INSIGHT: Taxation of Cryptocurrencies—In Anticipation of the IRS’s Call—Part 3

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.

Tax Reporting and Filing Requirements

In general, tax code Section 6001 provides record keeping requirements for income tax purpose. The tax code requires for each person to keep adequate records. Consequently, proper record keeping is required to substantiate a position on a return for income, loss, and basis amounts. In the context of virtual currencies, a payment made using virtual currency is subject to information reporting. Critical to accurate reporting is maintenance of adequate records to measure virtual-currency related income.

Consider the following example. A person who in the course of a trade or business makes a payment that is treated as fixed and determinable income (i.e., FDAP-like types of income, including rent, salaries, wages, premiums, annuities, and compensation) using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee. Payments of virtual currency are required to be reported on Form 1099-MISC, Miscellaneous Income, using the fair market value of the virtual currency in U.S. dollars as of the date of payment.

All federal insurance contributions including Federal Insurance Contributions Act (FICA) tax must be reported on Form W-2, Wage and Tax Statement. Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. A payor must solicit a Taxpayer Identification Number (TIN) from a payee. In the absence of a TIN, a payor must backup withhold from a payee prior to payment if the payor receives notification from the IRS that backup is required. Thus, employer payments with virtual currencies as a form of payment for services constitute wages for employment tax purposes and are subject to federal tax withholding.

Very generally, credit card intermediaries are subject to specific information reporting if in a calendar year more than 200 transactions are settled for the merchant and gross proceeds payments made to the merchant exceed $20,000. These third-party settlement organizations (TPSO) are required to report payments made to a merchant on Form 1099-K, Payment Card and third-party Network Transactions, if the above conditions are met. Notice 2014-21 provides that payments made in connection with bitcoin transactions or other virtual currency may be reportable on Form 1099-K. For reporting purposes, the value of the virtual currency is the fair market value of the virtual currency in U.S. dollars on the date of payment.

The Notice, however, fails to consider information reporting requirements of virtual currency transactions in exchange for property or cash that are not reportable on Form 1099-K. Instead, it provides a catch-all provision where taxpayers will be subject to penalties for failure to comply with tax laws, including virtual currency transactions. It also provides that underpayments attributable to virtual currency transactions may be subject to penalties, including accuracy-related penalties under Section 6662. Failure to correctly report virtual currency transactions may also subject the taxpayer to information reporting penalties under Section 6721 and Section 6722. The Notice does, however, provide relief under reasonable cause for failure to file an information return.

To avoid the above penalties, taxpayers engaging in virtual currency transactions should ensure they have a record keeping system to track the basis and gains or losses of each transaction. In particular, it would be prudent to keep track of all acquisition and sell dates, and any other cost basis information. It is unclear, at this time, whether taxpayers will be required to record all transactions on Schedule D, Form 8949, Sales and Other Dispositions of Capital Assets. For example, issuers of virtual currency may wish to create a tracking system or inventory for each currency issued. Similarly, retailers accepting virtual currencies should retain documentation on the amount of their sales. Documentation should be stored to provide substantiation or verify the value of the virtual currency at the time of the transaction in U.S. dollars.

It is also unclear at this time whether U.S. persons are required to reports gifts of virtual currency from a non-U.S. person or distributions from a non-U.S. entity (e.g., a foreign trust) on Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.

Taxpayers are, generally, required to report cash payments exceeding $10,000 received in a trade or business on Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business. Cash payments are defined to include U.S. currency, foreign currency, cashier’s checks, money orders, and other similar instruments. Given that Notice 2014-21 provides that virtual currencies are not currency, presumably Form 8300 reporting does not apply to virtual currencies.

International Considerations—Information Reporting Abroad

Notice 2014-21 also does not provide any guidance as to whether owners of virtual currencies must fulfill international reporting requirements. In general, U.S. citizens, lawful permanent residents, or individuals with substantial presence in the U.S. (i.e., U.S. persons) must file a Foreign Bank Account Report (FBAR) with the Treasury Department’s Financial Crimes Enforcement Network (FinCen) where the U.S. person has a financial interest in, or authority over, any financial account outside of the U.S. where the aggregate maximum value of the account(s) exceeds $10,000 at any time during the calendar year. A “financial account” for FBAR reporting requirements, includes the following:

• Bank accounts (e.g., savings accounts), checking accounts, time deposits or any other account maintained at a financial institution;
• Securities accounts such as brokerage or custodial accounts;
• Commodity futures or options accounts;
• Insurance policies or annuity contracts;
• Mutual funds or pooled funds; and
• Some pension funds and retirement accounts (excluding those under Section 401(a), Section 403(a), or Section 403(b)).

A “U.S. person” has a “financial interest” where: (i) the U.S. person is the beneficial owner of the account or has legal title to the account; or (ii) the holder of the account is a person acting as an agent, nominee, attorney, or otherwise a person acting on behalf of the U.S. person with respect to the account.

The IRS has not provided guidance at this time as to whether a taxpayer holding cryptocurrencies on a foreign cryptocurrency exchange (e.g., Xapo.com or Binance.com) or in a foreign virtual wallet (e.g., Blockchain.com) is required to report the account(s) on an FBAR within the meaning of the above types of accounts. However, based on the language contained in the IRS Letters, it appears evident that taxpayers holding cryptocurrencies in a foreign exchange or wallet will be subject to the same type of FBAR reporting. Under the heading “Reporting Virtual Currency Transactions,” IRS Letter 6174 provides that the obligation to report all sales, exchanges, and other dispositions of virtual currency “applies regardless of whether the account is held in the U.S. or abroad.” Taxpayers who have cryptocurrencies outside of the U.S. should therefore revisit their positions to ensure that they are compliant with all international tax reporting obligations, including FBARs.

In addition to the above, U.S. persons must also provide a Form 8938, Statement of Specified Foreign Financial Assets, annually with their income tax return regarding a “specified foreign financial asset.” The financial assets that must be reported on the Form 8938 is broader than what is required to be reported on an FBAR, and includes among other categories, “any financial account . . . maintained by a foreign financial institution” and “any interest in a foreign entity.”

For example, a taxpayer holding cryptocurrencies in physical form (i.e., not in cash), on a foreign virtual currency exchange (e.g., Xapo.com) or a wallet (e.g., Blockchain.com) would presumably be required to report the accounts for purposes of Form 8938 given that the taxpayer is holding a financial account (the wallet) maintained by a foreign financial institution (the exchange). Additionally, a Form 8938 reporting requirement may apply to the extent a U.S. person owns “an interest [the cryptocurrency] in a foreign entity [a cryptocurrency exchange or wallet that is formed under the laws of a foreign country].” Again, leaning on the language in the IRS Letters, a taxpayer holding a cryptocurrency on a foreign virtual currency is well-served to report his or her interest on Form 8938.

Contrast those examples with, for example, virtual currency exchanges formed in the U.S. (e.g., Coinbase.com or Gemini.com) where those assets would not be classified as “specified foreign financial assets” and thus normally not subject to Form 8938 reporting.

At this time, the government has not provided guidance as to whether taxpayers who own (i) an account on a foreign digital exchange, (ii) a foreign digital wallet, or (iii) a foreign private key should report any of these interests on an FBAR and Form 8938. However, based on the language in the IRS Letters, it would appear that the government intends to enforce reporting for taxpayers who hold cryptocurrencies abroad.

Takeaway

Cryptocurrencies are here to stay. The IRS’s “wake-up” call to enforce administration of taxation of cryptocurrencies has just begun. Much like taxpayers with accounts overseas for nefarious activities who didn’t believe FATCA had any teeth; so too will non-compliant taxpayers with cryptocurrency accounts and transactions that have not been reported to the IRS find themselves in a precarious position when the government contacts them for an explanation. However, in all fairness, given the growth and breadth of virtual currencies, the government also needs to provide additional guidance supplementing the one Notice it has issued. In the meantime, tax practitioners should become well-versed with the use and rise of cryptocurrencies (and the underlying technology, blockchain) to better advise taxpayers who will need their services in the future.

Part 1 of this series outlines the history and evolution of cryptocurrencies.

Part 2 of this series covers the taxation of virtual currencies, miners, and initial coin offerings; application of rules under tax code Sections 1091 and 1092; accounting method rules; like-exchanges pre-TCJA; tracking capital gains and losses; valuation methods; charitable giving, gifts, trusts, and estates; the loss of a private key or password; theft; and the growing enforcement initiative.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

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.