Over the past few years, we have received a growing number of inquiries regarding the taxation of so-called virtual or cryptocurrencies from individuals who have purchased such currency and others who are mining the currency. Thus far, these issues have been analyzed under existing tax rules, with some guidance from the Internal Revenue Service (IRS). Recently, there has been a flurry of discussion regarding the IRS’ increased focus on the taxation of cryptocurrencies. Further, IRS representatives have indicated that the topic is front-of-mind. This article outlines some of the primary tax issues and reporting obligations posed by such cryptocurrencies.
In 2014, the IRS first addressed the issue of virtual currency in a 2014 notice to taxpayers. In that notice, the IRS described virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account and/or a store of value.” Notice 2014-21. At their core, virtual currencies are just the newest version of currency. Historically, precious metals were used as currency to purchase goods or services. However, they were difficult to carry and store. Most modern currency, on the other hand, is known as “fiat currency”. Fiat currency is generally issued by a government, which sets its value. The actual value of such currency can vary depending on the strength of the government and economy backing the currency.
Cryptocurrencies, a form of virtual currency, do not rely on the strength of a government or the amount of gold one can transport. Cryptocurrencies are by their nature decentralized and not tied to a particular country or a particular bank. Their value rests on such factors as the scarcity of the currency, the security of the currency and the ability to use it. Understanding exactly how such cryptocurrencies are produced and developed is complex, but the following is a summary of how cryptocurrencies work.
Bitcoin, still the most well-known cryptocurrency, is a network that uses cryptography and runs on a computer protocol known as blockchain. Blockchain is a system which acts as a public ledger to keep track of transactions that occur and permits users to verify transactions with each other. “Mining” or production of new units, which are referred to as “bitcoins”, is limited by requiring computers to devote significant time and power to validate transactions, contribute to the public ledger and obtain the release of new bitcoins. This allows those who participate in Bitcoin to have a level of confidence that the technology is secure (not easily counterfeited), that there is a known quantity of bitcoins available and that new bitcoins will not be flooding the market. There is an easily accessed market to purchase bitcoins, sell them and track prices. These bitcoins, as well as other cryptocurrencies, can be held in a user’s wallet. This wallet is virtual in nature, similar to an account and consists of an encrypted numerical address.
One of the valuable aspects of these cryptocurrencies is that they can not only be used like money to buy goods, but can also be held for investment like a stock. Despite their name, cryptocurrencies are treated as property, not currency, by the IRS. If one is a vendor who accepts virtual currency for a transaction, this means that the vendor must track the value of the virtual currency, measured in U.S. dollars on that date it is received. Cryptocurrencies such as Bitcoin (and some others) are convertible into U.S. dollars and listed on an exchange or exchanges that update a cryptocurrency unit’s fair market value on a regular basis. If a virtual currency is not listed on an exchange, valuation can be difficult.
Some investors purchase and hold on to bitcoins with the hope that its increased scarcity, since only a certain set amount of Bitcoin will ever be released, will allow them to eventually sell their bitcoin units at a profit. The value of bitcoins, however, has fluctuated wildly over the past year or so. An investor who holds such property for investment purposes should receive capital gains treatment upon the sale of the units, while a business that holds units for sale to customers would be taxed at ordinary income rates. Notice 2014-21, Q-7/A-7. Persons who are in the business of mining new units of bitcoin would realize ordinary income upon the successful mining of the virtual currency, which is valued at the fair market value on the date it is derived. Notice 2014-21, Q-8/A-8.
While bitcoins are not considered currency, normal tax rules apply when it is used to pay someone in wages or compensation. The value of the payments in bitcoin units would be required to be disclosed on a W-2 or a 1099, as applicable.
In July 2019, the IRS announced that it was in the process of sending out over 10,000 letters to taxpayers regarding virtual currency issues. IR-2019-132. These letters focused on misreporting, failure to report or potential noncompliance with IRS requirements relating to the sale or receipt of virtual currency. The announcement indicated that the IRS had learned the names of the recipients through its ongoing compliance efforts, that it was “actively engaged in addressing non-compliance related to virtual currency transactions through a variety of efforts, ranging from taxpayer education to audits to criminal investigations.” The IRS appears to be taking a balanced approach of making sure that taxpayers understand their obligations with this still-novel technology, while emphasizing that continued ignorance of the tax reporting and compliance obligations relating to the currency will not be tolerated.
Following the July announcement, the IRS issued a new revenue ruling regarding some issues unique to virtual currency. Specifically, the ruling focused on whether receipt of virtual currency as a result of a “hard fork” or an “airdrop” constituted gross income under the Internal Revenue code. IRS Rev. Rul. 2019-24. As stated earlier, the distributed ledger technology used in virtual currency, such as blockchain, creates and maintains a digital recording of the transactions that have occurred. A hard fork occurs when there is a change to the cryptocurrency protocol that results in a change significant enough to require all users to update their software if they want to continue mining. In other words, a permanent change to the existing protocol for the ledger occurs that is incompatible with the existing version. The existing (legacy) ledger and policies regarding that ledger can continue in one direction, while the new protocol for the cryptocurrency can continue in another direction.
In the October 2019 Revenue Ruling, the IRS considered whether the occurrence of a hard fork results in gross income to a holder of virtual currency. In the example that was considered, the IRS examined a situation in which the distributed ledger of a hypothetical Crypto Y experienced a hard fork which resulted in the creation of Crypto Z. The IRS determined that a holder of Crypto Y would not be considered to have received gross income unless units of Crypto Z are transferred to an account owner by the holder of Crypto Y. In reaching this conclusion, the IRS analyzed whether there was an accretion to wealth under Internal Revenue Code §61. The IRS determined that there was no gross income merely because of the hard fork so long as the holder of the legacy units does not receive any new units.
In the same revenue ruling, the IRS analyzed a situation in which the hard fork causes distribution of the new Crypto Z units to holders of Crypto Y units. This can occur by an action known as an airdrop in which a holder of 50 units of a hypothetical virtual currency Crypto Y receives units of Crypto Z into its virtual currency wallet. In these situations, the vital question is whether the account holder has the power to transfer, dispose of, sell or exchange the new Crypto Z units. If the account holder has sufficient control over the new units, it has received ordinary income equal to the fair market value of the new units on the day they were received. If the Crypto Z units are later sold, that fair market value will be used as the account holder’s basis in the property.
Another issue that can arise is determining the fair market value of virtual currency is determining value. While some cryptocurrencies have readily accessible values on an exchange, others are valued differently on multiple exchanges and some are not valued at all. The IRS released a detailed Frequently Asked Questions (FAQs) on virtual currencies, which addresses these situations. If one receives a virtual currency for services performed or property sold and such currency is not valued on an exchange, for example, the value of the property and services will be used as the fair market value of the virtual currency received. In many cases, of course, establishing the value of the property or services will be difficult and may make accepting these non-exchange valued virtual currencies less attractive.
The FAQs did not specifically address the issue of how and when to report cryptocurrencies as foreign assets, but this is another area that advisers and tax preparers must consider and determine whether the specific cryptocurrency held by their clients would require a report as a foreign asset or foreign account.
As with any new product or technology, the IRS will continue to use traditional analysis to determine taxpayers’ obligations with regard to reporting and paying tax. The novelty and potential future widespread use of cryptocurrency appear to provide some unique difficulties that the IRS is attempting to address. It is clear that practitioners need to continue to learn about such technologies in order to advise clients regarding their obligations under current and likely future rulings.
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