The FBI Secretly Created a Cryptocurrency to Examine Pump-and-Dump Scams in the Crypto Market

In October 2024, it was disclosed by the US government that the FBI developed a cryptocurrency to probe price manipulations in crypto markets. The Ethereum-based token, NexFundAI, was crafted with the help of cooperating witnesses. This investigation resulted in the Securities and Exchange Commission (SEC) charging three "market makers" and nine individuals for schemes to elevate crypto asset prices fraudulently. Meanwhile, the Department of Justice (DOJ) indicted 18 people and entities for "extensive fraud and manipulation" in the crypto market.

Prosecutors claim the defendants made misleading statements about their tokens and performed "wash trades" to falsely suggest active trading. ZMQuant, CLS Global, and MyTrade, the three market makers, allegedly participated in wash trading or conspired to do so on behalf of NexFundAI, unknowing it was an FBI operation.

"This case puts a modern spin on traditional financial crime," remarked Jodi Cohen, special agent in charge of the FBI's Boston division. "It has culminated in charges against key figures of four cryptocurrency firms and market makers accused of orchestrating a scheme that swindled investors out of millions." One market maker, Liu Zhou of MyTrade, reportedly claimed to NexFundAI promoters about their capability to "manage the pump and dump" and facilitate "inside trading easily," according to prosecutors.

A crypto pump-and-dump scam is a deceitful scheme where crypto promoters artificially escalate the price of a cryptocurrency (the "pump") through deceptive claims, hype, or planned buying, only to liquidate their holdings at the apex, causing the price to plummet (the "dump"). Uninformed crypto investors who invest during the pump often suffer heavy losses when the price crashes.

An FBI representative mentioned that NexFundAI witnessed limited trading activity but withheld further details. During a press briefing, Acting US Attorney Joshua Levy verified that trading on the token was halted. The DOJ has reclaimed $25 million in fraudulent gains, which will be returned to defrauded investors. This case highlights the FBI's innovative methods to tackle evolving crypto-related fraud schemes.

Regrettably, not everyone is as fortunate as those defrauded investors who managed to recoup their losses due to the FBI. Some victims of pump-and-dump or pig butchering scams may never recover their loss.

A pig butchering scam is a deceit wherein individuals are persuaded to invest money in cryptocurrency into a bogus crypto trading platform that seemingly offers very high returns. Once the victims have invested part or all of their savings into the scam website, the scammer vanishes without a trace, leaving victims unable to withdraw or recover their money. Nevertheless, there may be specific pathways available for pig butchering scam victims to lessen their tax obligations by reporting the crypto losses.

Business Losses Stemming from Crypto Transactions

Business losses arising from crypto transactions (or from any other dealings) can be deducted against non-capital income, with losses incurred after 2005 being eligible to be carried forward for 20 years and backward for 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 weigh various factors, including:

• Transaction frequency/volume: High frequency or quick turnover suggests a business.
• Length of ownership: Short holding periods suggest commercial activities over capital investing.
• Knowledge of markets: Advanced knowledge or familiarity with cryptocurrency markets favours a business classification.
• Relationship to other work: Cryptocurrency dealings linked to a taxpayer's main business or employment imply business activity.
• Time spent: Considerable time spent investigating cryptocurrency markets indicates a business assessment.

The taxpayer's intention when acquiring cryptocurrency is the main criterion for identifying whether gains or losses are capital or business-related. Courts assess intention by examining objective elements, such as the purchasing and selling conditions, along with the above-listed factors. This complete evaluation determines whether the gains or losses are capital or business in nature.

Capital losses due to involuntary disposition

Under the Dallas Income Tax Act, a taxable event transpires 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 regarded 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 lays out rules to determine the timing of the disposition. The property is deemed disposed of on the earliest of the following dates:

• The day the taxpayer consents 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 regarding stolen cryptocurrency.

Pro tax tips – How Should a Crypto Fraud Victim Handle the Losses?

While claiming business losses would be more beneficial—and most victims aimed to trade while engaging with the fake websites—a significant obstacle is that no real transactions took place on these bogus platforms.

For capital losses due to involuntary disposition, victims must wait two years to claim the losses if no compensation is procured from a third party or tribunal. Consequently, victims of pig butchering or pump-and-dump scams are strongly encouraged to consult an experienced Dallas cryptocurrency tax lawyer to identify the best strategy to reduce 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 ascertain whether a pig butchering scam victim engaged in an adventure in the nature of trade, which could justify a business losses claim, Dallas case law reviews the taxpayer's intention at the time of purchasing cryptocurrency. This intention is evaluated based on several factors:

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

These factors collectively assist in determining whether the taxpayer's activities were conducted with the intention of trading, thus qualifying for business loss treatment.

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

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

1. The date the taxpayer consents to a full compensation amount for the destroyed or taken property.
2. The date a tribunal or court settles 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 merely provides general information. It is only current as of its publication date. It has not been updated and may be out of date. It does not provide legal advice and should not be relied upon. Each tax scenario is unique to its circumstances and will differ from the examples described in the article. If you have specific legal questions, you should seek the advice of a Dallas tax lawyer.