Editor: Mark Heroux, J.D.
Cryptocurrency, or virtual currency, is now a significant player in the investment marketplace, and, as a result, many challenging legal and regulatory questions have been raised across the globe. While cryptocurrency and its utilized technologies could radically change business processes, its inherently decentralized nature could serve as a vehicle for sinister activity and a challenge to those charged with compliance with the law.
The IRS is investing significant resources to combat potentially staggering levels of tax noncompliance with reporting income associated with cryptocurrencies, highlighted by its summons for account holder information from the U.S.-based cryptocurrency exchange Coinbase (Coinbase, Inc., No. 3:17-cv-01431 (N.D. Cal. 11/30/16) (order granting ex parte petition). This item (1) discusses some key U.S. tax implications and unanswered questions of cryptocurrencies and (2) identifies possible avenues of relief for taxpayers with unreported income or assets connected to cryptocurrency.
What is cryptocurrency?
Cryptocurrency is a digital currency. Cryptocurrency transactions occur through blockchain technology over a decentralized peer-to-peer network that takes the place of an intermediary. Cryptocurrency lacks legal tender status in nearly all jurisdictions, including the United States.
Cryptocurrency can be stored in a digital wallet using an app on a computer or a smartphone, or it can be held in a digital account on an exchange that enables account holders to exchange their cryptocurrency for different types of cryptocurrencies or for fiat currency.
The most well-known cryptocurrency, of course, is bitcoin, and other popular cryptocurrencies include ethereum, ripple, and litecoin. Many more are likely to emerge. As of this writing, CoinMarketCap.com tracks the market price of 1,664 cryptocurrencies. Cryptocurrency "forks" can occur when the rules for a blockchain change; this could result in a taxpayer's owning two types of cryptocurrencies that formerly were a single one — such as bitcoin and "bitcoin cash." There are cryptocurrency derivatives, such as bitcoin futures.
Notice 2014-21 and some unanswered questions
In Notice 2014-21, the IRS issued preliminary guidance on applying general tax principles to cryptocurrency, specifically, virtual currencies that have "an equivalent value in real currency, or that act as a substitute for real currency." The IRS does not view cryptocurrency as generating foreign currency gain or loss for U.S. federal tax purposes and, instead, treats cryptocurrency as property. As a result, cryptocurrency can be characterized as investment property (like stock), business property (like inventory), or personal property (if used to purchase groceries, for example). Considering that a taxpayer cannot deduct personal losses, the IRS must further distinguish between holding cryptocurrency for investment and for personal purposes.
A taxpayer who receives cryptocurrency as payment for goods and services must include its fair market value (FMV) at the time of receipt in gross income. FMV may be determined from a cryptocurrency exchange rate established by market supply and demand. Independent contractors who receive cryptocurrency for performing services are also subject to self-employment tax. For information-reporting purposes, the rules for Form 1099-MISC, Miscellaneous Income, apply, and backup withholding could be required if the payee fails to produce a taxpayer identification number.
For a taxpayer who engages in many cryptocurrency microtransactions, the recordkeeping required for tax purposes could be overly onerous — if not impossible — to satisfy. Notice 2014-21 states that the cost basis for cryptocurrency received is based on its FMV in U.S. dollars on the date received. The ABA Tax Section in a comment letter (available at www.americanbar.org suggested a de minimis exception based on either value or holding period, along with guidance on recordkeeping to mitigate the anticipated burden. The AICPA also recommended the need for a de minimis election as part of 27 FAQs for the IRS to consider incorporating as part of virtual currency guidance (available at www.aicpa.org.
Even taxpayers who are diligent to record every cryptocurrency transaction must address cost-basis issues, particularly upon the exchange of a large block of cryptocurrency that consists of several smaller blocks of a cryptocurrency portfolio accumulated over several years. First-in, first-out (FIFO), specific identification, and the average-cost method are all possible methods to keep track of basis (see Conlon, "Taxation of Bitcoin, Its Progeny, and Derivatives: Coin Ex Machina," 158 Tax Notes 1001 (Feb. 19, 2018)). But without specific IRS guidance on the appropriate approach, taxpayers must make an educated guess. The AICPA suggested in its comment letter that the IRS should allow FIFO treatment as an election or option.
Cryptocurrency forks: One significant item that remains unresolved is the tax treatment of cryptocurrency forks. When a bitcoin holder earns the right to receive bitcoin cash or bitcoin gold, is that income? The bitcoin cash is probably income because it has measurable value and is not a gift. What about the timing of income recognition? It likely depends on when the holder of the prefork cryptocurrency exercises dominion and control over the subsequent fork-split cryptocurrency (see Calvin, "When (and If) Income Is Realized From Bitcoin Chain-Splits," Bloomberg BNA Daily Tax Report (Jan. 4, 2018)). The ABA Tax Section sent the IRS a comment letter (available at www.americanbar.org asking it to allow a safe harbor for taxpayers who had a cryptocurrency split in 2017. The need for IRS guidance on this topic is increasing in urgency as cryptocurrency forks become more common.
Foreign asset reporting: A taxpayer who possesses cryptocurrency on a foreign-based exchange may be subject to the reporting requirements of FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), or Form 8938, Statement of Specified Foreign Financial Assets. Some exchanges enable users to exchange cryptocurrency for other cryptocurrencies, while other exchanges allow users to exchange cryptocurrency for fiat currencies. Regardless, these exchanges have custody of the users' cryptocurrencies and exhibit characteristics similar to foreign financial institutions. However, in 2014, the IRS issued the following statement:
The Financial Crimes Enforcement Network [FinCEN], which issues regulatory guidance pertaining to Reports of Foreign Bank and Financial Accounts (FBARs), is not requiring that digital (or virtual) currency accounts be reported on an FBAR at this time but may consider requiring such accounts to be reported in the future. No additional guidance is available at this time. [Erb, "IRS Says Bitcoin Not Reportable on FBAR (for Now)," Forbes (June 30, 2014), available at tinyurl.com/yav9z88v]
It is not clear whether the IRS statement referred only to digital wallets in possession of the owner or to exchange accounts as well. Considering the IRS's continued effort in international tax enforcement and the penalties for noncompliance, it seems prudent for a taxpayer to err on the side of caution and report foreign exchange accounts, unless the IRS issues guidance specifically indicating otherwise.
Because no centralized institution records each cryptocurrency transaction on the blockchain, it is inherently more difficult for the IRS to track these transactions — thus rendering cryptocurrency conducive to money laundering. That may continue to be the case until, perhaps, the IRS makes an example or two out of particularly noncompliant taxpayers.
To that end, the IRS has a dedicated task force investigating possible tax fraud by underreporting income from cryptocurrencies. In addition, the IRS Large Business & International Division recently added virtual currency to its list of compliance campaigns (see press release, "IRS Announces the Identification and Selection of Five Large Business and International Compliance Campaigns" (July 2, 2018), available at tinyurl.com/y9jwwo3s). In its summons to cryptocurrency exchange Coinbase, the IRS claimed that only 800 to 900 people electronically filed a Form 8949, Sales and Other Dispositions of Capital Assets, that included a property description likely related to bitcoin each year from 2013 to 2015 (Velarde, "Open Questions About Bitcoin Examined by Official, Practitioners," 155 Tax Notes 1095 (May 22, 2017)). However, IRS efforts seem focused on urging compliance (see IRS news release IR-2018-71) without providing more of the much-needed guidance on virtual currency.
Coinbase is providing — or already has provided — user data (including name, Social Security number, date of birth, and account activity) to the IRS for those who bought, sold, sent, or received more than $20,000 through their accounts in a single year between 2013 and 2015. This disclosure resulted from a court decision in November 2017 that narrowed the federal government's original John Doe summons to Coinbase (Coinbase, Inc., No. 3:17-cv-01431 (N.D. Cal. 11/28/17) (order to enforce summons)). While the decision apparently reduced the number of affected Coinbase customers by 97% to only 14,000 customers (Foster, "Judge Vastly Narrows Summons on Coinbase Bitcoin Exchange Users," 157 Tax Notes 1374 (Dec. 4, 2017)), precedent now paves the way for the IRS to issue summonses to other cryptocurrency exchanges.
Penalties for failure to comply
For taxpayers who have unreported income from cryptocurrencies, the civil penalties for failure to comply include:
- Failure to file a tax return under Sec. 6651(a)(1): 5% of the unpaid tax per month, up to 25%.
- Failure to pay taxes shown on the return under Sec. 6651(a)(2): 0.5% per month of the unpaid tax, up to 25%.
- Accuracy-related penalty under Sec. 6662: 20% or 40%.
- Civil fraud penalties under Sec. 6651(f) or 6663: 75% of the unpaid tax.
- Failure to file FBAR: Base penalty of $10,000 per failure to report an account per year; increasing, if the failure is willful, to the greater of $100,000 or 50% of the total balance of the foreign financial account per violation.
- Failure to file Form 8938: Base penalty of $10,000 per failure to report an applicable asset, with an additional $10,000 for each month the failure continues, beginning 90 days after the taxpayer is notified of the delinquency, up to a maximum of $50,000.
This list does not include possible criminal charges for tax evasion or other crimes.
Options to come forward
The IRS generally encourages taxpayers to come forward voluntarily and disclose tax noncompliance.
IRS streamlined filing compliance procedures: Taxpayers with undisclosed foreign income should at least consider the streamlined filing compliance procedures. This program is limited to taxpayers whose failure to report foreign income did not result from willful conduct. The program offers a streamlined procedure for filing amended or delinquent tax returns and terms to resolve tax and penalty obligations.
However, taxpayers may not be eligible for the streamlined compliance procedures if their failure to comply with tax laws governing foreign assets and income may be considered criminal or results in significant monetary penalties. For several years, the IRS Offshore Voluntary Disclosure Program (OVDP) has handled noncompliant taxpayers and provided protection from criminal prosecution if a taxpayer is accepted into the program and pays a hefty offshore penalty at a fixed percentage. That program, however, is no longer accepting new submissions — the deadline passed on Sept. 28, 2018. As of this writing, the IRS has said it would release additional information on how to make disclosures after that deadline. However, the streamlined filing compliance procedures continue.
If a taxpayer's noncompliance with respect to cryptocurrency transactions is not tied to a foreign asset or foreign account, the streamlined filing compliance procedures would not be appropriate.
IRS Voluntary Disclosure Practice: The IRS Voluntary Disclosure Practice remains an option for purely domestic cases and perhaps those with unreported foreign income. A voluntary disclosure through the Voluntary Disclosure Practice does not guarantee a taxpayer immunity from prosecution; however, it may result in the IRS's not recommending prosecution. Unfortunately, the Voluntary Disclosure Practice does not generally offer penalty relief. Instead, for penalty abatement, a taxpayer would have to assert reasonable cause for failure to disclose, and that would be unlikely for the IRS to grant, although possible. With the increased focus on cryptocurrencies, a U.S. Department of Justice attorney indicated a possible need for new voluntary disclosure procedures (see Velarde, "Voluntary Disclosure for Virtual Currency Is Domestic (Usually)," 159 Tax Notes 1358 (May 28, 2018)).
Do not leave states behind: A taxpayer with a federal income tax noncompliance issue may have a state income tax noncompliance issue as well. Many states offer some form of voluntary disclosure program for taxpayers to come forward and pay their back taxes.
Clearly, what is best for each taxpayer depends on the particular facts and circumstances — there is no one-size-fits-all approach. The amount of income undisclosed, the number of years involved, and the sophistication of the taxpayer are just some of the considerations.
Guidance from the IRS and other agencies on cryptocurrencies is likely forthcoming. Cryptocurrency technology is still fairly fresh and rapidly evolving, and how the tax agencies attempt to keep pace with the rate of growth and sophistication remains to be seen.
Mark Heroux, J.D., is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.