Before the rise of the Foreign Account Tax Compliance Act (FATCA) became a “thing” in the early 2000s, there were many fishing expeditions by the Internal Revenue Service into learning the methods Americans used to hold funds offshore—sometimes engaging in tax evasion. I make the distinction because not all Americans with funds overseas have a guilty mind. Some just prefer to diversify or are part of an international family structure. Nevertheless, the methods learned by the Department of Justice and the IRS eventually led to Congress’s enactment of FATCA in 2010. With the rise of cryptocurrencies and virtual currencies, the IRS is keen to learn more about the application and uses of these virtual currencies and is once again flexing the agency’s investigative and enforcement muscles to track down non-compliant taxpayers.
Limited Guidance from the IRS
In March 2014, the IRS published Notice 2014-21—the only guidance the IRS has published before issuing the IRS Letters on taxation of cryptocurrencies. As a threshold matter, the IRS analyzed whether a cryptocurrency should be classified as a currency or property for U.S. income tax purposes. In general, “virtual currency” is defined as “digital representations of value that functions as a medium of exchange, a unit of account, and/or a store of value.” A convertible virtual currency is defined as a subcategory of a virtual currency or one “that has an equivalent value in real currency, or that acts as a substitute for real currency.” The Notice presumably, therefore, does not address taxation of other forms of cryptocurrencies, such as those with smart contract features (ergo, ethereum). A “smart contract” refers to a computer protocol that automatically executes the terms of a bilateral or multiparty agreement(s) without an intermediary.
The following is a survey of topics relevant to taxation of cryptocurrencies.
1. Taxation of Virtual Currencies
At a minimum, the IRS has made it clear that for federal income tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency. Therefore, the rules applicable to currency transactions under subchapter J of the tax code are not applicable and thus virtual currencies cannot generate gain or loss for U.S. federal income tax purposes.
A taxpayer who receives virtual currency as a payment for goods or services must include in its gross income the fair market value of the virtual currency measured in U.S. dollars as of the date that virtual currency was received. The basis of virtual currency a taxpayer receives as payment for goods or services is the fair market value of the virtual currency in U.S. dollars as of the date of the receipt. Transactions using virtual currency must be reported in U.S. dollars as of the date of payment or receipt.
Where a taxpayer receives virtual currency in excess of his or her adjusted basis, the taxpayer recognizes taxable gain. Similarly, the taxpayer recognizes loss if the market value of the property received is less than the adjusted basis of the virtual currency. In general, tax code Section 1012 provides that a taxpayer’s basis in property is its cost. Section 1016 provides the rules with respect to adjustment to costs (i.e., stock splits, stock dividends, corporate reorganizations, etc.). In the context of virtual currencies, in determining basis or cost at the time of sale, careful review of the basis allocations is warranted.
The character of the gain or loss will depend on whether the virtual currency is a capital asset (e.g., stocks, bonds, and other investment property) in the hands of the taxpayer. Alternatively, a virtual currency that is not treated as a capital asset will yield either ordinary gain or loss to the taxpayer on its sale or exchange. Inventory and other property held for sale to customers or in a business are treated as property that is not a capital asset.
2. Taxation of Activities of Miners
A taxpayer who “mines” virtual currency realizes gross income upon receipt of the virtual currency at fair market value and as of the date of receipt. Furthermore, if a taxpayer’s “mining” of virtual currency constitutes a trade or business, and the mining activity is not undertaken by the taxpayer as an employee, the Notice requires the net earnings from self-employment (gross income less allowable deductions) resulting from those activities to yield self-employment income subject to self-employment taxes.
Similarly, where an independent contractor performs services constituting self-employment income and receives virtual currency for performing services, the fair market value of virtual currency received from services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income, subject to self-employment taxes. The Notice is silent as to whether ordinary and necessary business expenses under Section 162 associated with mining should be deductible.
3. Application of the Wash Sales Rule Under Section 1091
The application of the wash sales rules under Section 1091 to cryptocurrencies is uncertain. Very generally, a wash sale is a transaction where an investor sells stock or securities at a loss and then repurchases the same identical stock or securities back within a 30-day window. Congress, to ensure that a taxpayer isn’t able to claim a loss on essentially a phantom loss that has been created without any change in economic substance, enacted Section 1091 to disallow the loss. In addition, for Section 1091 to apply, the loss must be that of “stock or securities” and related contracts or options to acquire or sell “stock or securities.” In the context of cryptocurrencies, it is difficult to assess the application of the wash sales rules as the classification of a cryptocurrency or virtual currencies for purposes of these rules remain open and subject to debate.
4. Application of the Straddle Rules Under Section 1092
Very generally, the straddle rules under Section 1092 address offsetting positions in personal property that is actively traded. The tax code defines offsetting positions to mean “positions with respect to personal property if there is a substantial diminution of the taxpayer’s risk of loss from holding any position with respect to personal property by reason of his holding one or more other positions with respect to personal property.” Section 1092 straddle rules may be applicable to cryptocurrencies provided: (i) a virtual currency is treated as personal property for which there is an established market; and (ii) there are offsetting positions that may result in substantial diminution of risk of loss for that property. In the context of virtual currencies, the straddle rules may provide planning opportunities by deferring the recognition of losses and modifying the holding period of disposed property as per the rules.
5. Accounting Method Rules Relating to Virtual Currencies
To date, the IRS has not provided any guidance with respect to the appropriate accounting method for the sale of cryptocurrencies. A taxpayer may choose from three acceptable methods of computing gains and losses, namely: First-In First-Out (FIFO), Last-In Last-Out (LILO), and Specific Identification. In the absence of regulatory guidance, a taxpayer should ensure substantiation of documentation detailing each cryptocurrency transaction.
6. Treatment of Like-Kind Exchanges Prior to TCJA
Effective for exchanges completed after Dec. 31, 2017, the non-recognition of gain or loss on “like-kind exchanges” is only permitted on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property. Prior to the enactment of the Tax Cuts and Jobs Act (TCJA), Section 1031 treatment was available to the exchange of one virtual currency for another virtual currency. For example, a taxpayer may have exchanged bitcoin for ethereum and vice-versa.
Section 1031 is a non-recognition provision that provides an exception to the rule that all realized gains must be recognized. The underlying principle for a “like-kind” exchange is that the exchange of one asset for another does not trigger any economic gain. The assets are essentially swapped. Given that virtual currencies or cryptocurrencies have been classified as “property” under the Notice, the provisions of Section 1031 may be applicable to pre-TCJA virtual currency exchanges. The only limitation to the provision as provided in the regulations is that the definition of “like-kind” refers to “the nature or character of the property and not its grade or quality.” However, there are some nuances to the statute. For example, real property situated in the U.S. and real property situated outside of the U.S. is not deemed “like-kind.” (Section 1031(h)(1).) In the context of commodities, the exchange of silver bullion with gold bullion does not meet the requirements of Section 1031; however gold bullion may be exchanged with gold bullion. The IRS has not provided guidance as to the treatment of cryptocurrencies in the context of “like-kind” exchanges prior to the enactment of the TCJA. However, taxpayers who maintain a “like-kind” exchange position in the context of cryptocurrencies should ensure that they are fulfilling the reporting and disclosure requirements, including filing Form 8824, Like-Kind Exchanges.
7. Tracking Capital Gains and Losses With Cryptocurrencies
The IRS has also not addressed how to track the computation of capital gains and losses (basis and fair market value) in the context of “convertible” virtual currencies. A “convertible” virtual currency (e.g., a bitcoin) is one that can be freely exchanged into another virtual currency without regulatory oversight. When a virtual currency is used to purchase goods or services, a transaction occurs where parties are required to track the fair market value (FMV) of the currency at the time of the transaction. The taxpayer’s cost or basis will determine whether a gain or loss has occurred as well as its duration (short-term or long-term transaction).
Some practitioners have suggested simplifying the burdensome record-keeping requirements that are necessary to calculate virtual currency gains and losses by applying Section 1012 tracking methods under FIFO, LIFO, or the specific identification method akin to the way stocks are sold through an exchange. In addition to the above, some practitioners have suggested the IRS should provide a de minimis rule for taxpayers who may have a minimal amounts of virtual currency transactions or small transactions (e.g., purchasing coffee).
8. Valuation Methods Used to Value Cryptocurrencies
According to Notice 2014-21, transactions using virtual currency must be reported in U.S. dollars. In addition, taxpayers will be required to determine the FMV of the virtual currency in U.S. dollars as of the date of receipt. The IRS has provided that “if a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) and the exchange rate, in a reasonable manner that is consistently applied.”
The IRS fails to consider, however, how taxpayers should value, for example, tokens issued by companies that are not listed on an exchange with an established exchange rate. In addition, the IRS does not address the fact that there are numerous published exchanges and the values reported on those exchanges fluctuate. For example, Coindesk, Blockchain, Xapo, Google, Gemini, Winkdex, Bitstamp, and Kraken, all report bitcoin with slight variations. Some members of Congress have written to the IRS’s Commissioner in hopes for additional guidance on this narrow query.
9. Application of Cryptocurrencies and Tokens in the Context of Charitable Giving, Gifts, Trusts and Estates
Notice 2014-21 has confirmed that virtual currency should be treated as property for federal income tax purposes. However, because of the volatility and valuation issues pertaining to ascertaining the FMV of a cryptocurrency, most estate planners and fiduciaries exercising the “prudent investor rule” have been hesitant to structure cryptocurrency assets (transfer in trusts or as gifts). Queries surrounding valuation, determining how to claim lost tokens, and how to report cryptocurrencies on an estate tax return, among others, remain open issues. In addition, the IRS has not provided more robust guidance in terms of the transfer of virtual currencies in the context of charitable donations. According to the Fidelity Charitable 2018 Report, donations made to Fidelity Charitable using bitcoin grew to $69 million in 2017, nearly tenfold from the previous year. However, absent IRS guidance, investors who have made charitable contributions to a Section 501(c)(3) organization may face capital gains taxes for the cryptocurrencies they cashed. The investor may also “gift” the cryptocurrency directly to the charity without cashing the asset first and deduct the value of the donation, provided the assets were held for longer than one year.
Very generally, subject to a limited exception involving “readily valued property” such as publicly traded stock, a charitable contribution of property with a value of more than $5,000 requires a qualified appraisal from a qualified appraiser as well as an acknowledgement letter from the charity and a completed Form 8283, Noncash Charitable Contributions. In the context of cryptocurrencies, such as bitcoins, the IRS requires a taxpayer to provide valuation as provided in established markets. However, because cryptocurrencies are nascent, there are no established markets to offer accurate valuation which vastly fluctuates in terms of price on any given day. Practitioners have suggested a rule that would allow taxpayers to rely on an average of two established virtual currency markets and the substantiation requirements of Section 170(f), however the IRS has not provided any specific guidance to date on this score. In the absence of reliable guidance from the IRS, however, taxpayers should follow the rules for donated property.
10. Taxation of Initial Coin Offerings (ICOs)
In general, a company may wish to issue a token to either: (i) raise capital; or (ii) use the company’s platform to purchase goods and services. For marketing purposes, a company may also wish to air drop tokens (give away tokens for free) to raise awareness of its platform. Other tokens may have equity-like features, such as the right to dividend-like payments based on the issuer’s predefined performance objectives. Some tokens’ underlying utility may be blurred between debt and equity and the purpose of the investor (redeem to use on the company’s platform or hold for appreciation in value).
While Notice 2014-21 provides guidance with respect to the IRS’s views that convertible virtual currency is treated as property—and not as currency—for tax purposes, the IRS has not provided any guidance with respect to the tax treatment of a cryptocurrency issuer.
The tax treatment of ICOs is also unclear. Token issuances, also referred to as ICOs, took an unprecedented rise recently across the globe. An ICO permits a company to raise capital without issuing traditional debt or equity and to use the tokens to purchase goods and services. Each token has its own specific feature and functionality (i.e., authorized as a payment system for purchase of goods and services). In addition, some tokens have equity-like features permitting its holder to dividend payments based on the issuer’s preference or objectives.
The federal income tax treatment of tokens depends on the issuer’s location, onshore or offshore, as well as how the token is initially structured. The IRS has stated that it views a convertible virtual currency as property (and not as currency) for tax purposes. However, it has yet to provide guidance on the tax treatment of a crypto issuer. The first query is to analyze whether a crypto token is treated as debt or equity for federal income tax purposes. The second query is to determine whether the issuing company is a domestic or foreign corporation. If the issuing company is a foreign corporation, careful analysis with respect to the federal income tax rules pertaining to taxation of a controlled foreign corporation (CFC), Passive Foreign Investment Company (PFIC), and the international tax nuances enacted in the TCJA is warranted.
For example, an offshore foreign corporation with U.S. owners that meets the requirements of the CFC rules may be faced with subpart F and global intangible low-taxed income (GILTI) includible in the U.S. taxable income of any direct or indirect U.S. shareholder. Under the TCJA, U.S. shareholders of a CFC must include U.S. taxable income in their annual pro rata share of GILTI. (See Section 951A(a).) In the context of issuance of tokens by a foreign corporation that meets the requirements of a CFC, a practitioner should estimate the amount of GILTI a CFC will likely produce in a token sale and parse through the requirements of Section 951A(a), et al.
A hard fork occurs where there is a change in the underlying protocol splitting the cryptocurrency in two (e.g., where bitcoin splits into bitcoin cash), thus resulting in two blockchain coins. As a result of a hard fork, the taxpayer obtains a new coin (e.g., bitcoin cash) in addition to the original coin. The government has not addressed the tax treatment of a hard fork in the cryptocurrency context. However, some tax practitioners have analogized the treatment to that of a stock split or stock dividend. On March 19, 2018, the American Bar Association’s Section of Taxation requested the IRS to issue temporary guidance on “hard forks” including providing a safe harbor for taxpayers whose cryptocurrency split into different currencies.
11. Loss of Private Key or Password
One of the key attributes of virtual cryptocurrency is anonymity, except for the owner whose virtual currencies are protected by a private digital key that is unique and secured by a password only known by the owner. If the owner (an individual) misplaces the private key or loses his password, the virtual currency is inaccessible and forever lost. The tax code allows non-corporate taxpayers a deduction for certain losses arising from fire, storm, shipwreck, or other casualty, or from theft, incurred with respect to property that is neither used in a trade or business nor held in a transaction entered into for profit. (See Section 165(c)(3).)
For tax years beginning in 2018 through 2025, an individual’s otherwise deductible personal casualty and theft losses generally are deductible only to the extent that they are attributable to a federally declared disaster. Prior to the enactment of the TCJA, casualty losses under Section 165 were allowable. While the IRS and the Notice have not provided any guidance on this issue as it relates to virtual currencies, it is unlikely that the IRS would permit a casualty loss deduction prior to the TCJA with respect to virtual currencies for merely misplacing a private key.
12. Tax Implications in Case of Theft
In 2014, a virtual currency exchange platform referred to as “Mt. Gox” lost millions of dollars’ worth cryptocurrencies for its investors. A few years later, nearly 120,000 bitcoins were stolen from customer accounts at Bitfinex, an exchange platform in Hong Kong. The IRS has not provided guidance as to whether taxpayers could deduct virtual currencies that would meet the requirements of Section 165 prior to the TCJA or for years before 2018. As with the theft of other financial assets, if the virtual currency was acquired in a transaction entered into for profit, a theft loss would be deductible.
In addition to the ambiguities stated in the examples above, it would be helpful if the IRS provided guidance as to the tax consequences of cryptocurrencies in the context of funds and, more specifically, trading, investing, and mining of cryptocurrencies. For example, is the raising of funds recognized as income? What is the difference between stock offerings versus sale of goods and services? Does the 3.8% net investment income tax apply to virtual currencies? What is the treatment of restricted tokens provided to employees as additional compensation under Section 83? Should they be treated akin to the treatment of receipt of restricted stock? The IRS has not provided any guidance on these queries other than the general principles stated in the Notice.
Litigation—A Growing Enforcement Initiative
At the American Institute of CPAs National Tax Conference in Washington, D.C., late last year, the recently appointed Commissioner of the IRS, Charles Rettig, opened his comments with: “Remember Coinbase?” On Nov. 17, 2016, the DOJ, acting on behalf of the IRS, requested permission from the U.S. District Court for the Northern District of California to serve a John Doe Summons (the “Coinbase Summons") on Coinbase, Inc. Coinbase, a company based in San Francisco, is an exchange platform that facilitates the trading of cryptocurrencies. Customers may purchase, trade, and store cryptocurrencies (e.g., bitcoin or ethereum) on its platform. From 2013 through 2015, Coinbase maintained over 4.9 million wallets in 190 countries with 3.2 million customers served and $2.5 billion exchanged.
The Coinbase Summons initially targeted to obtain “information regarding United States persons who, at any time during the period Jan. 1, 2013, through Dec. 31, 2015, conducted transactions in a convertible virtual currency as defined in IRS Notice 2014-21.” As a result of the large number of potential customers that would fall within this broad spectrum, the request was later modified to Coinbase users who “bought, sold, sent or received at least $20,000" worth of cryptocurrency in a year. A year later, on Nov. 28, 2017, the U.S. District Court granted DOJ’s petition. The Coinbase Summons was a wake-up call for taxpayers who had quietly amassed a fortune in virtual currencies and who had failed to report to the IRS their gains that the government intended to collect its share of tax. The Commissioner was in fact warning the audience that the IRS was bolstering its enforcement capabilities to find and prosecute taxpayers who fail to report their cryptocurrency gains.
Part 3 of this series will cover tax reporting and filing requirements, and international considerations.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Sahel Ahyaie Assar is International Tax Counsel at the law firm of Buchanan, Ingersoll & Rooney. The views expressed in this article are those solely of the author.