Two Big Missteps of Previous Cryptocurrency Winners
Cryptocurrency’s resurgence compels tax education
Two years after bitcoin’s boom and bust, cryptocurrency is back — this time, with evidence to suggest more than a hype-driven bubble.
With over 1,500 virtual currencies now circulating, big business is getting on board. In early 2019, JP Morgan became the first major bank to announce the rollout of its own digital coin. Facebook recently made a big splash into the space with the introduction to their “Libra” digital coin with a goal to be a stablecoin tethered to the U.S. dollar. Starbucks has partnered with Microsoft and a cryptocurrency platform to track global coffee bean purchases, and Walmart is eyeing new payment options involving blockchain, the decentralized ledger technology for recording cryptocurrency transactions. With the backing of so many household name companies, crypto is back in the limelight, but with much less of a hype factor tied to it this time around.
What is the IRS crypto position?
As of today, tax guidance on crypto is extremely thin. In the only guidance issued to date, IRS Notice 2014-21 states that virtual currency should be treated as property for tax purposes. It’s not clear, however, what methods are acceptable for cost basis calculations and assignment, or the tax treatment of blockchain modifications that reward holders with new coins — such as forks — that can result in different cryptocurrency values. Recently, the IRS announced that further guidance, likely in the form of both a revenue ruling and revenue procedure, is coming soon that will address more specific crypto transactions and tax treatment.
It is nonetheless clear that taxpayers who fail to report income from virtual currency transactions — whether investments or in exchange for goods and services — risk audit exposure, as well as penalties and interest.
As cryptocurrency regains speed and draws more scrutiny, taxpayers should familiarize themselves with two critical missteps that faced winners in the last run-up.
Mistake No. 1: Treating crypto-mining as capital gains income
The last crypto boom proved to be a bonanza for crypto-miners. These are individuals and business groups who use their hardware to authenticate the automated cryptocurrency transactions to help update the blockchain ledger. The miner is then paid in the relevant cryptocurrency based on the transactions they are mining.
Crypto-mining should not be confused with stock trading, however. For tax purposes, the fair value of mining payments must be treated as ordinary income upon constructive receipt, since mining is a trade or business subject to regular income tax rates. Yet many miners have mistakenly treated the crypto payment as a deferred tax investment, thinking it is not taxed on receipt but only after they sold the digital currency — preferably at a favorable 20% federal long-term capital gains rate.
Mistake No. 2: Rolling the dice with the IRS
Even though short-staffed, the IRS has shown resolve to go after unreported crypto gains.
In one example, a San Francisco-based cryptocurrency exchange did not provide users official tax documentation to their recognized gains for tax return purposes, thereby creating an inherent foundation for non-compliance. The IRS, nonetheless, is vigilantly pursuing the unreported gains. It discovered that only 800 out of more than 14,000 users of the exchange had reported bitcoin-related gains of at least $20,000 in a year. The agency has since won a judgment for the exchange to identify and disclose the transaction of these individuals, and multi-year audits are underway.
The lesson is clear for stakeholders in the current crypto boom. Individuals bear the burden of both tracking and reporting all gains on their personal returns, regardless of whether they receive a 1099. It’s also important to note recent tax changes eliminated like-kind exchanges for most property types except for real estate. Therefore, exchanging one digital coin for another is now a taxable event.
It would be a mistake to assume the statute of limitations for IRS review expires after three years. The time horizon of audits may extend well beyond three years upon discovery of a fraudulent return or materially underreported income.
This reality, and the fact that cryptocurrency is moving into the mainstream, should compel individuals to familiarize themselves with cryptocurrency’s tax treatment. Otherwise, next time they could be the ones to go bust.
Business Tax Quarterly - Summer 2019