Legal Risks of Crypto Investing
Crypto is becoming more popular than ever before, but there are some legal risks to investing in it. Here are some ways to limit your risks.
If you’re thinking of investing in cryptocurrency within the U.S., you may be wondering if there are any legal risks that come along with it.
With traditional assets like stocks and bonds, buying or selling can create tax liability. And if you hold these assets in a foreign bank or exchange, you may need to file certain paperwork with the U.S. government.
And what about digital security? For years crypto trading took place on the fringes of internet marketplaces. Even though it’s gone mainstream now, you’re still going to want to concern yourself with privacy and cybersecurity.
So if you’re looking to get into this world, there’s a lot to process. How does this work with modern cryptocurrency exchanges? Crypto networks are international, after all. They don’t exist in any one country, so it may not be obvious what legal ramifications you may face if you invest in crypto from within the U.S.
When you’re investing in cryptocurrency, digital security and legality should be two of your primary concerns. In this article, I’ll explain the major legal risks associated with crypto investing, and I’ll outline a handful of options for limiting your risk.
There are a few different categories of legal risk from investing in cryptocurrency. Here is a brief summary of each of them.
- Tax risk: If you gain income from crypto and don’t report it, this can result in tax penalties.
- Risk of penalties for not reporting foreign assets: If you hold crypto in a foreign exchange and don’t report it, you could be penalized by the Financial Crimes Enforcement Network (FinCEN) or the IRS.
- Risk from selling crypto to an unlicensed person: If you sell crypto to anyone other than your exchange, this may violate money transmitter laws in the U.S. or your particular state.
- Risk from violating KYC/AML requirements: If you sell crypto to a person without knowing their identity, you may be violating know your customer (KYC) or anti-money laundering (AML) requirements.
I’ll go into more detail about each of these.
First, let’s talk about the biggest legal risk of crypto investing: tax penalties.
In the early days of crypto, no one really knew how the IRS was going to treat cryptocurrency. But as more and more crypto fortunes have been made, the IRS has begun to make it clear that they want their cut of the profits.
In Notice 2014–21, the IRS has stated that it considers cryptocurrency to be property, like a house, car, or yacht.1
This means that if someone gives you cryptocurrency, the IRS wants you to record the dollar value of it, both at the time it is given to you and at the time you sell it. And if you buy crypto at one price and sell it at another, the IRS wants you to record this as well.
All of this information has to be reported on your tax forms when you file, and you have to pay either ordinary income tax or capital gains tax on whatever income you made from these events.
If you fail to report these events, you may have to pay the extra tax you owe plus 20% or more in penalties.
FYI: Want to know more about taxes and other crypto regulations? Check out our complete guide to crypto regulations in the U.S.
Luckily, there are a few ways to avoid the wrath of the I.R.S. when investing in crypto.
Crypto tax software
The easiest way to report your crypto income accurately is to use crypto tax software to automatically track your crypto transactions. All you have to do is to tell these apps which exchanges, networks, and wallets you use. The apps will then automatically calculate your income from every transaction.
They will also tell you how much income counts as ordinary income and how much counts as capital gains. This way, you can easily make an accurate report of your income for tax purposes.
Here is a list of some popular crypto tax software solutions:
The one drawback to this method is that it can create privacy concerns. By revealing to the app which crypto addresses are yours, you create data that identifies you. If the app you use gets hacked, this data could be leaked to the internet, revealing your personal transaction history.
Depending on what you use your crypto for, this threat may or may not matter to you. So you’ll have to weigh the advantage of hassle-free taxes against the risk of a privacy breach.
Using a Form 1099-B
Beginning with the 2023 tax filing year, all centralized crypto exchanges will be required to provide a Form 1099-B to their users. This form will provide information about the trades you made in the previous year, including the amount of income you received from these trades.
Once the exchanges start providing these, you’ll be able to easily find out how much income you made from cryptocurrency trades on centralized exchanges.
Unfortunately, these forms won’t be available until next year. And even then, they will only contain information about trades done on a centralized exchange. If you’ve done any transactions on the blockchain itself, such as trades on a decentralized exchange or investments in a DeFi app, this won’t show up on the form.
So if you want to avoid using crypto tax apps in the 2022 filing season, you may need to rely on your exchange’s website or on block explorers to get records of your transactions.
Until the 1099-B comes available, one option to get information about your trades is to look through your exchange’s website. Some exchanges have launched special pages to help with taxes. For example, Coinbase has launched a tax resource center to help users with their crypto taxes, and Binance.US has offered instructions for its users on how to get their crypto income reports.
But again, this provides info about your exchange trades only. To find data about trades done in your private wallet, you’ll need to use a block explorer.
Pro Tip: Not sure which exchange to use? Head over to our resource on How to Choose a Legitimate Crypto Exchange.
Using a block explorer
If you don’t want to give out your wallet address to a crypto tax app, you’ll need to search the blockchain manually to find all of the transactions you did with a private wallet.
The easiest way to do this is to use a block explorer. Put your address into the search bar, and start cataloging all of the transactions that may have earned you income.
Here is a list of block explorers for some of the most popular networks:
- Bitcoin: https://www.blockchain.com/explorer
- Ethereum: https://etherscan.io/
- Binance Smart Chain: https://bscscan.com/
- Avalanche: https://snowtrace.io/
- HarmonyONE: https://explorer.harmony.one/
- Fantom: https://ftmscan.com/
- Polygon: https://polygonscan.com/
The risk of a penalty for not reporting income is the most common legal risk of crypto investing. It affects any investor who stands to gain income from crypto trades.
But some investors also face other potential legal troubles. In the next section, we’ll discuss a risk faced by investors who use offshore exchanges.
(Future) Risk of FBAR Penalties
If you hold $10,000 or more in a foreign bank, you are required to file a Form 114, Report of Foreign Bank and Financial Accounts (FBAR). This document is required by FinCEN, but its main purpose is to help the IRS prevent taxpayers from hiding money offshore.
For now, cryptocurrency is exempt from FBAR filing requirements. But in December 2021, FinCEN announced that it intends to amend regulations so that cryptocurrency will no longer be exempt.2
If and when these regulations go into effect, you’ll need to report any crypto held in a foreign exchange if your total foreign asset holdings is greater than $10,000. Not reporting it could lead to a penalty of up to $10,000 or up to 50 percent of the value of your offshore assets.
Did You Know: If you hold crypto in your own wallet, this will not have to be reported on an FBAR. Here is a guide to crypto wallets. Only crypto in the custody of an offshore exchange will need to be reported.
FBAR penalties may be a big legal risk to some investors in the future. But luckily, these are fairly easy to avoid. Once the new regulations are implemented, just disclose the dollar value of all of your crypto assets held in a foreign exchange.
But even if you file an FBAR, you may still not be out of the woods with regard to foreign exchange reporting. There’s still the whole issue of FATCA to consider.
(Possible) Risk of FATCA Penalties
The Foreign Account Tax Compliance Act (FATCA) requires U.S. citizens with at least $50,000 worth of “specified financial assets” in an offshore financial institution to report their total foreign holdings.3
A “specified foreign financial asset” is defined as an asset in “any financial account … maintained by a foreign financial institution” or “any of the following assets which are not held in an account maintained by a financial institution: any stock or security issued by a person other than a United States person, any financial instrument or contract held for investment that has an issuer or counterparty which is other than a United States person, and any interest in a foreign entity.”4
The question is, does cryptocurrency count as a “specified foreign financial asset” under this definition? Tax lawyers disagree over the answer to this question, and no one seems to be able to get a clear answer from the IRS either.
Until we get a clear answer from the IRS, the risk of FATCA penalties is one of the legal risks crypto investors face. But one way of avoiding it is to disclose all foreign exchange holdings of crypto on FATCA Form 8938 if you have more than $50,000 worth of foreign holdings.
This way, you’re safe even if the IRS decides to retroactively penalize people who didn’t file. (This is not tax or legal advice. We recommend seeking professional advice if you think you might fall into this risk category.)
So far, we’ve talked about the legal risk of holding cryptocurrency. But if you intend to sell your crypto eventually, you may run into additional legal problems when you do. We’ll discuss that next.
Risks From Selling Cryptocurrency
The safest way to sell cryptocurrency is to deposit it at an exchange and sell it through the exchange’s interface. This way, you’re interacting only with a licensed dealer of cryptocurrencies.
However, if you want to sell to someone other than your exchange, there are additional legal risks you may face. These include troubles from money transmitter laws, KYC/AML regulations, and securities laws.
Money transmitter laws
The U.S. has a law called the Bank Secrecy Act that requires “money transmitters” to comply with certain rules. One of these rules is that all money transmitters must be licensed with FinCEN.
If you provide a service of transmitting money from one place to another without a license, you may be subject to a fine of up to $5,000 per day for each day that you operate the service.4
FinCEN claims that cryptocurrency is “de-centralized virtual currency” and therefore qualifies as “money” under this definition. Under this interpretation, selling cryptocurrency for cash may be considered operating a money transmitter service.5
Each state also has laws about money transmission. In some states, selling cryptocurrency is explicitly defined as “money transmission.” If you sell crypto to an unlicensed person in certain states, you need a license with the state as well as with FinCEN. Idaho, Maine, New Mexico, New York, and Rhode Island are states in this category.
In other states, sellers of crypto who don’t hold cash on behalf of others are exempt from state money transmission laws. These include California, Illinois, and Kansas.
In Wyoming and a few other states, you don’t need any license at all to sell crypto, even if you do hold cash on behalf of others.
Pro Tip: Want to know the crypto laws and regulations in your state? Check out our full guide, Is Crypto Legal in My State?
If you are found to have operated a money transmitter service without a license, there could be penalties on both the state and federal levels. So this is a legal risk of selling cryptocurrency and one of the crypto pitfalls to avoid.
If you plan to operate a crypto exchange, you may want to investigate your state’s laws and even hire an attorney to make sure you’re not violating it. Otherwise, the easiest way to avoid penalties for being an unlicensed money transmitter is to sell your crypto to licensed exchanges only.
KYC and AML Provisions
If your crypto exchange business gets labeled a “money transmitter service,” not only will you need to get a license, but you’ll also have to comply with a complex set of KYC and AML regulations.
These regulations require you to collect personal information from your customers, including their names, addresses, birthdates, and driver’s license numbers. It also requires you to come up with a plan for detecting when your customers are using your service for criminal activity.
If the government thinks you haven’t done enough to stop your crypto sales from being used by criminals, it may impose fines on you. This is another legal risk of selling cryptocurrency.
The easiest way to avoid this risk is to sell crypto to licensed exchanges only.
The U.S. Securities and Exchange Commision (SEC) has stated that some cryptocurrencies may be considered securities.6 If you sell cryptocurrency to someone and promise that the money raised from this sale will be used to create a product, the SEC may impose a fine on you for “selling unregistered securities.”
Once again, the safest way to avoid this is to sell crypto to licensed exchanges only.
If you’re planning to develop your own cryptocurrency and sell it to others in order to raise funds for your company, it’s best to hire an attorney who knows the security laws well so that you can avoid any problems with the SEC.
By the way, if you’re thinking of buying a new coin that has just been developed, you may want to first determine that the coin is safe.
So these are the legal risks of investing in cryptocurrency. Some of these apply only if you sell crypto to someone who isn’t a licensed money transmitter. Others only apply if your crypto is stored on a foreign exchange. But a few, such as tax reporting laws, apply to all crypto investors.
Still, most of these potential pitfalls can be avoided by using software to track your transactions or by filing a few forms with some basic information.
So sure, there are legal risks for crypto investors. But with a few simple steps, these can be limited or eliminated.
Internal Revenue Service. (2014, Aug 14). Internal Revenue Bulletin: 2014-16.
Financial Crimes Enforcement Network. (2020). Report of Foreign Bank and Financial Accounts (FBAR) Filing Requirement for Virtual Currency.
Cornell Law School. (2020). 26 U.S. Code § 6038D – Information with respect to foreign financial assets.
Cornell Law School. (2020). 26 U.S. Code § 6038D – Information with respect to foreign financial assets.
Financial Crimes Enforcement Network. (2019, Jan 10). Enforcement Actions for Failure to Register as a Money Services Business.
Financial Crimes Enforcement Network. (2013, Mar 18). Application of FinCEN’s Regulations to Persons Administering,
Exchanging, or Using Virtual Currencies .
U.S. Securities and Exchange Commission. (2017, Dec 11). Statement on Cryptocurrencies and Initial Coin Offerings