IRS Tax Strategies For Virtual Currency

Cryptocurrency Tax Reporting Guide For U.S. IRS Tax Strategies For Virtual Currency

When you use crypto to pay for goods or when you exchange it for cash, recognizable transactions occur.  If the FMV of the property received in exchange for crypto exceeds the taxpayer’s adjusted basis in it (crypto), the taxpayer has a taxable gain.  If the value is lower than the basis, a tax loss occurs.  The nature of the profit or loss is dependent on whether the crypto is a capital asset for the taxpayer.

For virtual currency, basis is the FMV (fair market value) on the date the currency is acquired.  Of course, if it was ‘acquired’ as payment for services, it is taxable income subject to income and Social Security taxes.

IRS Enforcement

The IRS is increasing its effort to enforce compliance with crypto income.  Taxpayers will have to disclose to the IRS if they had any financial interest in any virtual currency during the previous year. Starting with the 2019 Form 1040, Schedule 1, Additional Income and Adjustments to Income, taxpayers will have to answer the question truthfully. Taxpayers must report any income, gain, or loss in any virtual currency on their federal tax returns.  The taxpayer can withhold no transaction, however small, irrespective of whether they received a payee statement or information return.  In the meantime, the IRS is extracting information on account holders from crypto providers.  The IRS used a federal warrant to require the information below from Coinbase,  for all accounts where the equivalent of $20,000 changed hands in any single transaction between 2013 and 2015:

  • Taxpayer Identification Number
  • Name
  • Birthdate
  • Address
  • Records of account activities
    • Transaction Logs
    • Documents that identify
      • The Date
      • Amount
      • Type of transaction
        • Purchase
        • Sale
        • Exchange
      • Post Transaction Balance
      • Names of Counterparties
    • All periodic statements of the account and invoices

Virtual Currency In A Business

  • Sole Proprietor X receives ten bitcoins from Y as payment for services rendered.
  • On the day, the bitcoins were valued at $400 each.
  • X recognizes $4,000 of business income.
  • Thirty days later, the bitcoins are worth $425 each.
  • On this day, X buys supplies and pays with two bitcoins. X recognizes $850 in business expenses AND a $50 gain on the bitcoins.
  • X is not in the trade or business of dealing bitcoins, so the $50 gain is capital. Any loss X made on the bitcoin will be a business capital loss.
  • If X spent the bitcoins for personal use, any loss would be personal and not eligible for deduction.
  • If X used Y’s services in her trade or business, she is subject to the Form 1099-Misc, Miscellaneous Income, reporting requirements because the value of the bitcoins is $600, or more.

Tokens

Security tokens represent real-world assets, often anticipated profits of blockchain-based enterprises, and it falls under SEC supervision. Utility tokens entitle its owners to future access to a product or service, and digital asset tokens signify the existence of an asset off the blockchain.

  • A is sure that bitcoin will increase in value, so he buys 15 bitcoins on March 15th, 20×1.  On May 19th, 20×1 he buys another 20 bitcoins for $460 each.
  • On April 3rd, 20×2, he sells ten bitcoins for $425 each.
  • A held the bitcoins for investment so any gain or loss will be capital in nature.
  • If he sold ten bitcoins from the March 15th batch, he must recognize a $250 long-term capital gain.
  • If he sells ten bitcoins from the May 19th, batch, he must recognize a $350 short-term capital loss.
  • The coins were held for investment purposes; hence the short-term capital loss can be included on his Form 8949, Sales and Other Dispositions of Capital Assets, for 20×2.

Tip

For tracking basis and identifying which bitcoins were sold, wallets should best be kept apart.

What We Don’t Know

  • (As property) Is crypto eligible for a valuation discount or premium in estate or gift tax situation?
  • Should the costs to acquire (and mine) crypto, be capitalized?
  • Are retirement accounts permitted to hold virtual currency?
  • The IRS is unclear as to whether crypto is a security. If it is, is it subject to the dealer rules of Sec. 475 and the wash-sale rules?
  • It is often tough to determine FMV because exchange rates are uncertain.
  • It is tough to obtain appraisals for charitable contribution deductions.
  • While required to track basis in virtual currency transactions, it is unclear which accounting method should be used (LIFO, FIFO, or another)?

Guidance And Enforcement Put Virtual Currencies Front And Center

The IRS recently issued a revenue ruling (Rev.Rul. 2019-24) accompanied by amended frequently asked questions to clarify existing guidance on the treatment of cryptocurrency.  The advice appeared in the wake of the agency’s announcement of a virtual currency compliance campaign and a regulatory project for reporting the gross proceeds from crypto transactions.

About Virtual Currency

The world of virtual currencies is ever-expanding.  Put simply, virtual currency, like Bitcoin, are digital tokens recorded on a blockchain.  Bitcoin was the first digital, open-sourced, and decentralized cryptocurrency. However, it is by no means the only cryptocurrency available today.

Virtual Property

In terms of IRS Notice 2014-21 issued in March 2014, the IRS considers virtual currency transactions as property in respect of taxation.

Additional Guidance

Despite the corpus of tax rules that apply to property,  many questions remained unanswered.  How should the taxpayer handle ‘airdrops’ and ‘soft and hard forks?’

  • AIRDROP

Distribution of virtual currency to an existing wallet address.

  • SOFT FORK

A change in the blockchain protocol that creates blocks that remain compatible under legacy rules.

  • HARD FORKS

A change in the blockchain protocol that creates blocks that are incompatible under legacy rules.

  • EXAMPLE

In 2017 a bitcoin hard fork created two versions of bitcoin.  As a result of the hard fork, all bitcoin holders received the same amount of bitcoin cash on the new blockchain, while holding on to their bitcoin on the original blockchain.

IRS Revenue Ruling In “Forks”

IRS Rev.Rul. 2019-24 ruled on the tax treatment of hard forks.

SITUATION ONESITUATION TWO
Taxpayer X held fifty units of Crypto X.Taxpayer X held fifty units of cryptocurrency Z.
Crypto X experienced a hard fork, which resulted in the creation of Crypto Y.Crypto Z experienced a hard fork, which resulted in the creation of crypto Q.
Crypto Y is not airdropped to an account owned by the taxpayer. , nor transferred in any other manner.Twenty-five units of crypto Q are airdropped to the taxpayer. As a result, the taxpayer held fifty units of crypto Z and twenty-five units of crypto Q after the airdrop.
IRS RULINGIRS RULING
Taxpayer X received no gross income from the hard fork (under Sec.61)Taxpayer X had accession to wealth and had gross income.
EXPLANATIONEXPLANATION
The taxpayer did not receive any units of the new cryptocurrency Y.The taxpayer had dominion and control of crypto Q t the moment it was recorded on the distributed ledger.
 The taxpayer had the immediate option to dispose of his crypto Q.
 The amount of gross income was equal to the FMV of crypto Q, an amount of $50 in the above example.
 The taxpayer’s basis in crypto S was $50
 The IRS cited Glenshaw Glass 348 U.S.426,431 (1955)

THE 2019 FAQs

The IRS finally provided definitions for virtual currencies: A virtual currency is a digital representation of value, other than a representation in the form of US dollar or a foreign currency, that functions as a unit of account, a store of value and medium of exchange.

  • Any assets that have the characteristics of virtual currency will be regarded as the same for tax purposes irrespective of its label.
  • A CRYPTOCURRENCY is a type of virtual currency that uses cryptography to secure transactions that are recorded on a distributed ledger such as a blockchain.

Sale Of Exchange Of Virtual Currency

  • Virtual currency is treated as property, and general tax principles for property transactions apply.
    • Taxpayers recognize a gain or loss if they exchange or sell virtual currency for another property or service.
    • The holding period that the taxpayer held the virtual currency determines whether a loss or gain is a short-term or long term capital loss or gain.
    • Cost basis consists of the amount spent to acquire the virtual currency and includes commission, fees, and other acquisition costs.
    • In the determination of gain or loss, the cost basis is taken into account.

Identification Of The Units Sold

When a taxpayer who owns multiple units of the same virtual currency that she acquired at various times, sells, exchanges, or disposes of some units, but not all,  she is allowed to identify which of her units she sold, disposed of or exchanged.

Requirements For Identification

  1. Document the specific unit’s unique digital identifier (private key, public key, and address).
  2. Supply records that disclose the full transaction information for all units of a specific virtual currency held in a single account, wallet, or address.
  3. The identification must include:
    • The date and time each unit was acquired
    • The taxpayer’s basis and the FMV of each unit at the time it was acquired.
    • The time and date every unit was sold, exchanged, or disposed.
    • The FMV of each unit when it was sold, traded, or disposed.
    • The amount of money or the value of property received for each unit.

Taxpayers who decline to identify a specific unit of virtual currency will be deemed to have sold, disposed of or exchanged their units of virtual currency in chronological order, on a FIFO basis.

When a taxpayer transfers virtual currency from one wallet or address he owns to another wallet, account, or address he holds, this is a transfer and not a taxable event.

Receipt Of Virtual Currency For Services Rendered

When a taxpayer receives virtual currency in payment for performing services,  gross income must be recognized even when the taxpayer conducts the services as an employee.

  1. The amount of income recognized is equal to the FMV of any virtual currency received for performing the service.
  2. If the taxpayer is an independent contractor, the FMV of the virtual currency received constitutes self-employment income, which is subject to self-employment tax
  3. If the taxpayer is an employee, the FMV of the virtual currency paid as wages is subject to federal income tax withholding, Federal Insurance Contributions Act tax, and Federal Unemployment Tax Act tax reportable on Form W-2, Wage, and Tax Statement.
  4. Virtual currency paid by an employer as remuneration for services constitutes wages for employment tax purposes.

Gifts And Contributions

  1. When a taxpayer receives virtual currency as a bona fide gift, income is not recognized until the taxpayer sells, disposes of, or exchanges the virtual currency.
  2. When a taxpayer donates virtual currency to a Sec.170(c) charitable organization, the taxpayer will not recognize income, gain, or loss from the donation.
  3. The amount of charitable deduction for the donation is:
    • If the taxpayer held the virtual currency for more than one year, the charitable deduction for the gift of his virtual currency is the FMV of the virtual currency at the time of the donation
    • If the taxpayer held the virtual currency for one year or less, the charitable deduction is the lesser of the taxpayer’s basis or its FMV.

Cryptocurrency FMV At Time Of Acquisition

  1. When a taxpayer acquires her cryptocurrency in a transaction facilitated by an exchange, the FMV is the amount that the exchange recorded.
  2. When a transaction is not recorded in a distributed ledger, then the FMV is the amount for which the cryptocurrency traded on the time and date of the purchase was it recorded on the ledger.
  3. For peer-to-peer transactions, the IRS accepts the value of the cryptocurrency as determined by a cryptocurrency explorer, as evidence.
  4. Taxpayers who do not use an explorer value, the onus is on the taxpayer to establish that the amount it uses is an accurate representation of the FMV.
  5. When a taxpayer receives cryptocurrency not traded on any exchanges and without a published value, the FMV is equal to the FMV of the property or services exchanged for the currency when the transaction occurs.

Compliance And Enforcement

  • Taxpayers should consider the filing of a ‘qualified amended return’ to correct previous filings without any risk of penalties – IF – the original return(s) were not filed fraudulently [Regs. Sec. 1.6664-2(c)(3)].
  • FOR EXAMPLE: If the taxpayer experienced a hard fork in years gone by (Rev.Rul.2019-24), which she failed to report in respect of gross income, she should file a qualified amended return to report the revised amount of gross income – without being penalized by the IRS.

Tax Recommendations

  1. It is appropriate to consult a tax practitioner to determine whether an amended return is required.
  2. Taxpayers who do not risk penalties for failing to report gross income.
  3. The IRS improved its enforcement of crypto taxation. Taxpayers should not base their decisions on their belief that they ‘will get away with it.’
  4. New enforcement strategies implemented by the IRS:
    • The IRS used the judicial process to gather data. In 2017 the DOJ enforced a John Doe summons against Coinbase Inc.
      • In it, the IRS sought significant information in respect of 13,000 specific Coinbase customers, including:
        • User profiles
        • Know-your-customer due diligence
        • Documents in connection with third party access
        • Transaction logs
        • Records of payments processed
        • Correspondence between Coinbase and these users
        • Account and invoice statements
        • Records of payments
        • Exception records produced by the Coinbase anti-money-laundering system
  1. In July 2018, the IRS announced a virtual currency compliance campaign by its LB&I division.
  2. In 2019 the IRS announced that they are sending letters to 10,000 taxpayers to inform them of tax compliance for virtual currencies.
  3. Recently the IRS started to require information reporting under Sec.6045 and most likely through Form 1099, where gross proceeds from cryptocurrency transactions must be disclosed.
  4. Form 1040, S. Individual Income Tax Return, now contains a yes-or-no question on Schedule 1, Additional Income and Adjustments to Income. The taxpayer is required to disclose whether she received, sold, sent, exchanged or otherwise acquired any financial interest in virtual currency.
  5. Taxpayers who hold virtual currency will have to disclose it.
  6. Should the answer be inaccurate, the taxpayer might face civil and criminal actions.
  7. Taxpayers now face a situation where it is the position of the IRS that most of the guidance on virtual currency transactions are based on long-standing principles. This means that virtual currency transactions of past years are subject to these principles even though there was almost no guidance available.
  8. The absence of any de minims exception for tracking personal virtual currency transactions (i.e., having a cup of coffee) may very well hinder the usefulness of virtual currency – OR – the compliance by taxpayers (due to administrative burdens).

Prudence

Taxpayers should diligently track their virtual currency transactions and continuously assess the tax consequences before entering into new trades.

Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services.  This article cannot serve as a substitute for such professional services or advice.  Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation.  This article is subject to change at any time and for any reason.

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Fulton Abraham Sánchez, CPA I am Certified Public Accountant, specialized in Tax Planning & Offshore Strategies for Real Estate, Hedge/Equity Funds, Fintech, Crypto, Expats, IRS Debt Resolution. You can email me fa@fascpaconsultants.com and follow us on Facebook : FAS CPA & Consultants.

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