Unchained - Friend.tech: The Legal and Tax Ins and Outs of This Year’s Hottest Crypto App - Ep. 540

Episode Date: September 5, 2023

Friend.tech, a decentralized social media platform in which you can buy and sell “keys” in your friends on X (formerly known as Twitter) whose value can go up and down, has become a viral sensation, racking up as many as 100,000 users since launching on August 10. Should keys be considered securities and thus regulated by the SEC? How should gains and losses be taxed? And how private should users assume their communications and transactions on the platform are? Securities and banking law professor at George Mason Law School JW Verret, and tax partner and co-head of the Digital Assets and Blockchain Practice at Fried Frank Jason Schwartz, share their thoughts.  Listen to the episode on Apple Podcasts, Spotify, Overcast, Podcast Addict, Pocket Casts, Stitcher, Castbox, Google Podcasts, Amazon Music, or on your favorite podcast platform. Show highlights: how Friend.tech works and how the price of keys is determined how Friend.tech is different from many other past attempts at creating a decentralized social media platform whether the keys offered by Friend.tech could be deemed securities by the SEC what wrapped Friend.tech tokens are and whether these could be considered securities why the traditional approach to crypto taxation is bad for most Friend.tech taxpayers what the tax implications of Friend.tech airdrops are what Friend.tech users should assume about their privacy on the app what the future holds for Friend.tech Thank you to our sponsors! Crypto.com Arbitrum Foundation Toku Guests: J.W. Verret, Associate Professor of Law at George Mason Law School Previous appearance on Unchained: Coinbase's Legal Action Against the SEC: How It Will Likely Unfold Jason Schwartz, tax partner and co-head of the Digital Assets and Blockchain Practice at Fried, Frank Friend.Tech Shows How Complicated Taxing Crypto Transactions Can Be by Jason Schwartz Links Unchained:  Friend.tech Threatens to Penalize Users That Move to Copies or Forks Friend.tech Clarifies That Database of 100,000 Users Was Not Leaked What Is SocialFi? A Beginner’s Guide The ‘Howey Test’ and the Debate Over Crypto's Legal Status - Crypto Security vs Commodity CoinDesk: Friend.tech Attracted NBA Influencers. So Why Does Everyone Think Crypto’s Latest Trend Will Die? Decrypt: Friend.tech Renames Its Token—But Is It Even Legal? Learn more about your ad choices. Visit megaphone.fm/adchoices

If I were defending, let's say, some key creator on Friend.com, what would the SEC try to claim? I think it would be very hard for them to claim security status. Hi, everyone. Welcome to Unchained, your no-hype resource for all things crypto. I'm your host, Laura Shin, author of The Cryptopians. I started covering crypto eight years ago, and as a senior editor at Forbes, was the first mainstream media reporter to cover cryptocurrency full-time. This is the September 5th, 2023 episode of Unchained. Toku makes implementing global token compensation

and incentive awards simple. With Toku, you get unmatched legal and tax tech support to grant and administer your global team's tokens. Make it simple today with Toku. Arbitrum's leading layer-to-scaling solutions can provide you with lightning-fast transactions at a fraction of the cost,

all while ensuring security rooted on Ethereum. Arbitram's newest edition, orbit enables you to build your own tailor-made layer 3. Visit arbitram.io today. Buy, trade, and spend crypto on the crypto.com app. New users can enjoy zero credit card fees on crypto purchases in the first seven days. Download the crypto.com app and get $25 with the code Laura. Link in the description.

Today's topic is legal and tax issues around friend tech. Here to discuss our J.W. Verrett, Associate Professor of Law at George Mason Law School, and Jason Schwartz, tax partner and co-head of the digital assets and blockchain practice at Freed Frank. Welcome, JW and Jason. Good to be here. Good to be here, Laura. Let's start by having each of you give your backgrounds so the audience understands how your experience relates to the topic at hand. J.W., let's start with you. Okay, I teach corporate securities and banking law at George Mason Law School, and I also teach accounting, forensic accounting there. I practice as a securities lawyer. I defend clients from the SEC and I do internal investigations of accounting matters

and also practice as a forensic accountant where I support litigation matters and in working on US versus Sterlingoff right now, which is taking a lot of time. Great to be here. Jason. And I'm Jason Schwartz. As you mentioned, tax partner and code of digital assets at Freed Frank. I have been a financial products and funds lawyer for many, many years, a crypto lawyer for several years now. I represent clients ranging from centralized exchanges to banks to large asset managers to Dow's in the crypto space. I'm also an enthusiast myself, and I have an embarrassingly large collection of digital art. Yeah, for those who are listening via audio, Jason's wearing, that's a hash mask shirt.

Is that right? This is an ex-coppy grifter. Oh, ex-c-okay, sorry. I'm clearly not up on all my different NFT collections. Okay, so for listeners who haven't had the chance to dive into Front Tech, which became a huge craze in crypto. It's sort of the latest craze since it's launched on August 10th. How about one of you describe what this, what friend tech is? So on friend tech, anyone can purchase keys to a chat room run by their friends,

moderated by their friends. And in effect, the price of the keys is set on a bonding curve so that the more people buy into a room, the more expensive the next key gets. In addition, at any point, any owner of a key can redeem that key back for the then current price of a key. So there's the financial aspects there. Just to be clear, when you said that, you know, buying the key, which originally was called a share, you get access to, you called it a chat room run by your friends, but it's run by the person who's key you purchased, right? Right. Okay.

Yes. And so it's, is it just that? just that it's sort of like this ticket to this chat room and pretty much that's it? Or are there other features? So, I mean, I think that right now this is in beta still, right? So features are being rolled out, it seems, on a daily basis, including, you know, changes to the nomenclature that they use, as you already alluded to. But the way it works currently is that the room moderator, you know, the person who's key or share you bought, is the only person who everyone in the room can see.

So, you know, if I'm the moderator, really it's just a stream of consciousness, you know, chat by me. People can respond to me and I can see their responses. And if I desire, I'll, you know, copy and paste their responses for coherence when I comment on their responses. But right now, it's fairly bare bones. And frankly, I personally find that. pretty charming. At first, it was plain text only. There weren't even line breaks allowed. Now you can have line breaks. They also now allow embedded URLs, but they don't yet have image sharing. I think image sharing is on an informal roadmap that I was made aware of. So, I'm sure they'll continue to

roll out features or I hope they'll continue to roll out features, but right now it is really bare bones. That said, I find it extremely exciting because it really is sort of, you know, the first, you know, successful Metaverse experience that I've practiced in. I mean, a lot of people think of Metaverse as, you know, something involving AR or VR, but really I think of it as, you know, a social experiment that includes, you know, self-sovereignty of your own data and friends. And, you know, in a sense, Twitter is probably like a good, you know, primitive for a Metaverse just without self-sovereignty. And it's just really amazing to see the, like, rapid rise in popularity with FrenTech. And finally, I can talk about the taxation of Metaverse transactions,

is not just hypothetically, which is like for me really exciting. And one other aspect I wanted to ask is that earlier you said that you could, you know, if you dispose of your key, you sell it. But it sounded like you were saying you only sell it back to the creator. So you, there's no secondary trading. To me, that's a really important feature. And we can we could get into why later. But yeah, that's exactly right.

When you purchase a key, it feels from your. perspective, from the purchaser's perspective, as if you're purchasing a token on the secondary market. But in fact, that's not what's happening. You are contributing ETH into a pool, effectively, a pool of EVE. And if you look at the contract, it's really just this monolithic smart contract that holds a bunch of EVE. And you receive a key in exchange. And if and when you want to dispose of your key, what you're really doing is just withdrawing ETH from the smart contract. And the amount of you can withdraw is determined by a very simple bonding curve. Okay. So, you know, one thing that I was curious about as I was looking at all this activity is there's been previous attempts at decentralized

social media. So how is FrenTech different? Okay. So full disclosure, I can't claim to be, you know, an expert in decentralized social media. I only have so many hours in the day. I try not to spend all of them on social media. But to me, the most important distinction is that Frontex is really easy to join. You know, it's built on base, which is an optimistic roll-up on Ethereum. All of the assets are self-custodyed. However, it requires very little, I should say relatively little, at least for a crypto, for a crypto native experience to join.

It's fully mobile, which I don't think other decentralized social media apps have been. It is really just a matter of clicking a few links on your phone and a wallet is set up for. you. It doesn't require you to write down a C phrase, even though it's your wallet. You know, you can, I actually, the developers don't have any access to the C phrase, but the C phrase is, I believe, stored online. But, but you can, you know, you can withdraw your ETH to another base wallet if you want. And to me, that's the most exciting. I guess, like, you know, some other, some other aspects, you know, obvious distinctions between Frent Tech and other decentralized social is that, Frentec is not so much aiming, I think, to connect people in a town square type environment as other decentralized social media experiments have with Twitter or Facebook or LinkedIn or something being the paradigm.

But rather is maybe aspiring to be more like, you know, WhatsApp, but where you buy a share or. a key, I should say, a key for unlimited and eternal access to that. Yeah. Or it's like on Telegram, there are those groups where you just broadcast. Yes, exactly. Yeah, it's more like that. Yeah. I mean, you know, this became so popular, so fast.

At one point, it's 24-hour fees were so high that only Ethereum and Lido generated more fees during that period, which, you know, is striking. So I think that goes to the usability that you mentioned. And GW, do you have any thoughts you want to add on anything just discussed? Just about how interesting it is. One of the fun aspects of it is it kind of reminds me of there are a few websites where you can hire someone famous to do a birthday jingle for you or something. Hire Gary Busey to say happy birthday to your friend. It kind of reminds me of that in a way.

That's part of what they're monetizing is the ability to access Kobe. It's expensive now. It's like $6,000 now to access Kobe. but to access him in the chat room where there are only 60 other people buying for his attention is a monetized thing, which kind of is part of what makes this interesting. I don't know if that will have legs beyond CT, but at least within that world, I think it's a, it's a way to kind of cut through the noise of CT and get ahead of the line and chat with somebody you really want to chat with.

So some people find that really valuable. I saw some post by someone in some obscure branch of the humanities that said, like, you know, I get to access the leading mind in this branch of humanities on friend.com. This is so cool for like a hundred bucks. I get to have chats with them. Now, that only works if the person issuing the keys spends a lot of time, responding to what their keyholders say to them, but that all will be governed by a market process.

So it adds a market process to social networks. That's why I think it's cool. Yeah. I actually, on that note, I did want to mention, You know, one thing that I neglected to mention, which is I said that there is a bonding curve. In my view, unfortunately, we don't yet, the creators or room moderators, I've been calling them, don't have the ability to set the price curve themselves. So to me, at least, I was a little off put initially by the,

the rapid rise of, you know, my price, right? Like, when I first joined Friend Tech, I think within a few hours, my shares were something like $100. And I'm not worth that. Or at least, I mean, I am worth a lot more of that, more than that in my professional capacity. But just for access to, you know, my effectively, you know, a less, you know, an uncensored version of my tweets.

I wouldn't pay that much. There are fees on each entry and exit, and the fees are actually 10% of the price at that time. And that's pretty high. I mean, what that means is that if you actually expect to make any money, flipping keys, you better expect very significant price increases between your purchase and your redemption. 5% of those fees are streamed in real time to the room moderator,

and then the other five, I guess, goes to the developers. That also creates an incentive that I think could be perverse, right? It seems like I would think that that would create an incentive to potentially increase volatility in your key price, right? You want buying and selling if you want to be streamed rewards. Now, maybe the rebuttal to that is, look, this isn't supposed to be financial. This is just, you know, this is really just supposed to be for fun. The financial aspect is secondary.

But if that were the case, then I don't think that the prices would, the price curve would be quite so steep. So I do think that there are some elements that really, you know, will need to be tweets if this is to appeal to Normies, you know, in the future. But it's a really exciting, primitive, at least, in my view. Yeah. Jason, are you saying you're worried that people, that some of your friends will be priced out? Is that the concern? Yeah. Yeah. Because I think it's worth it. I mean, you know, if I was more of an NFT collector, I'd want to pick your brain on, you know, the next project to get into and I'd use FrenTech to jump to the front of the line. So I think it's worth it, man. That's why I'm, I'm hodeling my crypto tech guy. But you can, you can just ask me that on telegram, right? I mean, that's the, you know, we'll see. I mean, you know, I think the access point, is really interesting.

And I think that, again, one thing that I find really charming is that, as I said, is that the app is kind of being built while people are using it and being onboarded. So, you know, maybe it'll morph into something that we don't quite expect. And, you know, I can imagine, like, many different use cases. One might be just access. And it might be that I'm not really the type of person whose room you want to follow, right? And maybe Kobe is a better person because he's really hard to get a hold of on Twitter, but maybe less so if he knows that you bought a key.

Yeah, I saw a few different people saying things that said, oh, they would prefer a model where people have to pay you to contact you, which is exactly what Earn.com used to be. So, you know, I could imagine certain people using it in that respect if they feel like they want to monetize their time. because frankly, when you were talking about how you wanted to be able to set your bonding curve not so steeply, I thought, oh, if I were on there, I definitely would set mine high because I don't want to have to answer random questions. Like, sometimes I'll do these Q&A episodes where people can send in questions. And for some reason, I think people think I know literally everything about crypto, because I get the craziest questions where it would take me like a day or two to research that to answer.

and they like seem to expect that I know one of the ones was something like how blockchain technology can be used can be applied in like satellite technology or something like that and I was like, why do you think that I know the answer to this?

You know, it was crazy. So anyway, point is I wouldn't want the, if I were on there, I would be worried that it was going to take over my life. I'd be like doing work for people. So I'd like set the price really high. But anyway, Okay, so let's turn. I admire that the reporter in you tried to figure out the answer to that question anyway.

No, I didn't. I was because it was a mailbag episode and I had so many questions. I was like, well, clearly I'm not going to do that one because I would have to take the time to research it. And it's not where it would take, you know, way more time than I have. Well, Laura, like there's something else that has like that has transpired on Frontex that I think is just fascinating. And this just goes to show like what profit seeking at. animals, crypto has shown human beings to be. There are now some participants in Frentec, Levy is one who has followed me,

who just buy keys. They amass keys. And then they encourage people to just buy into their room rather than buying into each of the individual rooms, each of the underlying individual rooms. And they just stream everything from the. rooms whose keys they own. So they're aggregators. I think that's just so fascinating.

And I'm really curious to see what transpires from that. There's also some people have actually, Levy as an example again, who have actually tokenized their own keys. So if you own a token that represents a fractional interest in a key, you can't use it to access a room, but you can use it to basically, you know, gamble on the price of keys, right? I was going to say, or hedge, you know, hedge potential price increases while you're saving money to join the room. But, you know, yeah,

it's speculation. So really interesting to see what else comes out of this. Yeah. Well, this is actually a natural segue to the next topic, which is, you know, one that I think a lot of been, a lot of people have been wondering about because obviously keys were originally called shares and that provoked a lot of commentary that this, you know, kind of indicated these were similar to securities. And there were a few tweets saying, hey, you guys, these are securities. JW, why don't you give us the argument that says that keys are securities and the one that says that they are not? Okay. And so we'll do the disclaimer. I'm a lawyer. I'm not your lawyer, not a lawyer for any listener, not providing legal advice. And it's a very risky.

to provide legal advice in crypto for anyone in that field providing securities advice because we're in a situation, we're in a world where I could provide you advice about the doctrine, as I know it, and you could still get sued by the SEC because I think they are irresponsibly abusing their power in ways that violate the law, simply but to make it clear. So I only do defense work. So if I were defending, let's say, some key creator on friend.com, what would the SEC try to claim? I think it would be very hard for them to claim security status. I think they have two routes basically to claim it was a security.

They would say first back when it was called the share, they would try to use a case called Landrith, which says that if you call it stock, it's not necessarily dispositive. If you call it stock or call it a share, it's not necessarily dispositive. But it might help if it also has the attributes usually associated with stock. and that's a somewhat flexible test that looks to different kinds of things like dividends and the SEC might try to claim somehow that the fee that's shared with the creator is some form of a type of a dividend even though it's really not I would be skeptical of the SEC

trying to jam this into the Landrith test for stock or the Howie test generally and I would be very confident if they tried to do that to a to a creator I'd be very confident in the defense because, again, because of the limitation on resale, but even if there were resales, I think on the commonality element and the efforts of others element, I think I could poke some holes in that. The other complication to this is that we didn't talk yet about the airdrops, the points that you get that are going to eventually translate into something. I'm not entirely sure what this weekly points will do, but that would probably enter into the analysis at some point. Yeah, I mean, so I'm obviously not a lawyer, but just from my knowledge of covering the space

and all the ways in which crypto tokens can be argued to be securities, I guess. The very simple argument that they are securities would be, you know, the four-prong test investment in a common enterprise, investment of money in a common enterprise with an expectation of profits from the efforts of others. And so you could say like, oh, people are buying these to speculate. They want to buy them early so that they can sell them later when the price is higher. And the price is determined by the efforts of the person whose keys you own, you know, whether or not they do a good job with their chat room or whether or not they're successful.

And so that's probably like a really simple or simplified maybe way to say that would be the pro argument. But it sounds like you don't agree or don't believe that they're security. So what is that argument? So, and let me go back to what you've aptly described. It would depend in part on what that particular creator did and said. So I could think of a fact pattern where the creator might make it a security just because they are loudly touting to the world, buy my key and you will get rich and you will have much profit in the future because I'm going to grow my presence and all of that.

I did a parody tweet about this. I hope the world started as parody, buy my keys, and I promise that your investment of money in the common enterprise by my efforts will increase in value. I was kidding. I was kidding, SEC, if you're watching.

I was kidding. And thankfully, I think only the bots are buying my keys right now. But so it might depend on how the individual creator touted to try to get people to purchase their keys. It would also have to reach a level at which it's a public offering. So, you know, I wouldn't be too worried about de minimis touting even. You wouldn't have to be pretty sizable offering of keys. I think that would be larger than anything that's happened on friend.com far.

So you would have to go to facts that an individual person was doing that were really irresponsible about trying to tell the world to come buy their keys and then they'll get rich off of doing so. Okay. But you don't believe their security. So walk me through, you know, your analysis that leads you to that conclusion. So the four-part test for Howie, I talked a little bit about Landrith. I don't think, I think it was a good idea to change the name that's not dispositive. It's just a good idea.

It's more careful, more thoughtful, decreases the risk that that test will apply. But the Landrith test, which is an alternative to the Howey test, the Landrith test says, does it seem like stock? then it's stock and therefore an investment contract and therefore security. Does it seem like stock? Does it have voting rights? Does it have dividends? It doesn't have to have all of them, but you look at a list of things usually associated with stock and you say most of them are there.

Okay, we'll call it stock. None of those are really here. I don't see dividends. I don't see voting rights. I don't see liquidation rights. I don't see, you know, anything like that. The right, you know, stock splits possibly happening. I guess there's some kind of a split phenomenon that happens here.

here, but I just don't see the Landtenth Test applying. Back to the how we test that we have all learned to love in crypto, an investment of money, that element of the test doesn't have much substance to it in the case law. Investment of money in a common enterprise. That's where we start to get tricky here. First of all, it's not really an enterprise. It's a chat room. It's a lot more like a ticket to a concert.

And even those have secondary markets. This doesn't have a secondary market yet. So it's, I think it fails the common enterprise element because it's just, it's just access to talking to a person. And there's no, there's no commonality in the way there is when you invest your money into a pool of assets that are then used to create value. But if secondary markets were to pop up, then would that change your analysis? It tips the scales a little bit in favor of a determination. but to my mind doesn't make it clear cut. Okay.

Let's also now talk about the ERC 20 tokens, which apparently, so this was created by crypto influencer Fubar. And it's a tool where people can create what he's calling wrapped friends, which are these ERC 20 tokens of the keys. So what do you think about wrapped friends tokens? Are those securities? I'm confessing my ignorance here. Can you tell me a little bit more about how those work?

Well, Jason kind of described it earlier. My understanding, my understanding is that a smart contract acquires a key and then issues a set number of ERC20s while holding the key. So if you buy an ERC20 effectively, just own an indirect interest in the key. But then is the price of that ERC 20 token pegged in any way to the value of the key? or is it just freely trading? A liquidity pool is set up to, so that arbitrageors will, in theory, ensure that the ERC20's price

tracks a fractionalized interest in the key. The presence of the market maker is a problem, I would say, for that setup. Other than that, it seems to lean more toward commodity than security, but the market maker could be a problem and could create the efforts of others in the fourth element of the HART test. Okay. Well, yeah, it's all so new that it sounds like.

It does remind me of some of the kids, some prior cases that were referenced, I think, in some of Marco Santore's original work in the SAF papers, that looks to a line of cases where a secured interest in gold or other types of commodities was sold and determined not to be a sale of a security, I think that line of cases is probably what you try to use to defend this. But again, it's litigation risk as high. I think he could maybe still win, but there's significant litigation risk, even if you think you've got right on the doctrine. I guess my full disclosure, I'm a tax lawyer, so not a security. lawyer. And I guess while I'm at it, not your lawyer, nothing I say here should be construed

as legal advice, nor the opinions necessarily of Freak Frank. These are my personal opinions. That said, I sort of have a question, J.W., which is, at least in the Ripple case, which I know is being appealed by the SEC, the judge's conclusion appeared to be, well, look, if the money isn't actually going to the person whose efforts are supposed to be turning the profit, then there's no investment of money in a common enterprise. And I would have thought that that would be a fairly strong argument to make here. I mean, I'm not getting the money if you buy keys. If I hold a key in myself, then the price of that key appreciate so I can resume it for more Eath, but there's really no money being sent to me. And same with if some, if some, you know,

Rando sets up a liquidity pool after buying my key, none of the money spent by people in purchasing ERC20s is necessarily going back to me. Do you think that that argument carries anyway? Yeah, I mean, I hope it survives from the Ripple case. We have a situation right now where we have two competing judges at the Southern District of New York. And Judge Torres said, you know, ruled that way. And in the terror case, we have effectively the opposite position. You're effectively betting on which way that's going to go at the Second Circuit. And that's a lot to bet with. I hope it goes Torres' way, but I'm just not sure. And I think it's kind of a coin toss right now. And this is the hard thing.

This is the unfair thing about compliance with laws. You could be relying on the ripple case. You could, in how you design a token listing, like a wrapped token that creates an interest in a friend. dot tech key. You could rely on the ripple case and then it gets overturned in the second circuit. And then, oops, now the SEC is going after you. Even though you're relying on good law at the time, that's the unfortunate situation we're at. And usually when this happens, the SEC creates.

guidance to help us through it. But the politics don't line up such that they want to do that. Yeah, there's a lot of uncertainty, obviously, at this moment, regarding all of these types of questions in crypto. So in a moment, we're going to talk about another area that's quite uncertain regarding crypto, and that is tax. But first, a quick word from the sponsors who make this show possible. Toku makes managing global token compensation and incentive awards simple. Are you designing your token compensation plan and grant templates with multiple law firms? Are you managing cliffs, vesting, and taxable events in a spreadsheet? Are you distributing tokens to your team manually? With Toku, you get unmatched legal and tax tech support to grant

and administer your global team's tokens. Easy to use token grant award templates, vesting tracking via online dashboard, tax withholding integration with payroll, automated distributions, great employee experience. Make it simple with Toku. Learn more at Toku.com slash unchained. Join over 80 million people using Crypto.com, one of the easiest places to buy, trade, and spend over 250 cryptocurrencies. With the Crypto.com Visa card, you can spend your crypto anywhere and get rewarded at every step. Up to 5% cashback instantly, plus 100% rebates for your Netflix and Spotify subscriptions, and zero annual fees. New users enjoy zero credit card fees on crypto purchases in their first seven days. Download the crypto.com app and get $25 with the code Laura.

Link in the description. Arbitrum stands at the forefront of innovation as the premier suite of layer 2 scaling solutions, bringing you lightning-fast transactions at a fraction of the cost, all with security rooted on Ethereum. From defy to gaming, Arbitrum 1 plus Nova is home to over 500 projects. And with the recent launch of orbit, Arbitrum welcomes you to build your very own, tailor-made, layer or as the Arbitrum ecosystem calls it, an orbit chain, directly on the Arbitrum tech stack. Designed with you in mind, Arbitrum empowers you to explore and build without compromise. Propel your project and community forward by visiting Arbitrum.io today.

With the RBC Avion Visa, you can book any airline, any flight, any time. So start ticking off your travel list. Grand Canyon? Grand. Grand. Great Barrier Reef? Great. Galapagos? Galapagos? Switch and get up to 55,000 Avion points that never expire. Your idea of never missing out happens here. Conditions apply. Visit rbc.com slash avion. Back to my conversation with JW and Jason. So now let's turn to the tax issues. Jason described for us friend tech transactions in the context of tax law and unfortunately listeners who are abroad, we're going to probably focus on U.S. tax law.

But what I would want to do is break it out also for the buyer and then the person, the creator or the person's, you know, whose keys were bought. Let's talk about both of their, you know, tax liability. Yeah, let's do that. So first of all, a brief introduction, which is ordinarily when you purchase a, a crypto token, that crypto token, according to the IRS since 2014 guidance that it issued, is treated as property. It hasn't said what type of property, so that's not always entirely helpful, but on the basis of that guidance, people have typically treated crypto transactions

as property transactions. So if I use ETH to buy some other token, when I spend the ETH, that's actually treated as a disposition of my ETH at fair market value. So I have gain or loss on the ETH, something that is kind of the pain of every crypto-Natives existence.

Then I take that new asset with a basis equal to the cost at the time. And when I eventually sell that asset, I have capital gain or loss equal to my fair market value of that asset, of that token when I sell it, you know, minus my basis. Right. So that's standard crypto taxation. Now, at first blush, you would think, oh, Frontex should result in the same taxation, right? I'm buying shares, particularly when they were called shares. I'm just buying shares.

This is the same thing as just buying IBM stock. Just with ETH. So, you know, I have a disposition of ETH. When I purchase, I have gain or loss on my ETH. I have an established basis. And then when I sell my shares, I have capital gain or loss. Capital gain is taxed either at your ordinary rate if you sell the asset within a year or at a preferential long-term rate.

If you hold the asset for more than a year, that rate caps out at 20%. So that's typically preferential for individuals who are subject to a maximum ordinary rate of 37%. 20% is a lot better than that. Capital losses are subject to limitations. You're only allowed to use them to deduct them against your capital gains for the year, plus $3,000 of ordinary income for the year. However, you can carry them forward forever. So last year, everyone had max pain capital losses. But, yeah, and they probably couldn't use all of those losses because no one had any gains.

But they could carry those losses forward for the next 50 years. And someday when crypto moons again, you know, we can all shelter our gains with all of the losses that we... I won't live long enough, I don't think. Use them all. Now, all of that being. said, as a general rule, tax law looks to the substance of a transaction rather than to its form. Okay. Now, that's a general rule, and general rules are meant to be broken. But we don't really have anything else to go by here in crypto. So we're kind of stuck saying, like, okay, substance over form

principles, let's dig in and see what's really happening on Frontec. And as I described in the beginning. What's really happening in FrenTech is the following, taken very simplistically. Laura, you and I each contribute $50 to a bank account, and then I pull out $75, leaving you with $25. And if I do that, as a general matter, I have $25 of ordinary income, not capital gain, because a bank account is not a separate piece of property. It doesn't have an issuer. It's just pooled money, right? And you have $25 of some type of loss,

and we have to determine whether you can actually deduct that loss. Tax law has a lot of rules about what losses can be deducted. So if you apply a substance over form approach to the taxation of Brentec, I think you're stuck with that results. And unfortunately, that result ends up being really bad for taxpayers, for most taxpayers. And here's why. As I said, my gain is ordinary income. Maybe that's not the worst thing in the world because, you know, I probably wasn't planning on holding Frentecke keys for more than a year to get the long-term capital gains rate.

So whatever. I would have had short-term capital gains, which are taxed that ordinary rate. rates anyway. But what about the loss that someone incurs if they redeem for an amount of that is worth less in U.S. dollar terms than the amount of Ead that they put in? Well, unfortunately, ordinary losses that are incurred outside of the business context, so when you're not running your own business and you incur ordinary losses, they're subject to severe limitations for individuals. Basically, ordinary losses are not deductible at all if they are miscellaneous itemized deductions. And miscellaneous itemized deductions are defined to basically

include all losses other than a very narrowly defined set of losses. And that narrowly defined set, it includes things like theft losses in a transaction entered into for profit. But these aren't theft losses, right? I mean, I say that I mentioned theft losses because so many crypto natives, including myself, have been fished at one point or another in their tenure as crypto natives and have had to figure out whether or not they can deduct the loss. You often can, if you can establish that that theft was, in fact, an illegal taking and that it was incurred in a transaction entered into for profit. But Frentec is not a theft loss.

What you're left with is maybe wagering losses. So wagering losses are deductible to the extent of your wagering income for the year. And then they die. They're not carried forward. So it's possible that, you know, you could treat Frentec as like a gambling app and you say, okay, accordingly, my losses are at least deductible to the extent of my income from Frentec. But unfortunately, wagering losses actually also are not defined in the tax code. There is a body of case law relating to, you know, gambling, but the gambling there tends to be, you know, sort of your traditional gambling cases, casino type gambling. That said, I did do a little bit of research before joining this podcast.

And I found one very esoteric tax code section that also uses the term wagering. And if you sort of dig deep into the regulations under that section, the regulations refer to wagering as including betting on contests. And contests includes contests involving popularity. whatever that means. So maybe you can conclude that that look forintech is just a popularity contest and I'm just betting on popularity and accordingly my losses are at least deductible

to the expense of my income from using Frontec. But it's really unclear. And wait, and does all this apply to both the creator and the buyer? Yeah. Okay. Yeah. So there are two streams of income that the,

that the creation, has, right? Stream number one is if the creator keeps their own key. You actually get your own key for free, one key. You can, you know, obviously buying more keys in yourself if you want to really go ham. But you get your key and presumably the receipt of a key up front of a key up front. You haven't actually even contributed anything to Frontec at that time. And then if you ultimately redeem that key, you know, you have, as I said, income or loss. Really, the creator is treated the same as anyone else with a key. The other stream of income to the creator are these trading fees, right? As I mentioned, there are this 10% fee that's imposed on every person's entry and exit into a key. and 5% of those fees are streamed in real time to the creator. And for those, the IRS says that you're taxed on the receipt of crypto

at the time that you have dominion and control over that crypto. Dominion and control basically means the ability to transfer. So at the time that those rewards become unlocked, I actually think they might still be locked. I don't know if you can withdraw the rewards yet. But at the time they become unlocked, presumably, we all have an income event equal to the then U.S. dollar fair market value of that. You see why I bought a share in Crypto Tax Guy. I'm going to be messaging on April 15, man.

And so for creators, the cost basis would be zero because it's like nothing when they create it. Is that it? Yeah. Okay. I think that's right. And you were saying for the airdropped points, the cost basis will be whatever it is like initially, the initial market price. Yes. Okay.

Yeah, well, let's talk a little bit more about these airdropped points because weirdly one thing is apparently they're recorded off chain. I totally don't understand why. That seems so weird to me. But anyway, JW, you know, you kind of alluded to them earlier. And I do think, you know, there's a securities question here too. Do you think users should be concerned about securities implications for the airdrops they're receiving? Well, I mean, no more so than any other airdrop in crypto. I'm not sure how it's going to work when it happens.

There have been assertions that airdrops or constitute an offer or sale of securities. But one thing, the Ripple case was good for this point. Ripple stood for the point that air drops are not securities by way of analogy to the other uses of token. distributions to employees that happened in the Ripple case. I think you can use Ripple to cite that air drops are not securities, which is an offer sale of securities, which is good if it stands up, continues to hold up. But I think that's also still pretty good law generally. There's been one case where the SEC settled with someone, Tomahawk, where the question

was over an airdrop, and as part of that air drop, the recipients of the air drop did a lot of work to obtain the airdrop that furthered distribution of the security. So it wasn't just an irdrop for using it or doing a little scavenger hunt or something on optimism. It was an air drop in exchange for doing things to promote the sale of whatever Tomahawk was, which is a different case than most of the airdrops we see today. They're all pretty careful. And so as long as friend.combeck's airdrop follows that model as just a reward to users for using, I don't think the Airdrop itself is going to be an offer or sale of a security. Remember, it has to not only meet the Howie test, but it also has to offer to sell securities or actually sell

securities. So the question is, is giving away something for free an offer or sale of that thing? There are some cases where the SEC has said, courts have gone along with the idea that if you're spinning off a subsidiary of a company and giving away the stock in that subsidiary to your existing shareholders, that's often how it will be like a big mega company. will have a small subsidiary, they'll give away the shares in that subsidiary to the shareholders in the parent company. So let's give them away. And the SEC says that constitutes an offer sales securities that has to be registered, even though you're giving them away for free because you intend to create a subsequent market in those securities by the free distribution of them. Anyway,

some people have said, because of those old cases about spinoffs of corporate subsidiaries, that means crypto airdrofts of securities. I think that's a bad analogy. Because first of all, we're talking about something that's already stuck in the first situation and therefore already an investment contract before we even get to the Howard desk. So anyway, don't get me started on air drops, but I think as long as they follow the general pattern that the responsible airdrops in recent years have followed, I think I think friend.com air drops should be fine, shouldn't be at high risk of security status. But again, that's assuming a good faith SEC following reasonable doctrine, which you can't assume.

you could do everything right and still get sued. All right. So now let's also talk about privacy issues because there have been a few related to Front Tech. One is that the app launched without a privacy policy, which is interesting given that it's in some respects a financial app. What are your takes on that? I never believe this was a private application. If I want to have a private chat, I'll go do it on Signal.

I'm not going to do it here. This is just something I'm kind of playing around with a little bit. But I don't think it has any more privacy than Twitter has, which is no privacy. So I just wouldn't assume it's also very centralized, right, in the same way that optimistic roll-ups like base on which it's on which this transactions are centralized. Coinbase can turn that off or roll it back at any time. So, you know, it's crypto-adjacent, but it's not fully crypto-native because it's not self-sovereign in that way, not private. But that's fine. When you know what you're getting?

And so you're saying because like a privacy policy, that's sort of like a standard thing, frankly, that a lot of, I think, lawyers would recommend that their clients use. But also these chat rooms are private. So I don't know if I fully understand what your point is. Well, I just, I wouldn't assume that no one can monitor what you're saying. I just, I wouldn't make that assumption. I would, when you connect to it, I would use a VPN. Like you should use a VPN when you'd use anything on the internet.

And why is that important? That's just a good default practice to use, especially if you're using a handle in using friend.com. But again, I wouldn't assume anything's private on this particular application. All right. And then crypto developer Bantag published a list of over 100,000 Front Tech user accounts and made public which base wallet address is connected to which Twitter profile. Frentek responded that this was publicly available information. Quote, they said this is just someone scraping our public API that shows the association

between public wallet address and public Twitter username. So what do you think? Was this a privacy violation or not? No, this is just a, it's only a privacy violation if you claim there's privacy and then you lie about the privacy. And I haven't seen this company do that. This is just the fact that it's not private to begin with. I thought I as a sort of lay person, I'm not the one wearing the Zcash t-shirt, but I don't, I didn't understand the, all the hull of blue over that. Well, I mean, I think initially, you know, most people wouldn't want their actual identity affiliated with their crypto wallet.

So just the fact that this got published, I think, was the initial. But, I mean, it's a blockchain. Like, everything is public. And if you own an NFT and you announce that, then your wallet is stocks. And this is effectively just, you're associating your Twitter handle with a wallet spun up by an app specifically to interact with that Twitter handle. So that's what I don't really understand. You know, there ought to be privacy software that enables me to, you know, to cleanse my eth, right? When I withdraw my ETH from, you know, from Frentec into my personal base wallet, I think it's a disgrace that we don't have, we as Americans don't have.

have access to privacy software that I can then use to, you know, wash that ETH and go dark again. I also happen to think it's a national security issue down the line because, I mean, the U.S. government doesn't want the transactions of every American broadcast to the world. And I think that they're, I know this is a topic for another podcast. It's like the exact opposite of what they're doing with the tornado cash situation. I think they definitely don't want. to use privacy software. But anyway.

They think they don't. But I mean, imagine if all of our Amazon purchases were just broadcast to the world. It would be a disaster. It's a serious national security issue. And I think that because the government doesn't yet take crypto seriously as a future transfer value protocol for settling value transfers among people at scale, They just haven't really bothered to think through the ramifications of denying Americans' privacy tools. Yeah, this is why we're, I was just going to say, this is why we're friend tech friends, Jason.

But you mentioned that, so yeah, the Ethereum blockchain is not private. It's fully public, especially now that tornado cash is sanctioned. But there is one blockchain that is private shielded transactions on Zcash or private. You can't move NFTs there, but we're working on that. And we're working on a project called Zcash shielded assets, where you take things from another blockchain and put it into a Zcash shielded note, which might include NFTs at some point. So you might have exactly what you're asking for, Jason, once they get something right. So ZSA is a big fan of them. One other issue with FrontTech is this question of whether or not users can kind of leave the app.

Like, you know, you could log off, you could disconnect your Twitter profile, but you can't stop your profile from being traded on the app. So I wondered if you thought that created a problem. I mean, I think that's part of what you get when you go in there. It doesn't seem like it would work the opposite way, right? it wouldn't it wouldn't people would be buying keys and then suddenly they wouldn't have value anymore um of course that could just just happen because you just quit um we quit responding to it but no i i didn't see that as a problem personally i don't know but maybe somebody else is a different different critique i haven't heard yet what what's the issue we're just you know again like this is

like a big pool of eat that people are shifting back and forth but i don't really see um any real privacy violation with people shifting to or from holders of, you know, holders of a ledger entry that has, you know, that's annotated with, you know, crypto tax guy. Yeah, I mean, there have been times in the past when certain social media platforms got, you know, people were leaving them on mass. that's, you know, not really the possibility with this. So maybe that's why some people are

mentioning that. So let's kind of prognosticate a little bit. There have been a lot of people that have been saying that Frentec will be a flash and pan and it'll die down just as quickly as other previous attempts at decentralized social media. And I was curious

for your thoughts. What do you think is going to happen? It's too cool not to either have a shot at growing or be copied by somebody else and done better? One of those two things will happen. Yeah, I agree, actually. I don't know how I feel about Frentec in its current form.

As I mentioned, you know, I think it's extremely buggy. No one would dispute that. I think that, you know, the price curve is bizarrely steep. And I think that there are potential perverse incentives created by the fees. But it is easily the most exciting thing I've seen in crypto this year. All right. Well, where can people learn more about each of you and your work? So, Jason Schwartz, you can Google me, Jason Schwartz, free frank.

I'm also crypto tax guy, Eith on Twitter, on LinkedIn. My LinkedIn is also crypto tax guy Eith, so I'm pretty easy to find. And I have a regular column with Coin Telegraph, where I write about privacy issues and crypto, law and policy issues. And you can find me at my law firm, Lawrence Law, LLC, or George Mason Law School websites and around D.C. doing various policy things advocating for privacy from the Zcash Foundation Board. And love to talk, talk crypto law policy or privacy with any of your listeners anytime. Hit me up on Twitter.

Great. Well, thank you both so much for coming on Unchained. Thank you. Thanks so much for joining us today. To learn more about J.W. Jason and the legal tax and privacy issues around Frentec. Check out the show notes for this episode. Unchained is produced by me, Laura Shin, with help from Kevin Fuchs, Matt Pilcher, Juan Aranovich, Sam Shremeram, Ginny Hogan, Leandro Camino, Shish, and Margaret

Korea. Thanks for listening. Unchained is now a part of the Coin Desk Podcast Network. We've joined forces with CoinDesk's other great shows like Markets Daily, where you can hear about the latest in digital assets seven days a week and much more. Subscribe and follow the CoinDisc Podcast Network today.