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2019 US Tax Tips: Bitcoin and Cryptocurrencies

2019 US Tax Tips: Bitcoin and Cryptocurrencies

Bitcoin and Cryptocurrencies – What You Should Know Before Preparing Your 2019 US Tax Return, FATCA, and FBAR

 

IRS, The Legend

The Internal Revenue Service (IRS) has a stellar record succeeding where other law enforcement agencies fall short, from the legendary conviction of Al Capone to the take down of the “Silk Road” website in the more recent past. For some years now, virtual currency transactions have been on the radar of the IRS. It established the cross-divisional Virtual Currency Issue Team (VCIT) in 2015, expanded its mandate in 2016, and agreed with the various recommendations made in the 2016 report of the Treasury Inspector General for Tax Administration[1]. With the expertise of its Crime Investigation unit, the IRS just added another accolade to a long list of accomplishments – they analyzed blockchain, de-anonymized Bitcoin transactions, and identified hundreds of predators associated with “Welcome to Video”, the world’s largest dark web child pornography site, which resulted in not only numerous arrests and forfeitures in various countries but also the rescue of at least 23 minor victims.[2]

The extent of noncompliant tax reporting with regard to virtual currencies was widely reported when the IRS summons to Coinbase in November 2016 revealed that Coinbase had 14,355 account holders whose transactions amounted to at least $20,000 each year, through which 8.9 million related transactions were carried out from 2013 to 2015. In contrast, the IRS had received only 800 to 900 returns with Bitcoin gains in each of those years.[3] But this is just the tip of the iceberg. The IRS has since stepped up its efforts, first launching a Virtual Currency Compliance campaign in 2018, then including virtual currency as part of its Priority Guidance Plan for 2019-2020.

In July this year, the IRS started sending more than 10,000 letters to taxpayers who had virtual currency transactions but potentially failed to report income and pay the resulting tax from their transactions or did not properly report the transactions. In some cases, taxpayers could be subject to criminal prosecution. IRS Commissioner Chuck Rettig said that the agency expected these taxpayers to take these letters very seriously by reviewing their tax filings and, when appropriate, amend past returns and pay back taxes, interest, and penalties. He added that the IRS was also expanding its efforts involving virtual currency, including increased use of data analytics.

IRS Means Business

In case you are still not convinced the IRS means business, here is what Gary Alford said at a panel hosted by EisnerAmper this June.[4] Gary is the IRS Criminal Investigation Special Agent and CyberCrime Coordinator who tracked down the elusive creator and operator of “Silk Road”, Ross Ulbricht (aka Dread Pirate Roberts)[5]. Ulbricht was subsequently convicted[6] and his website, which conducted various criminal activities through anonymize Bitcoin transactions, was shut down.

“We’re usually behind the curve — history is made and then we react to it. But in this case, we are ahead of the curve. We were there on ground zero, and we were waiting for the rest of the world to catch up to what we already knew… We already are aware that there were cases to be made, we just didn’t know if we were at the point where we can bring it for criminal prosecution. We believe we are at that point now. If we had 12 jurors and told them someone made all their money in bitcoin, we believe that they would understand.”

You Want to Comply But Don’t Know How?

Ah, the IRS will be glad to know you require no further persuasion and has just what you need.

Notice 2014-21 was the first set of guidance issued by the IRS on virtual currency transactions. On October 9 this year, the IRS followed up with Revenue Ruling 2019-24 along with 43 FAQs to supplement Notice 2014-21 and provide illustrations of how common virtual currency transactions will or will not be subject to taxation. This effort to educate taxpayers is part of the multipronged approach the IRS is taking to actively address non-compliance in this area.

Fundamental to the reporting and taxation of “convertible” virtual currency transactions, such as Bitcoin and Ethereum, is that:

  1. General tax principles apply; and
  2. Virtual currencies of all kinds (cryptocurrency, digital currency, and stablecoins, etc.) are treated as property, not foreign currency.

Decrypting the Codes

Before going any further, the IRS, which is known to speak in codes as a foreign language, thought it would be helpful to define, in English, some terms that are particular to virtual currency transactions. We can presume that techies who regularly engage in these transactions should recognize the processes described and the jargons. To those who are less technically inclined, let’s hope it is at least educational.

  • Soft fork: A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency. In other words, it will not result in any income to the taxpayer.
  • Hard fork: A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger and transactions involving the legacy cryptocurrency continue to be recorded on the legacy distributed ledger.
  • Airdrop: An airdrop is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop.

Every Imaginable Scenario Under the Sun (OK, that’s an exaggeration)

So then, what are the tax implications for each stage of the trading process? Below is a tabulation of the tax treatments in general:

  1. Acquisition: This could happen in a number of ways –
    Transaction Taxable Character of Income Payee Statement Basis Valuation[7]
    a. Compensation as Employee Yes Ordinary W-2 Fair market value[8],[9]
    b. Payment for Services as Independent Contractor Yes Ordinary 1099-MISC if valued at $600 or more Fair market value[8],[9]
    c. Mining Yes Ordinary[10] No Fair market value[8]
    d. Airdrop Yes[11] Ordinary No Fair market value[8],[11]
    e. Purchase with Fiat Money No N/A N/A Amount paid plus other acquisition costs such as fees and commission
    f. Exchange with Property or Another Virtual Currency No N/A N/A Fair market value[8],[9]
    g. Gift No N/A N/A Gain[12]: (a) Donor’s adjusted basis plus (b) gift tax paid on net appreciation

    Loss[12]: Lesser of (a) or (c) fair market value at time of gift

  2. Disposition: There are more ways than one –
    Transaction Taxable Character of Income Payee Statement[13] Sales Proceeds Valuation[7]
    a. Compensation of Employee Yes Capital gain/loss[14] W-2 Fair market value[8],[9]
    b. Payment for Services of Independent Contractor Yes Capital gain/loss[14] 1099-MISC if valued at $600 or more Fair market value[8],[9]
    c. Sell for Fiat Money Yes Capital gain/loss[14] No Amount received
    d. Exchange for Property or Another Virtual Currency Yes Capital gain/loss[14] Ditto Fair market value of property or virtual currency exchanged
    e. Gift No[15] N/A N/A N/A
    f. Charitable Contribution No N/A Written acknowledgement from charity >1 Year[16]: (a) Fair market value

    <=1 Year[16]: Lesser of (a) or (b) adjusted basis

When In Doubt, Go Back to the Basics

This is a lot of information but you are not quite ready to prepare your return yet. You should understand how the existing “general tax principles” will apply, irrespective of the form a virtual currency transaction may take.

  • Character of Income: The character of gain or loss from the sale or exchange of a virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
  • Information Reporting Requirements: A payment made using a virtual currency is subject to information reporting to the same extent as any other payment made in property.
  • Holding Period: Similar to other assets, your holding period for virtual currencies starts one day after the acquisition and ends on the day of the sale or exchange. If you receive it as a gift, your holding period will include the donor’s holding period.
  • Constructive Receipt: Rules of constructive receipt apply to virtual currency transactions. Generally, you do not have receipt if you do not have dominion and control of the virtual currency. This may happen if a new cryptocurrency created as a result of a hard fork is airdropped to an address contained in a wallet managed through an exchange but the exchange does not support the newly-created cryptocurrency such that the airdropped cryptocurrency is not immediately credited to your account at the exchange. If you later acquire the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency, you will be treated as receiving the cryptocurrency at that time.
  • Cost Basis and Specific Unit Identification: As with trading of stocks and bonds, there are opportunities for tax optimization.
    1. First-In-First-Out Basis: You are deemed to have sold, exchanged, or otherwise disposed of your virtual currencies in a chronological order starting with the earliest unit you purchased or acquired if you do not identify specific units of the virtual currency.
    2. Identify Specific Unit: In order to obtain a more favorable tax treatment, you may identify which unit or units of virtual currency you disposed of with documentation that must:
      1. show the following –
        1. the date and time each unit was acquired;
        2. your basis and the fair market value of each unit at the time it was acquired;
        3. the date and time each unit was sold, exchanged, or otherwise disposed of; and
        4. the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.
      2. and such documentation may either be records –
        1. of the specific unit’s unique digital identifier such as a private key, public key, and address; or
        2. showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address.
  • Establishment of Fair Market Value: Although fair market value of publicly traded securities can be readily ascertained, the same cannot be said of virtual currencies. If your virtual currency transaction is facilitated by an exchange, the fair market value is simply the amount recorded by the exchange for that transaction. But what if it is not recorded on a distributed ledge or that it is transacted by some other means? According to the revenue ruling, you will need to establish the amount the virtual currency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it had been an on-chain transaction. For peer-to-peer transactions and those not facilitated by an exchange, taxpayers must determine the fair market value of such transactions using one of the following methods:
    1. With Cryptocurrency or Blockchain Explorer: The value as calculated by an explorer that analyzes worldwide indices of a virtual currency for the exact date and time will be accepted as evidence of the fair market value by the IRS.
    2. Without an Explorer: Taxpayer must establish that the value used is an accurate representation of the virtual currency’s fair market value.
  • Non-Receipt of Payee Statement or Information Return: As with other types of reportable transactions, you must report income, gains, or losses involving virtual currencies regardless of whether you receive any W-2, Form 1099, or other similar statements or returns.

The Devil is in the Details

While the guidance may seem relatively complete, it is likely that taxpayers will run into roadblocks when they start to gather paperwork, crunch the numbers, and celebrate the annual ritual of tax return preparation. If you are one of those who detest spoilers, you may want to stop here. Otherwise, read on.

  • Administrative Burden of Tax Reporting: If you are in the habit of paying for your daily dose of caffeine with Bitcoin, you should realize by now the records you will need to maintain in order to report the gains and losses on your return could be onerous. The IRS did register the public’s concerns about potential administrative burden and is aware, as early as 2016, of policies implemented by the Australian Taxation Office to simplify tax reporting in relation to virtual currency transactions by bifurcating the tax treatment of personal and other uses[1]. It is clear, nevertheless, from the latest guidance that the IRS is not intending to provide for any de minimis exception similar to the personal transaction exception for foreign currency gains[17].
  • Report of Foreign Bank and Financing Accounts (FBAR): A United States person that has a financial interest in or signature authority over foreign financial accounts must file an FBAR on Form 114 if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year. There has been no formal guidance to date as to whether accounts in foreign exchanges and offshore wallets constitute reportable foreign financial accounts or whether value of virtual currencies counts toward the $10,000 threshold. The Treasury’s Financial Crimes Enforcement Network (FinCEN), which is responsible for processing FBAR did, however, respond to an inquiry from the AICPA Virtual Currency Task Force earlier this year and states that virtual currency held in an offshore account is not within the definition of reportable accounts[18],[19]. Cash balances in such foreign accounts and wallets, on the other hand, may still be reportable on FBAR. Furthermore, taxpayers should be aware that the reporting requirements may change in the future as the FinCEN is reportedly continuing its consultation with the IRS.
  • Statement of Specified Foreign Financial Assets (FATCA): Specified persons (including United States citizens, green card holders, and other resident aliens) must file Form 8938 if they have an interest in specified foreign financial assets and the value of those assets is more than the applicable reporting threshold. Unlike FBAR, which is governed by Title 31, reporting requirements for FATCA are defined by the Internal Revenue Code (IRC) under Title 26 and is administered by the IRS[20]. Since the IRS’ guidance has, thus far, focused only on the tax treatments of virtual currency transactions, taxpayer should not assume the IRS will take a similar stance for the reporting of virtual currencies on FATCA as the FinCEN.
  • Like-Kind Exchange: The Tax Cuts and Jobs Act enacted in 2017 changed the tax law on like-kind exchange and limits this deferral of gain recognition tax treatment to only exchanges of real property (i.e. real estate). Prior to 2018, the deferral also did not apply to, inter alia, stocks, bonds, notes, and certain securities. Since Notice 2014-21 provides that virtual currencies are treated as properties, some believe that like-kind exchanges that took place in 2017 or before could qualify so long as all the other requirements were met. In general, whether properties exchanged are of a “like-kind” also depends on their nature and character albeit not grade or quality. That’s a go then, some may conclude. But consider these: Does the exchange of U.S. gold coins for South African Krugerrand gold coins of equal total fair market value by an investor qualify for like-kind exchange deferral? How about the exchange of gold and silver bullions? The IRS ruled that neither qualify[21],[22]. There are, of course, other rulings that may lend support to a different argument. Nevertheless, these are reminders that taxpayers should tread carefully in this uncharted territory. Q&A-15 of the FAQs issued in conjunction with Revenue Ruling 2019-24 may also be a hint of the IRS’ position. Taxpayer taking a position on the return should, therefore, consider including a disclosure with the return to mitigate potential penalty exposure.

Are We All Good Now?

This depends on whether you are the glass-half-full or glass-half-empty kinda person. Certainly, we will be starting off on the right foot this coming tax season, aided by the guidance which we lacked just a year ago. Still, in the complex, ever-evolving ecosystem of virtual currencies, we should expect ambiguity and hold dear the mantra that “general tax principles” apply. We may not know what the new tax year of 2020 will bring but two things we know, for a fact:

  1. Can’t Say They Didn’t Ask Ya: Everyone filing a Form 1040 with Schedule 1 will need to respond to the question “At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
  2. Virtual Currency Transactions Will Not Remain Anonymous: Well, for long, at least, as far as the IRS is concerned.

We wish you and your loved ones a holiday season filled with love, peace, and happiness. Merry Christmas and happy new year!

[1] TIGTA, “As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions Are Needed to Ensure Taxpayer Compliance”, 2016-30-083 (September 21, 2016)
[2] Kelly Phillips Erb, “IRS Followed Bitcoin Transactions, Resulting In Takedown Of The Largest Child Exploitation Site On The Web”, Forbes (October 16, 2019)
[3] “Summons Enforcement Under IRC §§ 7602, 7604, and 7609”, 2018 Annual Report to Congress, Volume One, MLI #3
[4] Hank Tucker, “IRS Agent Who Took Down ‘Silk Road’ Turns His Attention To Recreational Bitcoin Investors”, Forbes (June 13, 2019)
[5] Nathaniel Popper, “The Tax Sleuth Who Took Down a Drug Lord”, The New York Times, December 25, 2015
[6] USA v. Ulbricht, 1:14-cr-00068, No. 183 (S.D.N.Y. February 5, 2015)
[7] General explanations only.  Application to specific circumstances may vary.
[8] Fair market value of the virtual currency, in U.S. dollars, on the date transferred and at the time the transaction is or would have been recorded on the distributed ledger.
[9] If the virtual currency is not traded on any exchange and does not have a published value, then the fair market value of the virtual currency is equal to the fair market value of the property or services exchanged for the virtual currency when the transaction occurs.
[10] Notice 2014-21, Section 4, Q&A-8.
[11] Assuming the taxpayer has dominion and control over the virtual currency with the ability to transfer, sell, exchange, or otherwise dispose of the virtual currency.
[12] Different rules apply to gifts between spouses.
[13] An exchange may be required to issue Form 1099-K to taxpayers who engage in transactions in excess of $20,000 per year and at least 200 transactions per year.
[14] Assuming the virtual currency is a capital asset in the hands of the taxpayer.  Ordinary gain or loss will result if the virtual currency is an inventory held mainly for resale to customers, for example.
[15] Not subject to income tax but may be subject to gift tax.
[16] For purposes of itemized deduction only.
[17] IRC §988(e)
[18] 31 CFR §1010.350
[19] Kirk Phillips, “Virtual currency not FBAR reportable (at least for now)”, Journal of Accountancy (June 20, 2019)
[20] IRC §6038D
[21] Rev. Rul. 79-143, 1979-1 C.B. 264
[22] Rev. Rul. 76-214, 1976-1 C.B. 218

American Expatriate Tax is a part of Contexo Global Mobility Solutions & Tax Consulting Ltd. registered in Hong Kong. Together, we help companies and individuals navigate through the complexities of global mobility and related tax issues. Here is where you will find a blend of expertise from Big 4 accounting firms and Fortune Global 500 companies but the attention of a boutique consulting practice. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.