreman is a Partner and Co-chair of the Taxation Practice Group and Samuel J. Brady is an associate in the Taxation Practice Group at Falcon Rappaport & Berkman.  The authors would like to thank Bristol C. Francis for his assistance with the drafting of this article.

[2] See generally, Comm’r v. Groetzinger, 480 U.S. 23 (1987).

[3] If you would like to listen to a two-part podcast on this topic, including discussions of common fact patterns, it can be found https://frblaw.com/podcast/ordinary-necessary-business-expenses-irc-162-and-212/ and https://frblaw.com/podcast/ordinary-necessary-business-expenses-examples-and-what-not-to-do/ .

[4] Id. at 30.

[5] Ellsworth v. Comm’r, 21 T.C.M. (CCH) 145 (1962).

[6] See generally, Groetzinger, 480 U.S. 23 (1987).

[7] Pinchot v. Comm’r, 113 F.3d 718 (2nd Cir. 1940); Aurynger v. Comm’r, 9 BTAM 40-1000 (1940); Neill v. Comm’r, 46 B.T.A. 197 (1942).

[8] Campbell v. Comm’r, TC Memo 1992-66 (1992).

[9] Morton v. United States, 98 Fed. Cl. 596 (2011); Storey v. Comm’r, TC Memo 2012-115 (2012);  However, in CCA 201747006, the IRS stated that it will not acquiesce on Morton and will continue to assert the holding in Moline Properties v. Comm’r, 319 US 436 (1943), is still good law on this point.

[10] Groetzinger, 480 U.S. 23 (1987).

[11] Id.  Many tax famous and important cases have surprisingly small amounts of tax at issue.  Perhaps the two tax cases that received the most press were Moore v. United States, 144 S.Ct. 1680 (2024) ($14,729 in tax) and Jarrett v. United States, 79 F.4th 675 (6th Cir. 2023) ($3,793 in tax), where the actual amounts at issue were essentially rounding errors when compared to the legal expenses.

[12] Groetzinger, 480 U.S. 23, at 35.

[13] Welch v. Helvering, 290 U.S. 111 (1933).

[14] As the payment of debts was made to support the taxpayers attempt to launch a new business, the Court held that the deduction was not personally deductible to the taxpayer but was, rather, an expense that needed to be capitalized. See Id. at 115.

[15] Deputy v. Du Pont, 308 US 488, 495 (1940).

[16] Welch v. Helvering, 290 U.S. 111, 113-14 (1933).

[17] Lilly v. Comm’r, 343 US 90 (1952).  It is possible that only one business in the same industry can have certain expenses, but courts upholding these kinds of deductions are atypical.  See, e.g., United Title Insurance, TC Memo 1988-38.

[18] Welch v. Helvering, 290 U.S. 111, 113 (1933).

[19] See Comm’r v. Heininger, 320 US 467, 472 (1943).

[20] United Title Insurance v. Comm’r, TC Memo 1988-38.

[21] A.S, Barber v. U.S., 85-1 USTC ¶ 9183 (1984).  A common example of this is a business owning a vehicle, such as an automobile or plane, and using it for travel.

[22] 47 T.C.M. (CCH) 238 (1993).

[23] See generally, Id.

[24] See Estate of Rockefeller v. Comm’r, 762 F.2d 264 (1985) in which the Court held that the taxpayer’s “trade or business” was working as a government executive and upon his resignation from that role and serving as chair of public commissions, deductions claimed were not in connection with his previous or any other trade or business.

[25] Richmond Television Corp. v. U.S., 345 F2d 901, 907 (4th Cir. 1965).

[26] I.R.C. § 195.

[27] Ellis v. Comm’r, 26 T.C.M. (CCH) 450 (1967); Forrest v. Comm’r, TC Memo-2011-4 (2011); See also I.R.C         § 195.

[28] Willits v. Comm’r, 78T.C.M. (CCH) 74 (1999); Haney v. Comm’r, 94 T.C.M. (CCH) 197 (2007); Vianello v. Comm’r, TC Memo 2010-17 (2010).

[29] See, e.g., Lloyd v. Commissioner, 55 F.2d 842 (7th Cir. 1932), aff'g 22 B.T.A. 674 (1931); and Mack v. Comm’r, T.C. Memo 1976-359 (1976).

[30] See Treas. Reg. § 1.162-1(b)(2). See generally, Havener v. Comm’r, T.C. Summ. Op. 2018-27.

[31] Examples include Carlisle v. Commissioner, 37 T.C.M 424 (1961) (legal fees); Brown v. Comm’r, T.C. Memo 2017-18 (no wage deduction for year in which business did not exist); and Slavin v. Comm’r, T.C. Summ. Op. 2016-28 (2016) (no deduction for capitalized mortgage interest).

[32] Anderson v. Comm’r, 35 T.C.M. 101 (1976), aff'd in unpub. op. (9th Cir. Feb. 6, 1979).

[33] Passive Activity Loss Audit Technique Guide, Catalog Number 83479V at 8 Internal Revenue Service (2005).

[34] Pub. L. 99-514.

[35] See IRC § 469 (d)(1) (defining passive activity loss as the excess of the amount of aggregate passive activity losses for the taxable year over the amount of income from passive activities during that taxable year).

[36] IRC § 469(h).

[37] There is no constraint on the use of active losses to offset passive gains, as Code section 469 only limits the use of losses and credits from passive activities.

[38] Treas. Reg. § 1.469-5T.

[39] Treas. Reg. § 1.469-5T(a)(1).  The 500 hours aggregates time spent by a married couple as if they are a single taxpayer.  T.D. 8175 (Preamble to Temporary Regulations), 53 Fed. Reg. 5686, 5696 (Feb. 25, 1988).  A short tax year still requires 500 hours.  Gregg v. United States, 186 F. Supp. 2d 1123 (D. Or. 2000).  While the hours can be substantiated by estimates, we strongly recommend keeping contemporaneous documentation.  See Treas.

Reg. § 1.469-5T(f)(4); T.D. 8175 (Preamble to Temporary Regulations), 53 Fed. Reg. 5686, 5697 (Feb. 25, 1988); Speer v. Comm’r, T.C. Memo 1996-323.

[40] Treas. Reg. § 1.469-5T(a)(2).  “Substantially all” is not defined in this context, but the IRS has signaled that they view it as being essentially synonymous with “everything", though courts have generally disagreed with such a strict definition.  Treas. Reg. §1.469-5T(a)(2); Conference Report to Accompany H.R. 3838, H.R. Rep. No. 99-841, 99th Cong., 2d Sess. (September 18, 1986); Windham v. Comm’r, T.C. Memo 2017-68 (2017); Fitch v. Comm’r, T.C. Memo 2012-358 (2012).

[41] Treas. Reg. § 1.469-5T(a)(3).

[42] Treas. Reg. § 1.469-5T(a)(4).  While there are numerous points here, perhaps the most important point is that the activities that are grouped do not have to be similar, and the regulations give an example using a restaurant and a shoe store.  Treas. Reg. § 1.469-5T(k) Ex. 4.

[43] Treas. Reg. § 1.469-5T(a)(5).

[44] Treas. Reg. § 1.469-5T(a)(6).

[45] Treas. Reg. § 1.469-5T(a)(7).  The final test is a true facts and circumstances test, and in general taxpayers are advised to not use it unless the activity requires an extremely small amount of time or has extremely strong facts given the overall facts and circumstances.

[46] King v. Comm’r, 90 TC 445 (1987). 

[47] Crissey v. Comm’r, TC Summ. Op 2017-44 (2017).

[48] See id.; see also, Kay v. Comm’r, TC Memo 2011-159 (2011).

[49] Higgins v. Comm’r, 312 US 212 (1941).

[50] See Holsinger v. Comm’r, TC Memo 2008-191 (2008); Crissey, TC Summ. Op 2017-44.

[51] YA Global Invs., LP v. Comm’r, 161 TC No 11 (2023).

[52] Or, if you’re so inclined to take a joke too far, baking, See https://docs.tezos.com/architecture/baking (last retrieved July 9, 2024).

[53] See, e.g., Cohan v. Comm’r, 39 F.2d 540 (2d. Cir. 1930).

[54] Loss is, in general, limited to the “aggregate amount with respect to which the taxpayer is at risk” for such activity.  I.R.C. § 465(a).  In a cryptocurrency trader’s case, it would be limited to the initial value of their investments (i.e., their basis).

[55] The Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018, Pub. L. No. 115-97 § 11012 (2017).

[56] Such as LLC members, partnership partners, and sole proprietors.

[57] I.R.C. § 461(l).  $250,000 for individuals or $500,000 for joint returns; this number adjusts for inflation and in Rev. Proc 21-45 is $270,000 for individuals or $540,0000 for joint returns in tax year 2022.  I.R.C. 461(l)(3).

[58] Pub. L. No. 117-196 § 99041 (2022).

[59] I.R.C. § 461(l)(3)(A).

DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.