Virtual currencies and related transactions are gaining popularity, but many tax practitioners are confused about their proper reporting and tax consequences. Despite the recent upsurge in virtual currencies such as bitcoin (BTC), the IRS has not issued comprehensive guidance on reporting requirements. Information in this article is based on the general guidance provided by the IRS in March 2014 in Notice 2014-21 and the application of general tax rules. This article describes a few key aspects of virtual currency phenomena, their tax ramifications, and what tax practitioners need to know about them.
In simple terms, currency is anything that has an attributed value and is commonly accepted as a medium of exchange in an economy. Traditional currencies such as the U.S. dollar and the euro have a physical component (paper or coin). In contrast, a virtual currency is an entirely digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. It is not controlled by any government (decentralized). It can be used to pay for goods or services and/or held as an investment. Virtual currencies, also known as cryptocurrencies and digital currencies, are typically stored in digital "wallets," not in traditional banks.
In general, many virtual currencies must be "mined" by powerful computers that solve complex mathematical algorithms, verify transactions, and group them into blocks on a blockchain. On the bitcoin blockchain, miners that submit blocks accepted by a consensus of nodes are rewarded with newly unearthed bitcoins. Large-scale miners house commercial mining computers in facilities called "mining farms." These are warehouses with thousands of computers mining for various virtual currencies and are often located in China or Southeast Asia, where operating costs are low. Mining can also be done on any consumer-grade computer at a home or office but will not be cost-effective due to low processing power.
Blockchain technology, the underlying platform for virtual currencies, facilitates their creation and is a system of worldwide distributed ledgers that record all cryptocurrency transactions in a series of cryptographically sealed blocks verified by a network of computers, or nodes. The technology underlying the blockchain helps make transactions written to the blockchain virtually impossible to alter after the fact. Well-known blockchains include the bitcoin network, ethereum network, Ripple consensus network, and Hyperledger. They offer different functionality and facilities. For example, the ethereum network processes transactions faster than the bitcoin network and allows peer-to-peer smart contracts and app creation.
In simple terms, a blockchain transaction can be summarized as: When Payer A sends virtual currency to Payee B, the transaction enters the blockchain as a cryptographic string of characters. Then, it is solved by a third-party independent miner to verify the amount, legitimacy, and accuracy of the transaction and the parties involved.
These currencies can be stored in digital wallets for appreciation. Also, they can be traded on third-party exchanges similarly to stocks. Exchange prices are determined by supply and demand similarly to foreign currency and stock markets. Trading platforms are virtual, so anyone can participate in any platform they prefer, subject to its terms and conditions. Popular platforms such as Coinbase, the Global Digital Asset Exchange (GDAX), and Gemini are in the United States. Owners of virtual currencies also can use them to pay for products and services or lend them to others to earn interest.
It is vital that tax practitioners correctly identify the client categories (payer/payee, miner, trader, or lender) with respect to virtual currency transactions. In other words, clients may receive virtual currencies by purchase, in exchange for products sold or services performed or through mining activities, in trades for other virtual currencies, or in borrowing transactions.Tax ramifications
Virtual currencies are treated as property for U.S. federal tax purposes and governed by the same general principles that apply to property transactions.2 Tax ramifications are based on the client category and/or nature of the transactions related to virtual currencies.
Virtual currency as a method of payment
Virtual currency paid by an employer to an employee should be included in W-2 wages, which are subject to Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes, similar to regular wages paid in U.S. dollars.3 The amount included on the Form W-2, Wage and Tax Statement, should be the fair market value (FMV) of the virtual currency at the date of disbursement to the employee. Employees paid in virtual currency should make sure that their employer has reported any wages paid in cryptocurrencies on their Form W-2.
Taxpayers who receive any type of virtual currency in exchange for products or services provided as an independent contractor must include in gross income the FMV of the currency at the date of receipt. Payments of virtual currency exceeding $600 in FMV to a taxpayer in a calendar year are subject to reporting on Form 1099-MISC, Miscellaneous Income. The amount to be reported is the FMV at the date of payment.4
Since the FMV of virtual currencies relative to the U.S. dollar is highly volatile, payers should keep accurate and complete records to support the FMV reported. Websites such as coindesk.com provide historical values of cryptocurrencies on specific dates. A daily average of high and low values can be used to measure the gross income on the date of payment. Further, virtual currency payments may be subject to backup withholding similar to regular payments. Also, it is important to know that the payee must report income even if he or she does not receive a Form 1099-MISC from the payer. This may be a common situation, as many payers are unaware of virtual currency reporting requirements.
Virtual currency mining
Miners must include in gross income the FMV of the currency mined as of the date of receipt.5 Although the IRS has not yet provided guidance to determine whether a mining operation is a passive or nonpassive activity, this can be determined by following the Sec. 469 rules pertaining to passive or nonpassive trade or business activities. For taxpayers who engage in mining as a trade or business and not as an employee, net income from mining is subject to self-employment tax. They can deduct mining-related costs, such as utilities, costs of noise insulation and electronic devices, allocable rent, repairs, etc. Taxpayers with small-scale mining operations set up in their homes may be eligible to deduct home office expenses related to these operations. For taxpayers passively involved in mining, net income generated will be passive and subject to conventional passive activity income/loss rules.
Interestingly, both active and passive miners may generate ordinary gains (not capital gains) as a result of a sale of new virtual coins to others. This is because new currencies mined may be "inventory" in the hands of the taxpayer. Sale of this inventory may trigger unexpected ordinary gains.6
Virtual currency trading
According to Notice 2014-21, virtual currency trading transactions are similar to buying and selling stocks; thus, treating these transactions as foreign currency transactions under the Sec. 988 foreign currency gain/loss rules is incorrect. Instead, for nondealers, they are governed by the general rules for sales and exchanges of capital assets. This means net short-term gains on virtual currency trading transactions will be taxed as ordinary income; net short-term losses will offset ordinary income up to the $3,000 limit on capital losses. Net long-term gains will generally be taxed at the preferential long-term capital gains tax rates, and long-term losses can be offset against ordinary income, again, subject to the $3,000 limitation.
Example 1: On Jan. 1, 2017, one BTC was purchased for $5,000. On July 25, 2017, it was sold for $8,000. The gain of $3,000 ($8,000 - $5,000) is short-term and will be taxed at the taxpayer's ordinary income tax rate.
Example 2: Assume the same facts as Example 1, except that the BTC was sold for $10,000 on Feb. 15, 2018. In this case, the gain of $5,000 ($10,000 - $5,000) is long-term and will be taxed at preferential rates.
A layer of complexity is added when virtual currencies are exchanged into other virtual currencies, not U.S. dollars.7 In fact, some virtual currencies, for example, cardano (ADA), can only be purchased using other virtual currencies. When one virtual currency is converted into another type of virtual currency, gain/loss must be recognized in U.S. dollars. This means the trader could owe a tax liability but have no real currency to pay it with.
Example 3: Assume the same facts as Example 1, except that the BTC was exchanged for ADA. 1 BTC = 10,000 units of ADA. 1 ADA = $0.60. This will trigger a gain of $1,000 [(10,000 × $0.60) - $5,000].
Many third-party virtual currency exchange services have not yet implemented any effective system to keep complete records of currency transactions or to issue Forms 1099 to traders. The IRS has sued one of the largest third-party exchanges, Coinbase, for customer information in an attempt to find underreported income.8 Therefore, it is important that clients maintain complete and accurate records of the date of the purchase, the date of the sale, and the FMV on those dates in computing gains or losses reported on Form 1040, Schedule D, Capital Gains and Losses.
Virtual currency lending
Virtual currencies can be lent by owners to others. For example, online platforms such as bitbond.com allow BTC owners to lend their BTC to other users. Lenders may receive interest rates of as much as 20%. These online platforms likely do not have a mechanism in place to report interest income on Form 1099-INT, Interest Income. Therefore, it is important for taxpayers to keep detailed records of interest they receive and report it on the tax return. Also, lending is a relatively new aspect of the virtual currency phenomenon, and the IRS has not provided any guidance regarding it.Foreign information reporting
Hacked digital wallets
A digital wallet that holds BTC or any other cryptocurrency is likely considered an account for foreign information reporting purposes. To reinforce international tax compliance, the IRS may require digital wallet owners to comply with FBAR (FinCEN Form 114, Report of Foreign Bank and Financial Accounts) and FATCA (Foreign Account Tax Compliance Act) reporting. Although there is no clear guidance on this matter, it is best to include digital wallets held overseas in these information reports to avoid possible penalties and start the running of the statute of limitation.
Virtual currency as an executive incentive
As mentioned above, virtual currency received as a method of payment or by mining or borrowing is stored in digital wallets. Although the blockchain mechanism underlying cryptocurrencies is virtually unhackable, digital wallets are susceptible to hacking. In several recent incidents, millions of BTCs were stolen from digital wallets. Unfortunately, for tax years beginning after Dec. 31, 2017, and ending before Jan. 1, 2026, individuals' theft losses not incurred in a trade or business or in any transaction entered into for profit are not deductible except to the extent attributable to a federally declared disaster, under amendments to Sec. 165 by the legislation known as the Tax Cuts and Jobs Act of 2017, P.L. 115-97.
A new class of high-net-worth individuals is emerging as a result of these virtual currencies. Proactive tax practitioners can obtain a first-mover's advantage by direct marketing toward this clientele. Growing acceptance of virtual currencies in the society also presents some new tax planning ideas that practitioners should look at closely. For example, employers may offer BTC as deferred compensation to executives and thereby bypass highly restrictive incentive corporate stock options. Note that any deferred compensation plan such as this would need to be reviewed in detail before execution.
Example 4: Assume 1 BTC offered to an executive at the date of a grant is worth $18,000. The corporation will include this amount on Form W-2, pay payroll taxes on it, and withhold necessary federal and state income taxes. The executive will record $18,000 as gross income.
In the future, assuming the BTC price goes up, the executive can sell the BTC and generate long-term capital gains. This is a win-win situation because the company pays relatively low payroll taxes on the date of grant and avoids dilution of corporate stock. The executive may find BTC more attractive than corporate stock due to its growth potential. He or she can sell the BTC in the future and may recognize long-term gains subject to preferential tax rates. Also, virtual currency payment as a part of employee regular wages or a bonus is an effective way to transfer compensation that may appreciate in the future. Thus, rewarding employees with an appreciating asset rather than with inflation-prone U.S. dollars can promote employee satisfaction and retention.Due diligence and tax planning
As virtual currencies gain popularity, practitioners should try to educate clients about any previously overlooked virtual currency reporting requirements. Practitioners should see if there have been any underreported or omitted virtual currency gains in past years. If there are, practitioners should advise the client of the potential consequences of the error and recommend corrective measures, as well as making clients aware that the IRS's reasonable-cause relief may be available for virtual currency-related misstatements. In addition, practitioners should make sure their tax engagement letter and year-end organizer reflect virtual currency reporting requirements.
Practitioners should proactively identify virtual currency-related transactions and assist clients in complying with the rules that apply to these transactions. In doing so, they will gain expertise in an emerging global industry.
7Prior to the enactment of P.L. 115-97, known as the Tax Cuts and Jobs Act (TCJA), some taxpayers took the position that the exchange of one type of virtual currency for another type of virtual currency was a like-kind exchange subject to Sec. 1031. However, TCJA Section 13303 limited like-kind exchanges under Sec. 1031 to exchanges of real property that is not primarily held for sale, in general, for exchanges completed after Dec. 31, 2017.
8Coinbase, No. 17-cv-01431-JSC (N.D. Cal. 11/17/16) (ex parte petition filed). See also "Tax Matters: Coinbase Notifies Customers of IRS Summons Compliance," 225-5 Journal of Accountancy 61 (June 2018).
|Shehan Chandrasekera, CPA, is a partner at JAG CPAs & Co. in Houston. For more information about this article, contact firstname.lastname@example.org.