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Legal Solutions
for DeFi Startups

STOs

Our Law Firm guides clients through the whole process of a security token offering (STO)- from structuring to conducting the STO in compliance with securities regulations and other US federal and state laws. Our attorneys leverage thorough understanding of US securities laws and experience with blockchain projects and DLT in guiding clients through the STO process to quickly and effectively bring it to a successful conclusion.

We also advise clients on appropriate structures and consequences of asset tokenization – be it real estate, collectibles or income-producing assets.

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Defining the Scope of STOs

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STO can be any offering and sale of digital tokens that are considered securities under US law. The broad Howey test, which has become commonplace for digital token issuers, still defines a “security” as any contract, transaction, or scheme whereby (a) a person invests money or anything else of value, (b) in a common enterprise, (c) and is led to expect profits, (d) predominantly from the efforts of others.

Security tokens sold during STO are any virtual tokens that exist on a blockchain and meet the definition of a security under US law, whether the tokens represent function on a platform (known as “utility tokens”), ownership of a real-world asset (asset-backed tokens), interest in a fund (fund tokens), equity (equity tokens) or debt (crypto bonds).

Accordingly, the scope of STO is very broad and may include, for example:

  • Tokenized traditional securities, like shares of stock in a corporation;

  • Tokens issued during ICO serving certain function on the project’s platform/ecosystem;

  • Tokenized fund interests, including venture capital and real estate funds;

  • Real estate;

  • Diamonds or precious metals;

  • Works of fine art, luxury cars and boats;

  • Interests in a limited partnership or other business entity;

  • Profit-sharing right in a business entity, etc.

 

Understanding the Advantages of STOs

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By going through STO process, companies and funds can raise capital from investors while benefiting from the advantages that blockchain affords, including:

  • Increased liquidity;

  • Simplified access to capital on a global scale;

  • Fractionalization of ownership;

  • Increased transparency and security;

  • Simplified investors’ management, etc.

 

Addressing the Risks Associated with STOs

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While STOs are becoming one of the most viable methods of raising capital and dividing ownership or profits, security token issuers must structure each STO very carefully to take into account various pitfalls presented by securities regulations, AML/KYC requirements, tax rules applicable to a different type of assets or entity type, etc.

Some of the major practical considerations that should be addressed by an issuer prior to launching STO are that security tokens may be subject to limitations on resale, trading on alternative exchange platforms in the U.S. and foreign jurisdictions, number of investors, and amount of capital raised.

Our lawyers are well-versed in the legal and practical issues that arise in the context of planning, developing, and offering security tokens in the US. We help our clients develop a comprehensive STO strategy that anticipates and responds effectively to the arising challenges.

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STOs Can Be Conducted Under Exemptions from SEC Registration: Reg D, Reg S, Reg A+, Reg CF

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Before any security, including a security token, may be offered or sold in the US, it must be registered with the Securities and Exchange Commission (SEC) or qualify for an exemption. Registering security is a costly and time-consuming process. But if an exemption applies to an offering, then it does not need to be registered.

Most commonly, STOs are structured under one of the following exemptions from registration offered by the US Securities Act: Regulation D, Regulation S, Regulation A+ or Regulation CF. Although exemptions under the SEC regulations eliminate the need to register STO with the SEC, qualifying for an exemption still requires careful compliance with US securities laws.

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Helping Clients Through Every Stage of STO

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Our attorneys represent a wide range of clients in all kinds of STOs, providing comprehensive services throughout the STO process, including:

  • Conducting a comprehensive token analysis to determine whether the token is a security under US law;

  • Determining the appropriate token structure;

  • Determining the appropriate corporate structure for STO (SPV/trust, fund, hybrid, etc.);

  • Structuring STO to qualify for an exemption from registration as security using Regulation D and Regulation S;

  • Drafting private placement memorandum, investment agreements, and related documents;

  • Developing AML/KYC policies and helping clients implement them to verify investors’ identities and eligibility to participate in the STO;

  • Providing post-STO legal support, including by advising our clients on secondary trading issues, subsequent usage of security tokens, and the applicability of money-transmitter and other laws.

 

Tax consequences

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Token issuers must consult professional tax advisers to develop a sound tax-planning strategy in the weeks and months before an STO. Any such strategy must account for (among other issues):

  • The type of tokenized interest and the rights associated with the token;

  • How income generated in the token sale will be treated for tax purposes;

  • What reporting and withholding requirements may apply.

The IRS issued IRS Notice 2014-21, IRB 2014-16, as guidance for individuals and businesses on the tax treatment of transactions using virtual currencies.

The IRS also published Frequently Asked Questions on Virtual Currency Transactions for individuals who hold cryptocurrency as a capital asset and are not engaged in the trade or business of selling cryptocurrency.

Launching a security token offering is a highly complex process that requires thorough research and careful planning. PLease read our Guide for Launching Security Token Offerings (STOs) in the US.

 

Resources:

Reg. A+ STO

Our Law Firm guides clients through offerings of securities, including tokenized securities (STOs), exempted from registration under Regulation A+ (Regulation A amended as a part of the JOBS Act or “Reg A+” for short).

Requirements for Reg A+ offerings are relaxed as compared to a registered IPO, still Reg A+ allows U.S. and Canadian companies to publicly advertise investment opportunities and raise up to $50 million in a 12-month period from an unlimited number of unaccredited investors. For these reasons, Reg A+ offering is often referred to as a mini-IPO.

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Helping Clients Navigate Through Reg A+ Requirements and Challenges

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Reg A+ issuer must be a U.S. or Canadian company. Securities qualifying for a Reg A+ offering are limited to equity and debt securities, including warrants, convertible equity securities and guarantees of such securities. Reg A+ excludes offerings of asset-backed securities or fractional undivided interests in oil, gas or other mineral rights. Reg A+ provides for two offering tiers:

  • Tier 1 – for offerings of up to $20 million in a 12-month period. Tier 1 does not require audited financial statements but is subject to the state requirements (“blue sky laws”) in every state where the securities are offered or sold.

  • Tier 2 – for offerings of up to $50 million in a 12-month period. The company must file audited financial statements and ongoing post-offering reports but the state “blue sky laws” are preempted. Tier 2 contains an additional limitation on the amount of securities non-accredited investors can purchase – 10% of the investor’s annual income or net worth.

  • Both Tier 1 and Tier 2 allow issuers to “test the waters” or solicit interest in the potential offering from the general public before or after the filing of the offering statement, subject to disclaimers and, after an offering statement is filed, disclosing the current preliminary offering circular. All solicitation material must be filed with SEC.

Reg A+ offering requires filing of an offering statement on the Form 1-A with the SEC and going through the qualification process until the SEC clears the offering by issuing a “notice of qualification.” The primary disclosure document to be prepared for the Reg A+ offering is called an “offering circular.”

 

The biggest challenge of a Reg A+ offering of digital or tokenized securities is the significantly heightened SEC scrutiny during the pre-qualification process caused by novel implications of blockchain technology and digital nature of the securities. Thus, issuers should be prepared to address numerous SEC’s comments and disclose to investors all the peculiarities of tokenized securities and associated risks, including related to the issuance, transferring and secondary trading. Issuers should consider conducting a private placement to accredited investors under Regulation D and/or a crowdfunding offering under Regulation CF while the SEC’s Reg A+ clearance is pending.

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Guiding Clients Through Reg A+ Offering and SEC Pre-Qualification Process

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Our lawyers will guide you through preparation, filing and pre-qualification process of a Reg A+ tokenized offering, including:

  • Structuring the offering and the security token terms.

  • Incorporating a new issuer.

  • Conducting legal due diligence of an existing ownership structure for the issuer to be eligible for Reg A+.

  • Drafting offering circular, preparing and filing Form 1-A with the SEC, responding to comments and working closely with the SEC during the pre-qualification process.

  • Advising throughout “testing the waters” and in relation to solicitation and marketing materials.

  • Advising on operational issues in relation to broker-dealers, crowdfunding platforms and regulated exchanges (alternative trading platforms).

  • Providing post-offering legal support of ongoing compliance, secondary trading, capital table management and investor relations.

 

Reg A+ Related Resources:

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STABLECOIN ISSUANCE

Our Law Firm assists clients with creation and issuance of collaterized stablecoins – blockchain tokens that are pegged to stable assets, like US dollar or gold. Unlike classic digital currencies, such as Bitcoin or Ethereum, stablecoins are often pegged 1:1 to a physical asset, which is maintained in custody off-chain and can always be claimed and redeemed in lieu of the stablecoin. This is designed to provide for the coin’s stability as opposed to the volatility of digital currencies that are not backed by collateral.

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Helping Clients Navigate Through Legal Requirements Related to Stablecoins

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Because off-chain collateralized stablecoins are directly linked to the fiat currency or other assets held in reserve, such stablecoins are often referred to as a digital representation of the pegged fiat currency or off-chain asset.

The dual nature of stablecoins creates additional level of structuring and compliance. On the one hand, stablecoins are deployed on blockchain and enjoy the benefits of the global decentralized technology. On the other hand, maintaining stablecoins’ collateral requires custodial, banking, licensing, audit and other arrangements under control of trusted centralized parties.

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Guiding Clients Through the Process of Issuing and Maintaining Stablecoins

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Our lawyers will guide you through the full lifecycle of your stablecoin. Our services include:

  • Advising on designing, issuing and trading stablecoins in compliance with US federal and state laws and regulations;

  • Advising on licensing requirements and obtaining the necessary licenses, such as Money Services Business, New York BitLicense and other state licenses, Limited Purpose Trust Company (licensing requirements will depend on a client’s business model/arrangements with licensed third parties);

  • Representing clients in establishing relations with major licensed and regulated trustees/custodians, banks and auditors;

  • Advising on KYC/AML policies and procedures;

  • Drafting, reviewing and negotiating trust, custodial, technology services and other agreements with third-party providers;

  • Advising on and assisting with stablecoin listings on digital currency exchange platforms.

 

Resources:

  1. Department of Financial Services. Information and Resources for Virtual Currency Business Activity (BitLicense) available at https://www.dfs.ny.gov/banking/virtualcurrency.htm

  2. Department of Financial Services. DFS Continues to Foster Responsible Growth in New York’s Fintech Industry with New Virtual Currency Product Approval available at https://www.dfs.ny.gov/about/press/pr1809101.htm

  3. Official Portal for North Dakota State Government. Securities Commissioner Issues Order Against Union Bank Payment Coin available at http://www.nd.gov/securities/news/news-archive/securities-commissioner-issues-order-against-union-bank-payment-coin

  4. Harward Law School Forum on Corporate Governance and Financial Regulation. Stablecoins available at: https://corpgov.law.harvard.edu/2019/02/10/stablecoins/

  5. Harward Case Study. The State of Stablecoins – Why They Matter and Five Use Cases available at http://www.academia.edu/Documents/in/Harvard_Case_Study

  6. Harvard Blockchain Lab. Social Media Platforms and Cryptocurrency – Ingenious or Unrealistic available at https://blogs.harvard.edu/blockchain/social-media-platforms-and-cryptocurrency-ingenious-or-unrealistic/

NFT Launch

Our Recent Publications Discussing Legal Consideration for Operating NFT Platforms and Issuing NFTs:

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Whether an individual is selling a unique piece of digital art or transferring a more traditional creation into NFT form, the Dilendorf Law Firm offers a suite of legal services to ensure a successful launch and compliant secondary market trading of NFT digital assets.

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Our team offers a wide range of services for individuals considering an NFT offering:

  • Compliance with SEC, FinCen, and state laws concerning virtual currency

  • Anti-money laundering and money-transmission compliance

  • Structuring sale of NFTs as regulated securities

  • Tax planning for NFT transactions

  • Intellectual property governance, including royalties

  • Setting up corporate entities and LLCs to hold NFTs

  • Asset protection strategies

  • Consultation on the most advantageous platforms and blockchains for NFTs

  • Implementation of smart contracts for blockchain transactions

 

NFT offerings can be structured to meet the needs of various asset classes. Our team can assist with converting a wide range of art into a non-fungible token. These include:

  • Digital and non-digital art

  • Music

  • Collectibles

  • Literature

  • Films

  • Gaming collectibles

 

What is happening in the NFT world?

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Perhaps it was the announcement that Christie’s would hold its first auction of digital art with a piece expected to sell for more than $20 million, or it could be the burgeoning interest among investors and art lovers in owning a unique artistic creation that exists within a crypto wallet. Nevertheless, this is one of the more remarkable developments within the crypto sphere, and it is a clear reflection of just how “virtual” our daily lives have become.

Headlines about multi-million-dollar NFT sales have begun to eclipse the incredibly rapid ascension of Bitcoin, with history-making sales of digital art tokens being one of the biggest breakthroughs of early 2021. According to a recent market insight report from NonFungible.com, NFT trading in 2020 was valued at more than $250 million, an increase of nearly 300 percent over the prior year.

Platforms such as OpenSea, Nifty Gateway and Rarible are seeing more and more people willing to pay large sums of money or cryptocurrency to purchase tokens representing ownership of digital art and other non-fungible objects, which may be reauctioned at a later date at higher prices.

 

Fungible vs. Non-Fungible Tokens

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One way to understand the distinctive nature of non-fungible tokens is to compare them to ordinary dollars or bitcoins. Unlike the typical interchangeable and divisible “fungible” tokens, which can be divided into smaller units, non-fungible tokens were developed according to Ethereum’s special standards, specifically ERC-721 and ERC-1155, making them unique and indivisible.

By implementing these new standards, non-fungible tokens have solved the problem of monetizing digital artwork, thereby opening doors for a medium that is unrestrained by physical limitations. For the first time, a standard has been set forth enabling “verifiable digital scarcity”. The ERC-721 standard empowers UCA holders in copyright-intensive disciplines, such as collectibles and gaming, to maintain intellectual property rights over their cryptographic creations.

Because their value is rather subjective and they cannot be sold off in pieces without spoiling the “whole”, NFT’s are a good metaphor for most modern art. However, their unique structure opens up dozens of questions about how they will be policed.

Creators and investors will be asking the same questions about taxation, intellectual property rights, and how the transfer of digital art “tokens” will be regulated. When an original piece of art still exists in its physical form, how will the tokenized asset stand on its own?

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What issues might arise in an NFT offering?

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The structure of NFTs—modeled after artwork rather than currencies or shares—implies they are not subject to the same financial regulation as other types of crypto, but they still risk falling afoul of intellectual property law and consumer protection laws.

Anyone who is entering the world of NFT art will need to seriously consider it from the perspective of taxation, corporate structure, and intellectual property.

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  • Will transfers of such tokens be subject to a gift tax or viewed as purchase transactions?

  • How will the token be valued separately from the physical property it represents?

  • Which rights will the eventual owner be given for the potential display of the artwork?

 

Our cryptocurrency compliance and taxation attorneys are prepared to answer these questions and more. It is our goal to ensure that our clients’ NFTs are properly structured to reduce tax liability while continuing to earn royalties for their creators.

As industry-leading legal consultants specializing in cryptocurrency and blockchain technology, the Dilendorf Law Firm is connected with the latest developments in the world of digital assets. We work diligently to help clients comply with federal and state regulations while protecting their interests through sound asset protection and intellectual property strategies.

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Resources:

 

Taxation of Digital Assets and NFTs:

Crypto Tax Planning

As one of the top cryptocurrency law firms in the United States, our Law Firm helps clients respond to IRS letters, as well as IRS subpoenas, audits and other crypto-related tax situations.

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Our team will:

  • Analyze and respond to IRS letters

  • Reconstruct data for the filing of amended returns

  • Protect crypto assets from liability by transferring them to an LLC or corporation

  • Educate clients about existing case law and legal procedures for filing amended returns

  • Offer guidance about recordkeeping for future tax years

 

Our tax compliance practice helps clients to correctly report cryptocurrency assets on the current year’s tax return, file amended returns for prior years, and remain compliant with the IRS.  According to the IRS, if a U.S. taxpayer does not accurately report his virtual currency transactions, he may be subject to future civil and criminal enforcement activity.

Individuals who have been engaged in cryptocurrency trading within US and non-US exchanges may be subject to new IRS compliance efforts. In fact, the IRS has collected 10,000+ names of American taxpayers who own digital currencies, many of whom will receive letters stating that previous tax-year transactions were incorrectly reported.

As IRS Commissioner Chuck Rettig explained, “Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest, and penalties.”

Individuals who have received one of these letters will have questions about how to comply, especially if some of their transactions occurred on multiple foreign exchanges.

Virtual currency is considered property for federal income tax purposes. Generally, U.S. taxpayers must report all sales, exchanges, and other dispositions of virtual currency. An exchange of a virtual currency (such as Bitcoin, Ether, etc.) includes the use of the virtual currency to pay for goods, services, or other property, including another virtual currency such as exchanging Bitcoin for Ether. This obligation applies regardless of whether the account is held in the U.S. or abroad.

More information can be found on www.irs.gov and in Notice 2014-21 which describes how general tax principles for property transactions apply to transactions involving virtual currency.

Through its Virtual Currency Compliance Campaign, as well as increased use of data analytics, the IRS aims to help taxpayers fully understand their obligations under the US Tax Code. Their guidance for compliance is to follow the “general tax principles applicable to all transactions in property” for the reporting of digital assets. Accordingly, if one purchases Bitcoin and then sells it or swaps it for something else, a capital gain or capital loss will be incurred. Any captured gains must be reported, and taxes must be paid.

Three different versions of the letters were issued to taxpayers: Letter 6173, Letter 6174, and Letter 6174-A. Taxpayers in all three categories are urged by the IRS to file amended or delinquent (late) returns as necessary, depending on their unique situations.

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  • Letter 6173 – You may have received this letter if you “have or had one or more accounts containing virtual currency and may not have met your U.S. tax filing and reporting requirements for [virtual currency] transactions.”

  • Letter 6174 – You may have received this letter if you “have or had one or more accounts containing virtual currency but may not know the requirements for reporting transactions involving virtual currency.”

  • Letter 6174-A – You may have received this letter if “have or had one or more accounts containing virtual currency but may not have properly reported your transactions involving virtual currency.”

 

Our cryptocurrency and tax compliance practice has experience with tax guidance for numerous holders of cryptocurrency, and we can help determine the most appropriate course of action.

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What do individual taxpayers need to know for reporting virtual currency to the IRS in 2020 tax filings?

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  • Anyone who has sold off some of their crypto assets will need to report that in their 2020 tax return.

  • The IRS is asking filers to report on whether they sold, received, sent, exchanged, or otherwise acquired any financial interest in a virtual currency.

  • The “Yes” box must be checked even if a taxpayer received crypto for free, exchanged for goods or services, or swapped for other property, including digital assets.

 

Most major cryptocurrency exchanges will provide taxpayers with a Form 1099-K, but only if their gross payments exceeded $20,000 and they made more than 200 transactions.

People who have traded on multiple exchanges will be more spread out and it will be far more challenging to gather all of this information to calculate gains and losses.

Many tax professionals have complained that a $20,000 threshold is too high, because most taxpayers have either done less than 200 transactions on a single exchange, or they have used multiple exchanges and will not hit this threshold on any of them. However, taxpayers are still required to report these transactions for tax purposes, even when the threshold is not met,

 

Three crucial factors that taxpayers should know about cryptocurrency:

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  • What is the fair market value of the virtual currency at the time of the transaction?

  • What is the basis, or the amount paid when asset was acquired?

  • What was the holding period, or the length of time the asset was held before being sold?

 

If the holding period was greater than one year, it will be considered a long-term capital gain, and if it is less than one year it will be considered ordinary income.

The difference in tax treatment is quite dramatic. Long-term capital gains are subject to tax rates of 0%, 15%, or 20%, while ordinary income rates can be as high as 37%.

 

How to prove the fair market value of digital assets to the IRS

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If cryptocurrency is received in a peer-to-peer transaction, or another transaction not facilitated by an exchange, the fair market value of the cryptocurrency is determined as of the date and time that the transaction was recorded on the distributed ledger, or when it would have been recorded had it been an on-chain transaction.

As evidence of fair market value, the IRS will accept the “value as determined by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates its value at an exact date and time.  If an explorer value is not used, the evidence must be provided that establishes the value used is an accurate representation of the virtual asset’s fair market value.

In such cases where the cryptocurrency does not have a published value, an acceptable method of establishing value is to make it equal to the fair market value of the property or services exchanged for the cryptocurrency at the time the transaction was made.

For additional questions about your tax reporting requirements in connection with cryptocurrency transactions, please contact Dilendorf Law Firm by calling us at 212.457.9797 or emailing us at info@dilendorf.com 

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Additional Resources:

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