It’s been said that nothing is certain but death and taxes—so why should cryptocurrency be any different? Since the IRS’s first published cryptocurrency taxation guidance in 2014, tax professionals and taxpayers have struggled to understand their cryptocurrency reporting obligations. The IRS has since published a clarifying ruling and frequently asked questions to address a number of common cryptocurrency taxation issues. But as U.S. taxpayers increasingly adopt virtual currency and blockchain technology for both domestic and foreign transactions, questions continue to arise about cryptocurrency tax-reporting requirements.
Overview of IRS Cryptocurrency Taxation Rules and Requirements
Cryptocurrency is treated as property for federal tax purposes. The IRS treats cryptocurrency as it would any other property, and applies general principles of taxation to virtual assets. Taxpayers must, therefore, claim as gross income the fair market value of cryptocurrency received in exchange for goods or services. Fair market value is calculated as of the date of receipt of the cryptocurrency in U.S. Dollars. Taxpayers should exercise care in valuing cryptocurrency, as we anticipate a number of future challenges with respect to crypto valuations.
The IRS also warns that taxpayers must report gains or losses associated with cryptocurrency exchanges and must recognize the fair market value of any successfully mined cryptocurrency as income. Professional miners may also be subject to self-employment taxation based on the net earnings of their cryptocurrency mining activities. Employees who are paid in virtual currency are subject to the same federal withholding requirements that would apply if they were paid in U.S. Dollars. Bitcoin and related virtual currency payments may be considered legal wages in the United States, the value of which is determined by the fair market value of bitcoin in U.S. Dollars at the time of payment.
The IRS warns that underreporting the value of cryptocurrency may result in tax and penalty liability. In fact, the IRS has stated that it is “actively addressing potential non-compliance in this area through a variety of efforts, ranging from taxpayer education to audits to criminal investigations” in light of major cryptocurrency underreporting in 2019 and earlier years.
Recent IRS Cryptocurrency Taxation Guidance
Despite the IRS’s treatment of cryptocurrency as a traditional asset, virtual currency raises a number of unique questions. The IRS recently attempted to address some of the common cryptocurrency questions and concerns for the 2019/2020 tax year. That guidance addresses the following topics (though readers should note that there appear to be a number of shortcomings in the IRS’s guidance and its apparent understanding of the underlying cryptocurrency transactions):
- Hard Fork – When a cryptocurrency ledger undergoes a major protocol change that results in a new cryptocurrency ledger (with a shared history) whereby both the legacy and new cryptocurrency exist in some fashion, questions arise as to taxpayer liability. The IRS guidance provides that a taxpayer is not required to report gross income as a result of a hard fork if she is not issued new cryptocurrency. This, however, raises some interesting questions, because a hard fork (as the phrase is commonly used) virtually by definition results in the issuance of a new cryptocurrency.
- Airdrop Post Hard Fork – The IRS indicates that if new cryptocurrency is airdropped after a hard fork, it is considered gross income once the taxpayer actually receives and has dominion and control of the units. The IRS indicates that a taxpayer does not have tax liability simply because the new currency is recorded on a new ledger after a hard fork. Apparently, it believes that a taxpayer must receive the currency via an airdrop for liability to attach. Again, however, this position is difficult to understand, as an airdrop and a hard fork are generally two distinct events that need not be connected.
- Short v. Long Term Gains and Losses – If you’ve held the cryptocurrency for one year or less before selling or exchanging it, the transaction is generally considered to result in a short-term capital gain or loss (unless it is not held as a capital asset). Any virtual currency held for more than one year before the exchange would generally result in a long-term gain or loss. The holding period begins on the day the coin is acquired and ends the day it is exchanged.
- Peer-to-Peer (off-chain transactions) – Any coins received outside a cryptocurrency exchange (off-chain) are still subject to fair market valuation as of the date and time the transaction is either recorded on a distributed ledger or would have been recorded had it been an on-chain transaction. According to the IRS’s website, “The IRS will accept as evidence of fair market value the value as determined by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time. If you do not use an explorer value, you must establish that the value you used is an accurate representation of the cryptocurrency’s fair market value.”
- No Published Value – As the cryptocurrency market continues to evolve, new forms of virtual currency arise. Cryptocurrency that is not traded on an exchange and is otherwise without an established fair market value has a value equal to that for which it was exchanged. For example, Taxpayer A exchanges 10 Bitcoin for two units of Virtual Currency B. Each unit of Virtual Currency B is worth the fair market value of 5 Bitcoin in U.S. Dollars as of the date of the transaction.
- Gifted Virtual Currency – Any virtual currency received as a gift (not exchanged for anything of value including a good or service) is not considered income until it’s sold or exchanged.
Establishing the value of off-chain virtual currency and calculating taxable gains and income after a hard fork often present complex federal tax issues that are best addressed by an experienced cryptocurrency taxation and exchange attorney, such as those at Freeman Law PLLC.
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) 984-3000 to discuss your cryptocurrency and blockchain technology concerns.