“Nothing is certain but death and taxes”—even when it comes to cryptocurrency. [1] That time-tested insight, traditionally attributed to Benjamin Franklin, appears poised to go head-to-head with the technological innovations behind the cryptocurrency movement. Cryptocurrency, such as Bitcoin, is virtual currency that uses cryptography for security.[2] It is not issued by any central governmental authority, rendering it—theoretically at least—immune to direct government interference or manipulation. But recent developments confirm that the IRS is targeting cryptocurrency transactions. And it believes that there are unreported cryptocurrency gains on a massive scale.
How is Cryptocurrency Taxed?
The IRS has issued limited guidance on the taxation of cryptocurrency. On March 25, 2014, the IRS released a news release and Notice 2014-21, which provides guidance on cryptocurrency taxation.[3] The IRS’s position is that cryptocurrency is property, not currency, because it does not have legal tender status in any jurisdiction. Therefore, general tax principles that apply to property also apply to cryptocurrency.
A few general rules follow from this limited guidance. Because it is classified as property and not as currency, exchanges of virtual currency do not create foreign currency gain or loss. When cryptocurrency is received in exchange for goods or services, the basis in the cryptocurrency is its fair market value in U.S. dollars at the date of receipt. This places the burden on taxpayers to determine the fair market value of the cryptocurrency at the date of receipt. In some cases, this is relatively straightforward, as the most highly traded cryptocurrencies trade on exchanges where value is based on market supply and demand. Once basis is established, the taxpayer must determine gain or loss on any transactions involving cryptocurrency. If the fair market value of property received exceeds the taxpayer’s adjusted basis of the cryptocurrency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the cryptocurrency. The character of the gain or loss depends on the character of the cryptocurrency in the hands of the taxpayer.
When cryptocurrency is received through mining,[4] the fair market value of the cryptocurrency at the date of mining is included in the taxpayer’s gross income. If a taxpayer’s mining activity rises to the level of a trade or business within the meaning of the tax laws, and the mining activity is not performed as an employee, the net earnings from self-employment resulting from those activities constitute self-employment income and are subject to the self-employment tax. If cryptocurrency is received by an independent contractor as payment, much like if the independent contractor received cash, the cryptocurrency is also treated as self-employment income. If cryptocurrency is received as wages for employment, it is subject to the same treatment as wage income that is received in the form of cash.
Again, cryptocurrency is generally treated as any other property received under the same circumstances. It is essential that taxpayers take a proactive approach and maintain thorough records in this context. Taxpayers should be aware of these issues and should use experienced tax law and accounting professionals.
Will the IRS Come Down Hard on those Who Don’t Report Cryptocurrency Income?
The IRS has already taken steps to crackdown on failures to report cryptocurrency transactions. The IRS believes—at least it has stated in federal court pleadings—that only 800 to 900 taxpayers reported their cryptocurrency gains from 2013-2015. Yet it is estimated that millions of cryptocurrency-related transactions occurred during that timeframe. Furthermore, as U.S. and European taxing authorities continue to clamp down on banks, the IRS believes that taxpayers are looking for new ways to protect their income and assets from taxes. As new, more private forms of cryptocurrencies develop, the IRS believes that taxpayers are increasingly using cryptocurrencies as a way to hide money.
Notably, there are remarkable similarities between the cryptocurrency movement and the events that led to the IRS’s crackdown on undisclosed offshore bank accounts almost a decade ago, just before it began its 2009 Offshore Voluntary Disclosure Program. For example, the IRS is actively seeking information about taxpayers and transactions involving cryptocurrency from third parties. In 2016, the IRS summonsed Coinbase, one of the most popular cryptocurrency exchanges, to provide information about its customers and transactions. Coinbase initially refused to comply and fought the summons.[5] The district court, however, ultimately enforced the summons, but only after narrowing its scope. As a result, Coinbase produced the taxpayer ID number, name, birthdate, address, records of account activity including transaction logs, and all periodic statements of account or invoices for accounts with at least $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013 to 2015 period. It can be expected that the IRS will continue to seek records from other exchanges, and to focus its efforts on taxpayers with cryptocurrency transactions.
The IRS has also formed a group of cryptocurrency experts, and has partnered with private firms, including cryptocurrency software companies, like Chainalysis, to help regulate the taxation of these transactions and to detect unreported transactions. Chainalysis allows the IRS to better trace the movement and, ultimately, the ownership, of cryptocurrencies.
Conclusion
Expect the IRS to continue its crackdown on unreported cryptocurrency transactions. Now, more than ever, taxpayers must be diligent in record keeping and aware of IRS cryptocurrency guidance. Taxpayers with prior reporting issues should also consider steps to become compliant.
Cryptocurrency and Blockchain Attorneys
Have cryptocurrency or blockchain issues or questions? Freeman Law is an innovative thought leader in the blockchain and cryptocurrency space. Blockchain and virtual currency activities take place in a rapidly evolving regulatory landscape. Freeman Law is dedicated to staying at the forefront as these emerging technologies continue to revolutionize social and economic activities. Contact Freeman Law to Schedule a consultation or call (214) 984-3410 to discuss your cryptocurrency and blockchain technology concerns.
[1] Concepts and views from the following articles are referenced throughout this posting: Rob Urban, Governments Worry that Cryptocurrencies Could Be the ‘Next Swiss Bank Account’, Bloomberg (Jan. 29, 2018); Annie Nova, ‘Wild West’ Days Are Over for Cryptocurrencies, as IRS Steps Up Enforcement, CNBC (Jan. 17, 2018); Robert Alter, The Taxation of Crypto Virtual Currencies: IRS Enforcement Initiative, New Jersey Law Journal (Dec. 25, 2017); Jacob Gershman, IRS Crackdown on Bitcoin Exchange Fuels Privacy Worries, The Wall Street Journal (March 27, 2017).
[2] Cryptocurrency, Investopedia, (last visited March 16, 2018).
[3] IRS Virtual Currency Guidance: Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply (IR-2014-36), IRS (March 25, 2014); Notice 2014-21, IRS (March 25, 2014).
[4] At the most basic level, “mining” is the process that generates or creates a cryptocurrency. See What is Cryptocurrency Mining?, Guide Me Trading (Feb. 10, 2016).
[5] United States v. Coinbase, Inc., No. 17-CV-01431-JSC, 2017 WL 5890052 (N.D. Cal. Nov. 28, 2017).
