Tax Considerations for Crypto Custody and Security Services
Understanding the Tax Implications for Safeguarding Digital Assets
In the world of cryptocurrency, there's an old saying: “Not your keys, not your coins.” It's a cautionary phrase reminding users that if they don’t control their private keys, they’re effectively handing over ownership of their crypto to someone else. This leads us to an increasingly critical part of the digital asset economy: crypto custody and security services.
Whether you’re an individual investor using a custodial exchange or a business managing wallets for clients, how these services are structured has real tax implications. In this article, we’ll explore how custody and security interact with U.S. tax law, what crypto holders need to know, and how service providers should approach compliance and risk mitigation.
1. What Are Crypto Custody and Security Services?
Before we jump into taxes, let’s clarify what custody and security mean in the crypto space:
Crypto Custody refers to holding crypto assets on behalf of another party. Think of Coinbase Custody or BitGo — institutions that securely manage private keys for high-net-worth individuals or businesses.
Security Services encompass broader safeguards, such as multisig wallets, hardware storage, insurance coverage, cold storage, key sharding, and even disaster recovery planning.
These services are essential because cryptocurrency transactions are irreversible. If private keys are lost or stolen, the crypto is gone forever. As the industry grows, so does the demand for secure and compliant custodial solutions.
2. Tax Status of Crypto Custodians
Here’s where things get interesting from a tax perspective. If you provide custodial services, you might fall into multiple tax categories depending on how your business is structured and what you actually do:
a. Service Providers vs. Financial Institutions
In the eyes of the IRS, most crypto custodians are treated as service providers, not financial institutions. That means you’re not subject to the same tax rules as traditional banks — but you are liable for ordinary income taxes on fees collected for custody or security services.
Tax Example:
If your company charges $5,000/month to store crypto in cold storage for clients, that income is taxable just like any other business revenue — even if the crypto itself never moves.
b. De Facto Ownership and Tax Risk
If your custody model gives you full control of a client’s funds (especially if you hold both the public and private keys), the IRS might interpret that as constructive receipt or beneficial ownership — creating gray areas where tax liabilities could arise for you or your clients.
Why this matters:
If the IRS claims you “owned” client crypto for tax purposes (even temporarily), it could complicate how gains, losses, or income from that crypto is reported.
3. Tax Considerations for Individual Crypto Users Using Custody Services
Let’s flip the coin and talk about what tax implications individual users face when entrusting their crypto to custodians:
a. No Tax Just for Moving Assets to Custody
Transferring your crypto from your personal wallet to a custody provider — even an exchange wallet — does not trigger a taxable event. It’s considered a self-transfer unless the underlying asset changes ownership or is traded.
But here's the catch: if your custodian lends, stakes, or rehypothecates your crypto on your behalf, you could incur taxable income.
b. Staking, Lending, or Earning Yield While in Custody
Some custodians offer custodial staking or lending services. If you earn rewards while your crypto is in custody:
Staking rewards are generally taxed as ordinary income at the fair market value when received.
Lending interest is treated like interest income and also taxed at ordinary rates.
These earnings must be reported, even if you haven’t withdrawn them.
4. Cold Storage and Tax Audit Risk
Cold storage — where assets are kept offline and disconnected from the internet — is a favored method for both custodians and individuals looking for maximum security. But from a tax compliance lens, this opens up a new challenge:
a. Proving Ownership and Cost Basis
If you’re audited, the IRS will want to know:
When you acquired the crypto
For how much
Whether it was ever sold or transferred
If your crypto is in cold storage, you must maintain thorough documentation to prove:
Your cost basis (original purchase price)
Your holding period
The wallet address and access logs
Failing to do this could mean:
Disallowed capital loss claims
Delayed audits
Or even penalties for underreporting
5. Security Losses: Theft, Hacks, and Insurance
Unfortunately, security breaches happen — whether it's due to phishing attacks, compromised key storage, or internal fraud. If crypto is stolen or lost, can it be claimed as a deduction?
a. Claiming Theft Losses Post-TCJA
Before 2018, theft losses could be deducted under Section 165 of the tax code. However, the Tax Cuts and Jobs Act (TCJA) suspended personal casualty and theft losses through 2025 unless directly connected to a federally declared disaster.
That means most crypto theft or hacks are not deductible for individual taxpayers — even if you lost a significant amount. For businesses, however, the story might be different:
b. Business Loss Deduction
If you’re a crypto business or trader and assets were lost due to security failure, you might be able to deduct that loss as an ordinary business expense — but documentation is critical.
c. Insurance Payouts Are Taxable
If you receive an insurance payout after a loss, the payout may be taxable income if it exceeds your original basis. For example:
You bought 1 BTC at $5,000.
It was hacked when BTC was worth $40,000.
Insurance pays you $40,000.
Your gain is $35,000, taxable as a capital gain depending on your holding period.
6. International Custody: Offshore Risks and Reporting
Using offshore custodians may sound like a good idea for asset protection, but it comes with a landmine of IRS reporting obligations.
a. FBAR and FATCA
If you hold crypto with a foreign custodian (outside the U.S.), and your balances exceed certain thresholds, you may need to file:
FBAR (FinCEN Form 114) if aggregate foreign accounts > $10,000
FATCA (Form 8938) if you meet the income and asset thresholds
Failing to file these can result in hefty penalties — even if the crypto sits idle.
7. Compliance and Reporting Best Practices
Here are some smart practices for crypto custody clients and service providers alike:
For Individuals:
Use reputable custodians that issue tax reports (e.g., 1099 forms).
Track all wallet transfers — even between your own wallets.
Document staking/lending rewards as income when received.
Report security breaches or hacks with accompanying police/incident reports.
For Custody Providers:
Maintain segregated wallets per client for clear audit trails.
Avoid commingling crypto in shared hot wallets.
Issue year-end reports detailing all crypto movement and rewards.
Consider SOC 2 certification or other security audits to build trust.
8. Future Trends: IRS Scrutiny and Regulation
The IRS and Treasury are actively closing the gap in crypto tax compliance. Recent regulatory signals suggest:
Form 1099-DA (Digital Assets) will likely be required for custodians and brokers starting in 2025.
Custodial platforms may be classified as brokers, increasing their obligations under the Infrastructure Investment and Jobs Act.
Self-custody is still preferred for those seeking privacy and full control, but comes with more reporting responsibility.
Custodians and security service providers should prepare now for increased compliance burdens and customer reporting duties.
Conclusion: Ownership, Security, and Tax Go Hand-in-Hand
Crypto custody and security are more than just technical issues — they’re legal and tax-sensitive domains that require careful planning. For everyday users, understanding how custodial services impact income, gains, or losses is crucial. For businesses, staying ahead of IRS scrutiny means having airtight recordkeeping and being ready for regulatory evolution.
As crypto goes mainstream, the IRS is watching. And whether you’re storing assets yourself or relying on a third party, your tax liability hinges on who controls the keys, how assets are used, and what income is generated.
At CoinFlask, we believe that crypto users and companies alike should be empowered with both technological safety and regulatory clarity. If you’re navigating complex custody arrangements, reach out — we can help decode your wallet activity and prepare you for tax season, the smart way.
DISCLAIMER: The views and opinions expressed are those of the authors and do not necessarily reflect the official policy or position of CoinFlask. Do your own research. This is not financial advice