The FBI Secretly Created a Cryptocurrency to Probe Pump-and-Dump Schemes in the Crypto Market

In October 2024, the US government disclosed that the FBI devised a cryptocurrency as part of a probe into price manipulation in crypto markets. The Ethereum-based token, NexFundAI, was developed with inputs from cooperating witnesses. The investigation resulted in charges from the Securities and Exchange Commission (SEC) against three "market makers" and nine individuals accused of schemes to inflate crypto asset prices. Separately, the Department of Justice (DOJ) charged 18 people and entities with "extensive fraud and manipulation" in the crypto market.

Prosecutors claim the defendants made false statements about their tokens and conducted "wash trades" to falsely indicate active trading. ZMQuant, CLS Global, and MyTrade, the three market makers, allegedly engaged in wash trading or conspired to do so for NexFundAI, not knowing it was an FBI operation.

"This case showcases a modern twist on traditional financial crime," said Jodi Cohen, special agent in charge of the FBI's Boston division. "It has led to charges against leaders of four cryptocurrency companies and market makers accused of orchestrating a scheme that defrauded investors of millions." One market maker, Liu Zhou of MyTrade, allegedly bragged to NexFundAI promoters about his company's ability to "control the pump and dump" and facilitate "inside trading easily," according to prosecutors.

A crypto pump-and-dump scam is a fraudulent scheme where crypto promoters artificially elevate the price of a cryptocurrency (the "pump") through deceptive claims, hype, or coordinated buying, only to sell off their holdings at the peak, causing the price to plummet (the "dump"). Unwary crypto investors who buy in during the pump often suffer significant losses when the price collapses.

An FBI spokesperson stated that NexFundAI saw limited trading activity but declined to provide further details. On a press call, Acting US Attorney Joshua Levy confirmed trading on the token was disabled. The DOJ has recovered $25 million in fraudulent proceeds, which will be returned to defrauded investors. This case highlights the FBI's innovative strategies to tackle evolving crypto-related fraud schemes.

Unfortunately, not everyone is as fortunate as those defrauded investors who could recover their losses thanks to the FBI. Some victims of pump-and-dump or pig butchering scams might never recover their loss.

A pig butchering scam is a fraud in which people are persuaded to invest money in cryptocurrency into a fake crypto trading platform that seemingly generates very high returns. Once the victims have contributed some or all of their savings into the scam website, the scammer disappears entirely, and the victims can never withdraw or recover their money. Nonetheless, specific options may be available for the pig butchering scam victims to reduce their tax burden by claiming the crypto losses.

Business Losses from Crypto Transactions

Business losses from crypto transactions (or from any other transactions) can be deducted against non-capital income, with losses incurred after 2005 eligible to be carried forward for 20 years and back three years. For example, a business loss from 2018 can offset income from 2015 to 2038. However, only 50% (66.67% after June 25, 2024) of capital losses are deductible, and these can only offset capital gains. Capital losses can be carried forward indefinitely or back three years.

When assessing whether cryptocurrency transactions result in capital gains or business income, courts consider various factors, including:

• Transaction frequency/volume: High frequency or quick turnover suggests a business.
• Length of ownership: Brief holding periods point to business activities rather than capital investing.
• Knowledge of markets: Advanced knowledge or experience in cryptocurrency markets favors a business characterization.
• Relationship to other work: Cryptocurrency transactions linked to a taxpayer's primary business or job suggest business activity.
• Time spent: Significant time spent researching cryptocurrency markets leans toward a business assessment.

The taxpayer's intent when acquiring cryptocurrency is the key criterion for distinguishing between capital gains and business income. Courts assess intent by examining objective factors, such as the purchase and sale circumstances, along with the factors listed above. This comprehensive evaluation determines whether the gains or losses are capital or business-related.

Capital losses due to involuntary disposition

Under the Chicago Income Tax Act, a taxable event occurs when a property is disposed of, either voluntarily, such as through a sale or gift, or involuntarily, such as through theft, destruction, or expropriation.

If a taxpayer loses cryptocurrency to a pump-and-dump or pig butchering scam, it is treated as an involuntary disposition, with the proceeds of disposition valued at zero dollars. The victim can claim half (66.67% after June 25, 2024) of the cost of the lost cryptocurrency as a capital loss.

For involuntary dispositions, the Income Tax Act specifies rules to determine the timing of the disposition. The property is considered disposed of on the earliest of the following dates:

• The day the taxpayer agrees to an amount as full compensation for the lost property;
• The day compensation is finalized by a tribunal or court, if a claim has been made; or
• Two years after the loss, if no claim is made before a tribunal or court.

These provisions ensure clarity in determining the timing and treatment of involuntary dispositions for tax purposes, particularly for situations like stolen cryptocurrency.

Pro tax tips – What Position Should a Crypto Fraud Victim Take Regarding the Losses?

While claiming business losses would be more advantageous—and most victims intended to trade when engaging with the fake websites—a key challenge is that no actual transactions occurred on these fraudulent platforms.

For capital losses due to involuntary disposition, victims must wait two years to claim the losses if no compensation is provided by a third party or tribunal. As a result, it is strongly advised that victims of pig butchering or pump-and-dump scams consult an experienced Chicago cryptocurrency tax lawyer to identify the best approach to minimize their tax liabilities.

FAQ:

What's the legal Test for Business Losses vs capital losses in crypto fraud such as Pig Butchering or Pump-and-Dump Scams?

To determine whether a pig butchering scam victim engaged in an adventure in the nature of trade, which could support a business losses claim, Chicago case law examines the taxpayer's intention at the time of purchasing cryptocurrency. This intention is assessed based on several factors:

• Transaction frequency or volume: Frequent or high-volume trading indicates a business activity.
• Length of ownership: Short holding periods suggest trading rather than long-term investing.
• Knowledge of cryptocurrency markets: Advanced understanding or expertise supports a business characterization.
• Relationship to other work: Connections between cryptocurrency activities and the taxpayer's primary job or business point to trading motives.
• Time spent on activities: Substantial time devoted to cryptocurrency dealings leans toward a business operation.

These factors collectively help establish whether the taxpayer's activities were conducted with the intent of trading, thereby qualifying for business loss treatment.

When Can a Taxpayer Claim Capital Losses from an Involuntary Disposition?

A taxpayer can typically claim capital losses from an involuntary disposition on the earliest of the following dates:

1. The date the taxpayer agrees to a full compensation amount for the destroyed or taken property.
2. The date a tribunal or court finalizes the compensation amount, if a claim has been made.
3. Two years after the property was destroyed or taken, if no claim has been filed with a tribunal or court.

Disclaimer: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Chicago tax lawyer.