Hello World – A LukkaTax Story

Hello World: A LukkaTax Story

By jd

[The press release on LukkaTax can be accessed here and the website here.]

Good day Lukka Community! Today is another big one for the company as we announced our latest product, ‘LukkaTax’ — a ‘do-it-yourself’ tax preparation tool specifically aimed at helping those brave souls that want to calculate their own crypto tax exposure. It’s a must have if you have transactions on multiple exchanges. Note: this product complements our ‘LukkaTax for Professionals’ product announcement from last week. That product is aimed at providing a crypto tax prep tool – in partnership with – specifically for accounting firms and sole practitioners who provide service to 55% of the market who prefer to have someone else do their taxes (which is what I do – thanks Vince!). LukkaTax supports the other 45% of the market.

Why LukkaTax?

So the rest of this blog will try and provide you a bit of the thinking there. WARNING: this is a longer blog so go get a coffee before you jump in. But, for those that just want the Reader’s Digest version, it’s this: We invented the dedicated crypto tax software product category in 2014, we know it better than anyone, we (re)built what we believe is the best solution in the world for it, and we priced it at $20 bucks to make it an easy buying decision – and if you go here – it’s only $10 BUCKS if you buy before 1/15/2020 – so go out and get a subscription, it’s an unbelievable deal. Note: pricing is not impacted by transaction volumes. Yea, you read that last bit right. 

Big Picture.

Over time we expect the world to convert to digital assets. That might come from tokenizing stuff like sneakers, or use of cryptocurrencies like bitcoin, or maybe stablecoins like Libra from Facebook or even tokenized fiat currencies. We don’t know for sure but looking at the current traction and uptake by millennials and younger generations – the biggest owners of the tech – this seems like a very good probability. Personally, I think gaming might be where we see the real traction in the shorter-term, but I digress – let’s just say we are very big believers that assets will continue to move to digital platforms and that the trading of those assets, often against each other with no dollars/fiat involved, is going to continue to create a myriad of tax issues that we want to help solve.

Legacy Players.

Of course, there are lots of existing tax prep software platforms out there that provide service for other asset classes, so why won’t someone like say, H&R Block or TurboTax just roll in and take this over? We get that question a lot. Look, those platforms need very clean data to work. They are like super high-performing Lambos that can crank out millions of returns when given the right fuel. The only problem is that crypto data is like pond water mixed with lawn mower gas. 

If you try and put that kind of fuel in those type of high-performance platforms, you blow up the engine. It just doesn’t work. Why? Because crypto data – by design – is distributed and decentralized. Which means there are no standards. Owners of crypto platforms can do whatever they want with data structures and they don’t care about making it clean and readily available for tax reporting purposes. So you need someone in between the crypto ecosystem and the big tax prep shops. You need someone to go out and get the data, clean, value, and match it correctly and optimally, and then provide it in the 93+ octane fuel way that the big software platform providers need to run their engines. In a broad sense, that’s what we are doing with our tax reporting solutions.

Regulatory Actions.

The LukkaTax product announcement coincides with recent tax compliance announcements regarding cryptocurrencies, referred to as ‘virtual currencies’ by the Internal Revenue Service. For those of us that have been at this for the last five years or so – what we realize is that this is the year. The IRS isn’t playing games anymore. For example, 2019 will be the first year that the IRS will explicitly ask taxpayers to document their virtual currency activity, prioritizing this question to the top of its new IRS Form 1040 Schedule 1. For those with activity, transactional details must then be itemized on IRS Form 8949 (see FAQ #40) which includes cost basis, proceeds, and itemized gain or loss. Finally, for those taxpayers who did not report in previous tax years – the IRS has also made it clear – amend prior year returns.  What I can tell you is that everyone in the space knew this moment would come so don’t play cutesy. Remember you are dealing with public ledgers and the IRS has tools to check your work. If you think you are going to out-smart them you really are taking an awfully big risk. Be smart. 

Market Size.

Anyway, there’s a need here – a job to be done – in Clayton Christensen speak, but how big is the opportunity? On this point, we had to look very hard at survey data. What we found is that based on the most recent numbers, anywhere from 7-14% of Americans own crypto. That’s about 25-45 million potential U.S. taxpayers (sources here and here – there are lots more surveys out there, just google it). Even at those percentages, which we think will grow quickly over time, it’s a big market. Sell anything 25-45 million times and you’re going to Sizzler.

Build Rights.

With all that being said, why are we, Lukka, the right players to build this product? We might build an awesome product, but if the consumers don’t believe – for whatever reason – that we have the right to build it, then we will fail. On this point, we have history on our side. In 2014, Jake Benson, our CEO, founded Lukka (named Libra at that time) and built the world’s first commercial crypto tax prep tool, LibraTax. If you’ve been in the space for a while, you know LibraTax. For a long time, it was THE go-to tool. Over the last couple years, we focused more on enterprise solutions and institutional investors, but supporting the retail market segment has been central to the company since it was started. Like I said above, we invented this category, so we believe consumers will agree we are the right folks and buy our solutions.

Experience as a Service.

Next we got into concepting. What should this specific product be? The first thing that is very clear is that it needs to be a guided experience. Everyone in our space knows how Herculian a task this can be. It’s just really really hard to get the right answer, so we wanted to try and make it simple. We want to make it feel like we had our Customer Success team sitting in the room with everyone using our software. We weren’t going to point at Mt. Everest and say, go get it! That’s just not very sherpa. On this point, we just didn’t find any other tool that nailed the experience and as a SaaS platform, that was the key. So that’s where we started. Please note, on this point, we talked to a lot of great and smart people, but we especially got a lot of killer feedback from a guy named Greg LaFollette. He’s a tax product Original Gangster from, AICPA, and Thomson Reuters before that. He’s full of great insights. Thanks Greg 🙂

Product Ethos.

Before we get into product differentiators and all that…there is one broader point worth mentioning. In building out LukkaTax, we had the benefit of not only having built LibraTax, but also leveraging three years of experience in building and running our institutional products. This is beyond important. For example, every single month we help a ton of hedge funds strike NAV – net asset value. This is the calculation used to determine the performance of all their trades. For non-finance types, what you should know is that this is an exacting science – like financial brain surgery. You cannot be wrong. Your numbers have to be correct, every month. You don’t get any points for being 98% right. So, for us, that means we need to be exact — right down to the 18th decimal point! That kind of standard has instilled in our company a level of understanding about where the speedbumps are in tax reporting that you cannot buy. You have to live it, and we do each and every month. We have an ethos of accuracy that is simply woven into the fabric of our company.

Product Differentiators.

Connectivity. We have decided to only use files not API’s this year. This is different than every other product on the market – including our own LibraTax and all our institutional products, all of which use APIs to a point. The thinking here is simply around data completeness and reconciliation. What we know, as one of, if not the largest integrators to post-trade exchange APIs, is that crypto data is almost always incomplete. In a dataset of say 100, you might get anywhere from 97-99% of the data, then you have to use a variety of rec tools to figure out where your gaps are. Now, some API’s are almost always right, but most are almost never. So, if we stand in the shoes of our customers this could be framed as a question of convenience vs. completeness. Perhaps it’s easier to drop in a read-only API key and secret than pulling down and uploading a transaction file – we don’t think so – but perhaps some will argue that point. Regardless, what we do know if you rely on API’s you are putting your customers at risk of missing transactions, and that’s simply not something we are willing to do. Getting audited is right up there with root canals, so that’s just a straight no go.

Enrichment. There are two aspects to enrichment to discuss. The first relates to non-standardized crypto data. What you should know is there are a ton of duplicated and fraudulent tickers in cryptoland, plus many of the tickers change all the time. Then you have new tickers/pairs every day, while some die every day, and of course – because why not – the formats are different everywhere. For example, XLM/USD and $_str could represent exactly the same thing on different exchanges in cryptoland. That means everyone in this business needs to continuously update their security masters to make everything look the same. 

Voila — enter Lukka Reference (“Ref”) Data! Lukka is the only company that uses its own industrial-strength, commercially-viable solution to standardize and normalize crypto data. And, perhaps more importantly, we update our data daily. Further, in addition to pulling down all that ref data from exchanges, we look across all our enterprise clients to see what new tickers and pairs are being traded – in real time – to further improve accuracy of our ref data. This is key, as you need to take every single transaction and match it down to very specific metadata to make sure that we are matching data correctly. You don’t want to report three different matched pairs for Stellar just because they have three different tickers on three different exchanges. 

The second aspect of enrichment is valuation. This is a critical topic for all readers. Question: how do you report gain / loss on crypto-to-crypto trades where the exchange has no fiat on-ramp (or the pair does not have a fiat value)? We knew this was going to be a common situation for many potential LukkaTax users so we couldn’t just skip it. In looking at current practice by other tools, we noted pretty much everyone used a VWAP index. That’s a problem as the IRS has explicitly rejected the use of indexes in various tax reporting contexts and Q&A 29 was silent on this issue. Further, after doing our research, we believe that when the IRS takes up the issue they are going to again reject index use due to the problems of fake volume and wash trades reported on certain exchanges. So what to do?

Well, we looked at the approach the IRS has taken when valuing financial assets outside of an organized exchange, i.e., the “principal market” approach. In the crypto ecosystem, a principal market approach would price a crypto asset by scrutinizing reliability of exchanges, pricing data, and trading volumes. So, where we landed was to create a single floating exchange pricing method called Lukka Prime, which embraces the principal market approach and is consistent with GAAP/IFRS financial reporting standards. Lukka Prime rejects the use of broad indexes that are polluted by fake volumes. We believe this is the best approach for valuing crypto-crypto trading pairs, and reduces IRS adjustment risk. Note: we are happy to report that Lukka Prime is automatically applied in LukkaTax for pricing purposes. To the extent there is an asset that doesn’t have a Lukka Prime price, customers are given the ability to manually enter their own. Note: all the math and factor determination on Lukka Prime can be found in our whitepaper: here.

Calculation. We are all the way down in the weeds now, so I’ll be brief. First, we are very careful in how we account for crypto fees. Many tools treat crypto fees incorrectly when the fee is paid in a crypto asset. One cannot just translate the fee into USD, you have to treat the payment of a fee in crypto as a separate disposition. That disposition will produce a gain or loss where the price of the asset has moved since its acquisition. Thank Binance Coin for making this a widely used financial innovation. A lot of tools get that wrong and by extension the overall tax output.

Next, we match at a global level, not an exchange level. We are able to do this because, as discussed above, we normalize all tickers/pairs across all exchanges via our Ref Data. If you don’t have that capability you will match trades on an exchange level. This creates non-optimized matching such that say, XLM is matched on one exchange and STR is matched on another even though they should be matched together because they are in fact the same asset.

Wrap Up.

Ok, let me wrap this up with one final point. Every single feature in LukkaTax is there by design. Interestingly, one of the most challenging aspects to this was thinking what not to include. We could have piled in a ton of other capabilities. How about adding in support for Bitmex perpetual swaps? Or, allowing for manual specific identification across every transaction even though you’re only supposed to use spec id if you match at the time of the transaction? We looked at all of that and had to make a bunch of calls regarding what would millions of users require in a highly automated tool.

We believe we have made a product that walks that line, and over time we will add many more features based on customer feedback. However, if you believe we missed the mark and/or we need to rethink something, I’d like to know pronto so please hit me up here: Well, if you made it this far, excellent, I hope this was useful and helps you understand just how deep we go in thinking about product design and positioning. We are in this for the very long haul, and if you buy our stuff, we will work our damndest to make the best crypto tax software in the world for you. Alright, so – if you do your own taxes – go here to buy a subscription for $10 before 1/15/20, it’s easily the best value in the space. Plus, stay on the lookout for videos, webinars, meetups and all that stuff to help as you get ready to report!

Happy Holidays, jd.