BITCOIN & OTHER CRYPTO-CURRENCIES
U.S. Income Tax Issues, Complications & Planning
With the recent rapid rise in the value of the best known crypto-currency, Bitcoin, our collective attention has been piqued.
What place does crypto-currencies hold in our future? (whether revolutionary sea change or fad) is not the focus of this article.
In fact, the objective is much more mundane. Let’s discuss the practical issues involved with the taxation of these newly minted currencies.
Given the “new frontier”, governments are just now beginning to address their financial impact. At the top of their list, of course, is how do we track them and tax them. It is about “showing them the money”
Does the US government [IRS] have a reason to be concerned about its taxpayers not reporting crypto-currency transactions?
The numbers would seem to bear witness. In 2013, only 807 taxpayers reported BTC (Bitcoin) transactions. In 2014, there were 893 and only 802 in 2015.
It is not difficult to reach the conclusion there are lots of unreported transactions.
It is even more obvious when you consider major businesses such as Expedia.com, Microsoft, Overstock.com and Dish Network accept Bitcoin as a means of payment. Are they really working that hard for only 800 taxpayers? I don’t think so.
The IRS Weighs In
In 2014, the Treasury Department issued IRS Notice 2014-21 which among other things defines a virtual currency [crypto-currency] as: “a
digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value…”
These virtual currencies trade on exchanges and function in literally all the same ways and manner that traditional currencies do.
They are purchased for investment, traded on currency exchanges, used to purchase goods and services and fluctuate in value. What they do not have is government backing of the crypto-currency.
The IRS’s Problem
The vast majority of crypto-currency transactions avoid tax information reporting. The IRS is taking action via creation of a virtual currency investigative team.
One of their recent actions was to file a “John Doe” summons on Coinbase, Inc. which is one of the largest virtual currency exchanges. The IRS wants to gain access to Coinbase’s data to identify U.S. customers and the transaction records for them.
The courts have now sided with the IRS and allowed the summons to be issued.
Vexing Taxation Issues
The technical tax issues and arguments about crypto-currencies can be overwhelming. Let’s see if we can break it down into the basics you need to know as a U.S. taxpayer.
• IRS Notice 2014-21 defines the government’s position as any virtual currency treated as “property.” When you buy, sell or trade “property”, its tax treatment depends on its purpose in your hands.
A plot of land might be part of your principal residence, a long-term investment, a business asset or even inventory. Each has different reporting and tax filing requirements and consequences.
• Crypto-currencies [CC] may be held for investment, purchase of goods and services for business or for personal reasons.
• The sale, trade or exchange of a CC may result in a taxable capital gain or loss if held as an investment.
• An exchange for goods and services for personal use could result in a taxable gain or a non-deductible loss.
• If the CC’s purpose does not qualify as a capital asset, any gains or losses from a sale of the CC are then taxed as ordinary income. As an example: A business accepts various crypto-currencies on a regular basis as payment for product or services.
• CC’s received for goods and services in your business could also generate self-employment taxes. So, an attorney who receives Bitcoin as payment for legal services would report ordinary revenue on the FMV of the Bitcoin at the time of receipt. Then the attorney owes self-employment tax if they are a sole proprietor or otherwise subject to S/E tax.
• An employer using CC’s to pay an employee for wages must also pay and deposit federal and state employment taxes (in U.S. dollars).
• A company paying for services must report the transaction to the IRS on Form 1099-MISC if the value of the payments exceeds $600 per payee per year and the recipient is an individual, partnership or LLC.
A trap for the unwary involves all of the complex foreign account reporting requirements for U.S. persons. A “U.S. person” may be a US citizen, US resident alien, US corporation, partnership, estate or trust.
One of those requirements is the Foreign Bank Account Reporting via Form 114.
U.S. persons with a financial interest in, or authority over, bank accounts, securities, or “other financial accounts” located in foreign countries must file Form 114 if the aggregate (total) value of all these accounts exceeds $10,000 at any time during the calendar year. [31 C.F.R. §1010.350(a)]
“Other financial accounts” includes accounts with investment funds or with any business that accepts deposits as a financial agency. Failure to file Form 114 starts at $10,000 for non-willful violations and may increase to up to 50% of the highest value of the account for willful violations.
The IRS Can Find You
2017 marked for the first time when US headquartered Bitcoin exchanges were obligated to report to the government information regarding Bitcoin transactions on a country-by-country basis.
The IRS will then automatically exchange this information with other governments via tax information exchange agreements.
While certain exchanges such as Coinbase, Inc. reside within the USA and are not subject to FBAR reporting, many of the exchanges are not.
Most of the largest bitcoin exchanges are located in foreign countries. It is YOUR responsibility to figure out which accounts may force you to file an FBAR.
Keep in mind that many on-line wallets do not provide any financial services.
An online wallet stores copies of private keys. The user of the online wallet does not need to use the wallet to access their bitcoin. So, an online wallet service never has control or custody over its users’ crypto-currencies. It doesn’t function as a money transmitter and appears to avoid the requirement to report under the FBAR regulations.
If the right hand doesn’t get you, the left hand will.
An additional foreign reporting requirement for U.S. individuals with at least $50,000 of foreign financial assets at the end of the tax year becomes subject to FATCA [Foreign Account Tax Compliance Act] reporting.
These accounts must also be reported on Form 8938 which is included in your personal tax return. The failure to file penalty for this form starts at $10,000 per instance.
How you use a crypto-currency has a potentially significant tax impact.
Held as an investment for more than 365 days, the CC qualifies for the more favorable long-term capital gain rates.
If you are sitting on a loss position, then “harvesting” the loss before it reaches the one-year mark may be advisable. Capital losses may offset capital gains but are only allowed as a deduction up to $3,000 more than your gains.
So, if you suffer large crypto-currency losses, you might receive little tax benefit.
Using a crypto-currency account for personal purchases results in gains being taxed and losses treated as non-deductible. Having mixed- use of your crypto-currency account complicates the tax picture even more. Why? Because you have to prove everything to the IRS if audited.
The best approach is to use the Crypto-Currency account only for investment
If you need to spend CC for personal reasons, then consider converting the CC to cash and use a government currency for the personal purchase.
If that is not feasible or possible, then maintain two accounts where one is used exclusively for investment and the other exclusively for personal purchases. This approach provides a greater defensive position in case of IRS audit.
For business owners accepting CC’s, maintaining accurate and up to date records is extremely important. An IRS auditor will employ a higher level of skepticism and the burden of proof is with the taxpayer (except in criminal prosecution cases).
Keep in mind that the IRS appears determined to audit virtual currency businesses and once they have their data, they have access to everyone that trades in the crypto-currency.