Crypto Tax: Tax treatment and reporting of cryptocurrency transactions

Crypto Tax: Tax treatment and reporting of cryptocurrency transactions

Cryptocurrency tax laws and guidance develop at a much slower pace than the technology that gives rise to the issue. Much uncertainty remains, but to the degree possible, Blue J helps clarify tax obligations arising from cryptocurrency transactions. Not sure how to report gain from transactions involving bitcoin or other crypto? In this blog post, we cover the most important terminology, what transactions are not taxed, the crypto tax implications of gains and losses arising from cryptocurrency transactions, how to report them, and possible penalties for inaccurate reporting.

Generally, the IRS treats virtual currency as property and applies general tax principles applicable to property transactions to cryptocurrency transactions.1 So, for example, cryptocurrency received from trades undertaken in the course of a business will usually be treated as business income, as in those instances cryptocurrency will likely not constitute a capital asset (§ 1221(a)(1) of the Internal Revenue Code). When an individual taxpayer engages in some minor cryptocurrency trading, on the other hand, any gains will usually be treated as capital gains, provided the cryptocurrency is held as a capital asset. Cryptocurrency received as wages and as a reward for mining and staking cryptocurrency will, in turn, commonly be treated as ordinary income. The available IRS guidance applies mainly to cryptocurrency held as a capital asset. 2

Definitions

The IRS defines virtual currency and cryptocurrency as follows:

Virtual currency

“Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange. Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency.” 3

Cryptocurrency

“Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.” 4

“Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in multiple places at the same time with no central data store or administration functionality.” 5

Non-taxable transactions

As a general rule, no tax implications arise upon the following transactions:

• Purchasing cryptocurrency with cash and merely holding it; 6
• Receiving cryptocurrency as a bona fide gift; 7
• Transferring cryptocurrency between one’s own wallets; 8
• Transferring cryptocurrency between different accounts held by the same owner on different exchanges, or from external wallets to an exchange account held by the same owner; and 9
• Donating cryptocurrency to a qualified tax-exempt charity or non-profit organization. 10

Income from transactions involving existing cryptocurrency

Cryptocurrency trading

Selling cryptocurrency held as a capital asset for legal tender, for another virtual currency, or exchanging it for a service constitute barter transactions. Consequently, a capital gain or loss that occurs on the transaction must be recognized and reported.

If property other than capital assets is transferred in exchange for virtual currency, an ordinary gain or loss will result. 11

One consequence of the IRS’s characterization of cryptocurrency as property is that cryptocurrency transactions cannot currently generate foreign currency gain or loss for U.S. federal tax purposes.12 Therefore, Subpart J does not currently apply to cryptocurrency transactions. This guidance may require updating given that El Salvador has accepted Bitcoin as legal tender. 13

Payment of wages

If an employee receives cryptocurrency as payment for salary or wages, this amount constitutes income that must be reported. The cryptocurrency’s fair market value in U.S. dollars is further subject to Federal Income Tax withholding tax, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax. These amounts must be reported on Form W-2, Wage and Tax Statement. 14

Income from original cryptocurrency

Income from mining, staking and hard forks constitutes ordinary income that is taxable at the time it was received, or, in the case of income from hard forks, when it is received and dominion and control could be established over the new cryptocurrency.

Reporting requirements

The Code and Regulations require taxpayers to maintain records that are sufficient to establish the positions taken on tax returns. Taxpayers should therefore maintain records documenting their income, such as receipts, sales, exchanges, or other dispositions of cryptocurrency and their fair market value. 15

Forms

I.R.S - Form 8949 - This form is used to report sales and other dispositions of capital assets.

I.R.S. Form 1040 (Schedule D, Capital Gains and Losses). On this form, the taxpayer has to provide a summary of capital gains and losses. Form 1040 now requires every taxpayer to check a box indicating whether or not he or she disposed of cryptocurrency in the previous tax year. In instances where the IRS has information regarding the taxpayer’s unreported cryptocurrency accounts, the taxpayer may receive a letter underlining the seriousness of omitting this information. 16 It is unclear at this time whether a taxpayer who owns a partnership interest in a partnership that disposed of cryptocurrency in that tax year is required to answer this question in the affirmative. It is further unclear how such an individual would report the partnership’s transactions if they do not know whether the partnership engaged in cryptocurrency dispositions.

I.R.S Form 1099-MISC (Miscellaneous Income). Cryptocurrency exchanges have begun to use this form to report rewards and fees income from staking, Earn and other such programs if a taxpayer has earned $600 or more in the relevant tax year. An exchange, such as Coinbase, sends one copy of the form to U.S. resident taxpayers and one to the IRS. The IRS will expect the taxpayer to itemize and report those transactions on their income tax returns. 17

Penalties

In light of the fragmented guidance provided by the IRS to-date, taxpayers may face uncertainties with regard to their income reporting obligations, particularly in light of the fact that much of the cryptocurrency-related guidance was not provided in a form that is binding on the IRS There is no hiding behind the anonymity of cryptocurrency transactions either, as is obvious from the fact that the IRS was successful getting permission to serve a John Doe summons on Payward Ventures Inc., and Subsidiaries d/b/a Kraken (Kraken) seeking information about U.S. taxpayers who conducted at least the equivalent of $20,000 in transactions in cryptocurrency during the years 2016 to 2020. 18 Some relief is available by means of the reasonable cause defense, however, it remains unclear how reasonable cause may be established in the context of underreported income from cryptocurrency transactions

Footnotes

1 I.R.S. Pub. No. 544, Cat. No. 15074K (Mar. 16, 2021) which is a guide on capital assets, capital gains, and capital losses applies to cryptocurrency transactions while it makes no mention of cryptocurrency.

2 Notice 2014-21, 2014-16 I.R.B. 938, I.R.S. - FAQs on Virtual Currency Transactions. Note that the FAQs on the IRS’s website were accessed for purposes of this Template Overview on December 17, 2021. The IRS may change the content or numbering at any time without tracing such changes. Furthermore, the guidance provided therein is not binding and hence unreliable for taxpayers to some degree. Where reliable guidance is available, reference to that guidance is provided herein. Such guidance is, however, scarce. See I.R.S. Pub. No. 544, Cat. No. 15074K (Mar. 16, 2021) for guidance on how to distinguish capital assets and non-capital assets.

3 A1. of I.R.S. - FAQs on Virtual Currency Transactions. Note that the FAQs as well as Notice 2014-21, 2014-16 I.R.B. 938 explicitly only apply to convertible virtual currency.

4 A3. of I.R.S. - FAQs on Virtual Currency Transactions.

5 Rev. Rul. 2019-24, 2019-44 I.R.B. 1004, p. 2.

6 A5. of I.R.S. - FAQs on Virtual Currency Transactions. Note that the FAQs on the IRS’s website were accessed for purposes of this Template Overview on December 17, 2021. The IRS may change the content or numbering at any time without tracing such changes. Furthermore, the guidance provided therein is not binding and hence unreliable for taxpayers to some degree. Where reliable guidance is available, reference to that guidance is provided herein. Such guidance is, however, scarce.

7 A31. of I.R.S. - FAQs on Virtual Currency Transactions.

8 A38. of I.R.S. - FAQs on Virtual Currency Transactions.

9 ibid.

10 A34. of I.R.S. - FAQs on Virtual Currency Transactions; I.R.S. Pub. No. 526, Cat. No. 15050A (Mar. 3, 2021).

11 A19. FAQs on Virtual Currency Transactions.

12 Notice 2014-21, 2014-16 I.R.B. 938.

13 Concerns to that effect were flagged to the IRS already in 2015 by the Section of Taxation of the American Bar Association. American Bar Association - Comments on Notice 2014-21 (Mar. 24, 2015).

14 I.R.S. Pub. No. 15, Cat. No. 10000W (Dec. 16, 2021) applies. A11. of I.R.S. - FAQs on Virtual Currency Transactions.

15 A46. of I.R.S. - FAQs on Virtual Currency Transactions.

16 See Department of the Treasury - Letter 6173, (6-2019), Letter 6174 (6-2019), Letter 6174-A (6-2019).

17 See, e.g., Coinbase Tax Resource Center.

18 See Department of Justice News Release - “Court Authorizes Service of John Doe Summons Seeking Identities of U.S. Taxpayers Who Have Used Cryptocurrency,” (May 5, 2021).