Limited guidance on taxation
Despite the billions of dollars (which is projected to be trillions in 2018 according to a September 2018 Satis Group report) flowing in and out of the various cryptocurrencies such as Bitcoin, Ethereum and Litecoin, the United States taxation of these products is governed mostly by Internal Revenue Service (IRS) Notice 2014-21 issued back on March 25, 2014. With regards to the nuances and uncertainties not covered by the notice, the IRS has chosen to remain mostly silent.
What is cryptocurrency
What is a cryptocurrency? Unlike United States Dollars, British Pounds or Euros, cryptocurrencies only exist in the virtual universe, meaning there is no tangible paper bill or metal coin that can be physically touched. Nor are they considered legal tender. Instead the Internet and only the Internet is used to transfer Bitcoin or Ethereum tokens from their originators to every subsequent owner. A price is set at an Initial Coin Offering (ICO) or Initial Public Coin Offering (IPCO) and then trading begins in the virtual universe. This is done through a secure Internet portal account sometimes called a coin wallet.
A register, accessible to all owners extemporaneously, tracks everyone’s ownership and is called a blockchain. This register is updated every time ownership changes. The details of your ownership represented in this blockchain that all others can see is sometimes called your public key. Access to spend any of your cryptocurrency in your coin wallet is provided by a private key. This private key is a long list of numbers and letters which needs to be kept secure to prevent losing access.
There are three types of cryptocurrency tokens generally – utility, security and payment:
- Utility or user tokens enable the holder access to a future service being developed – Filecoin, Flipcoin and Storj are examples.
- Equity security tokens are similar to stock shares in that they carry an ownership element, may have voting rights and can earn “dividends.” Digix is an example. Debt security tokens act as short-term loans to a company and earn the equivalent of interest – Steem utilizes such a scheme.
- Currency or payment tokens are used as their name implies – Bitcoin, Litecoin, ZCash and Monero are examples.
How cryptocurrency is exchanged
Cryptocurrencies can be exchanged in a few ways. They can be sold for cash on certain websites that act as exchanges such as Coinbase, Bitstamp or Kraken. They can be exchanged for other types of cryptocurrency on sites such as Shapeshift. They can be sold directly to another person at a price you set that is accepted on sites such as LocalBitCoins or BitQuick. They can even be converted to a local currency and withdrawn from an ATM at places found on Coinatmradar.
For investors not wanting to own cryptocurrencies directly or wanting to use a manager to invest in them, options have begun to open up. Privately traded partnerships such as hedge funds or private equity funds have begun to trade in cryptocurrencies and offer investors access to their appreciation (or depreciation) through the private placement of these partnership interests.
Coinbase’s institutional arm has been approved as a qualified custodian by the state of New York and BitGo by South Dakota. This license allows them to securely hold deposits of cryptocurrencies much like a bank account.
Fluctuations in cryptocurrency value depend mostly on people’s perception of the value and are not necessarily tied to anything – such as earnings of a company, the value of gold or what your dog wants for breakfast that morning. Their creation came from a desire to allow fast, better secured, less costly transfers of value between consumers and producers without the use of bank accounts or credit cards. Ability to avoid use of trusted intermediaries while retaining anonymity was also coveted.
Ideally, they would be immune to fluctuations in just one country’s currency and to counterfeiting or theft. Obviously, as the market has grown and speculators have stepped in, cryptocurrency’s utility has increased from a way to pay for goods or services to also an avenue for speculative investment. Because of the sometimes extreme volatility in values created by these speculative investments, some merchants or individuals won’t accept these highly fluctuating cryptocurrencies in lieu of more traditional forms of payment.
Cryptocurrencies are generally taxed in one of two ways, depending on how they were acquired. One area the IRS has not addressed is whether their use affects their taxation as well.
Mining classified as a U.S. trade or business
When involved in the “mining” or creating of cryptocurrencies, the taxpayer could be considered as engaged in a trade or business. The implications of such can be significant. Income generated from a United States (U.S.) based trade or business is generally Effectively Connected Income (ECI) – that is, U.S. sourced and subject to federal tax withholding if any profits flow through a partnership or joint venture to a foreign entity or individual.
If a partnership interest involved in producing such income is sold, the proceeds would also be subject to withholding under the new Tax Cuts and Jobs Act (TCJA) changes to Internal Revenue Code (IRC) §864 and §1446 taking effect in 2018. Such income will presumably also be treated as subject to self-employment tax under IRC §1401 if not received by an incorporated entity. If any of the income flows to a pension plan, charity or IRA account, it could also create an unexpected tax liability as this income will also be classified as Unrelated Business Taxable Income (UBTI) under IRC §512.
For amounts flowing to an individual, such income would be treated as ordinary income and not receive any preferential tax rate such as those available to long term capital gains or qualifying dividends. A limited partner would classify such income as passive under IRC §469 and generally avoid paying self-employment tax on any profits. General partners and limited liability company (LLC) managing members would receive non-passive income subject to the self-employment tax. If the self-employment tax element is a concern, structuring the entity as a limited partnership (LP) instead of as an LLC might be preferable. By statute, limited partners in an LP are not subject to the self-employment tax. LLC members are not distinctly protected by that same statute.
Another possible unexpected consequence of “mining” is that such income could also be classified as state-sourced and have state income taxes and withholdings due. If where customers reside and where the “mining” is done differ, different states’ sourcing rules could possibly subject more than 100% of the income to state income tax as there is not universal uniformity across states with regards to such rules.
Cryptocurrency is not tangible personal property nor is it services and so its sale would not incur sales or use tax as would be due in other retail businesses.
Mining classified as a hobby
If the “mining” of a cryptocurrency does not rise to the level of a trade or business, the IRS could argue any losses incurred should be classified as hobby losses under IRC §183 and not be allowed. Generally, a good faith expectation of profit governs such classification. Usually, a single occurrence does not rise to the level of trade or business.
Held for investment
If the taxpayer is not “mining” and only involved in buying and selling cryptocurrency created by others, it is treated as an investment in property. As such, gain or loss is treated as capital in character. For individuals, if it is held one year or less, it is treated as short term capital gain or loss and long term if held longer.
Under the TCJA, long term capital gains carry a maximum federal rate of 20% and short-term capital gains carry a maximum federal tax rate of 37%. Only $3,000 of capital losses in excess of capital gains are allowed to an individual per year and any of these unused losses can be carried forward indefinitely. Such income is also net investment income for purposes of the 3.8% tax on individuals with modified adjusted gross income over $200,000 ($250,000 for married couples filing jointly).
For corporations, no capital losses in excess of capital gains are allowed and there is not a different federal income tax rate for long term versus short term. With some restrictions, capital losses may be carried back three years for corporations and forward only 5 years, dissimilar to the rules for individuals.
Under the TCJA, however, corporations are subject to a maximum federal tax rate of only 21%. In the past, long-term investments were probably held at the individual level because of the tax rate differential providing a more beneficial answer. Now, if long-term investments’ appreciation help fund a business, it may make more sense to leave them in a corporation. Most states do not have a different rate for capital versus other types of income.
Such capital gains or losses on sales of cryptocurrency are presumably portfolio and not passive for purposes of limited partners in a fund that invests in cryptocurrency. As such, income would not be able to be offset against other passive losses such as from a real estate limited partnership interest.
Presumably, if one were to buy and sell cryptocurrency continually throughout the year, losses would be subject to the wash sale rules under IRC §1091. Different types of cryptocurrency probably would not be treated as “substantially identical” for this section but if such a trading strategy were employed, these rules need to be considered.
To avoid having to analyze the historical trading for purposes of such tracking, could the Bitcoin or Ethereum be treated as a security and be eligible for the mark-to-market rules of IRC §475(f) if a timely election is made? Since cryptocurrencies are not traded on what is defined as a qualified exchange at this time, presumably they would not be eligible for IRC §1256 mark-to-market treatment as 60% long term capital gains/losses and 40% short term capital gains/losses. Cryptocurrency does not create foreign currency gains or losses as defined by IRC §988.
Shorting a cryptocurrency (borrowing with the promise to repurchase in the future in the hopes the value will drop) would also require looking at the straddle rules of IRC §1092.
Debt tokens, presumably, would be subject to the market discount and original issue discount rules of IRC §1276 and §1272. Some of the gains might need to be reclassed as ordinary income or a current inclusion of income might be required depending on the interest actually paid.
After the TCJA took effect at the beginning of 2018, only exchanges of real property are eligible for a tax-free exchange under IRC §1031. Prior to the new tax law, this was uncertain as the law did not specify real property, but only property.
Expenses attributable to the trading or investing in Bitcoin as an investment would be subject to the same rules as investing in other securities, i.e. either being classified as an “above-the-line” ordinary deduction or as a miscellaneous itemized deduction whose benefit was eliminated for individuals by the TCJA. For corporations and PFICs, there is no such limit on these expenses and they are essentially treated as deductible expenses.
Assignment of basis for sales and forks
In terms of which layer is sold and how to assign a tax basis to such layer held for investment, the default method for sales of stock under Treasury Regulation §1.1012-1 would be first in, first out (FIFO). However, the option to identify the highest priced layer as being sold first is allowed. Such identification must be made at the time of the sale. Despite the regulation referring to sales of stock, many practitioners are applying these rules to cryptocurrency because of the similarities and not the average cost method available to holders of mutual fund (Regulated Investment Company) shares. No Form 1099s are currently issued from cryptocurrency operators, so the taxpayer would have to track the various layers and tax basis of each layer.
Another area of uncertainty with regards to tax treatment is that of forks of cryptocurrency (such as Bitcoin Cash for holders of Bitcoin). Forks generally occur when there is a change in the software that cryptocurrency miners use, sometimes because of a dispute, and owners of the current cryptocurrency receive new keys that give them value on a new blockchain.
Should this transaction be treated the same as a stock split and just some of the cost basis assigned proportionately to it? Is no basis assigned under the argument that no ascertainable value exists for the new cryptocurrency? Is income recognized to the extent that the new fork has a market value? If the old cryptocurrency is eliminated, is this some sort of tax-free exchange similar to those offered for stock under IRC §368, even if this does not all happen all at once? On these questions, the IRS has so far remained silent. However, there is a Supreme Court case from 1955, Commission vs. Glenshaw Glass Co. that many practitioners site as perhaps the governing doctrine.
According to the case, when a taxpayer receives undeniable accessions to wealth, clearly realized, and over which the taxpayer has complete dominion, a recognition of income must occur. If the new cryptocurrency, the fork, has value and can be traded without hindrance immediately, it appears there could be a taxable event upon the fork.
Unlike a stock split where the price has just been altered per share, something new has been created: a new cryptocurrency. If, however, a value cannot be placed on the fork or it cannot be traded now or with any definite timeframe in the future, it may not have to be recognized as income today. The IRS, however, is generally not too keen on deferrals of what they deem to be income and so these restrictions would have to have merit. Regardless, forks have not been directly addressed by the IRS and so either approach is not definitively correct and each case should be analyzed individually.
Used to pay personal expenses
What if cryptocurrency is directly used to pay for personal expenses? A gain or loss might be incurred. If it’s a loss, the taxpayer would have to argue that the cryptocurrency was held for investment and then a capital loss could be recognized. Personal-use asset losses are not deductible – such as losses on sale of a car or a personal residence like a house or boat.
If it’s a gain, the taxpayer would be required to recognize the gain under IRC §61. Failure to report such a gain could extend the statute of limitations from the normal three years the IRS has to assess additional tax to 6 years if the excess is substantial. Substantial is defined in this context as over 25% of gross income for the year. Some states extend the statute even longer than the federal government. If the omission is deemed fraudulent, however, there is no time limit.
If cryptocurrency is received for services as an employee, income still needs to be recognized for income tax purposes and all required payroll taxes paid by the employee and employer.
Besides properly reporting the income tax consequences of any cryptocurrency transaction, any direct or indirect holdings of cryptocurrency could potentially be subject to information reporting as well. The filing requirements of Form 114, Report of Foreign Bank and Financial Accounts or the so-called FBAR, and Form 8938, Statement of Specified Foreign Financial Assets should both be considered if the cryptocurrencies are held by an offshore vehicle or held in an offshore coin wallet. Failure to file these forms in some cases can be argued as willful and the penalties severe.
Owners of cryptocurrency also need to comply with the Anti-Money Laundering rules initiated by the Bank Secrecy Act of 1970 and possibly file Currency Transaction Reports or Suspicious Activity Reports. All carry stringent recordkeeping requirements.
While there is a lack of specific guidance on the taxability of cryptocurrencies, the proper treatment and consequences can be extrapolated from other sources in most examples. Proper disclosures should be considered to prevent possibly severe penalties for non-compliance.
For questions on this topic or for other help with any other tax or accounting issues, please contact the team of seasoned professionals at Mazars USA.