The USC Gould School of Law hosted its 2021 Tax Institute online from Monday, Jan. 25 through Wednesday, Jan. 27. One of the evening discussions focused on cryptocurrency and taxation. How should consumers file their taxes if they own Bitcoin, Ethereum, Litecoin or other cryptos? The IRS has only provided limited guidance so far.
Bitcoin is the most popular cryptocurrency and it was created in 2009. The Internal Revenue Service or the IRS still hasn’t provided any tax code provision or regulation to this day. Unlike stocks and mutual funds, consumers must treat crypto as a form of property similar to purchasing empty land or a home.
In 2020, PayPal began allowing customers to purchase cryptocurrency on its website and app. In addition, consumers can turn in their loose change for crypto using a Coinstar machine in a grocery store, gas station or other location. Looking ahead, the S&P and Dow Jones indices announced they will launch cryptocurrency indexes later this year.
The USC Tax Institute discussion featured two speakers: Megan L. Jones, an associate in the private client and tax team at Withersworldwide and Shahrooz R. Shahnavaz, a partner representing tax law clients at Loeb & Loeb LLP.
USC Gould Executive Committee Member Burton Forester introduced the panelists: “Bitcoin has become a big deal with daily quotations being announced on such stations as CNBC on their stock market programs. Both speakers cover cross-border transactions as well as cryptocurrency which is our topic this evening.”
Shahrooz R. Shahnavaz: “As you all know, this is a sector and industry that has rapidly grown over the last few years. Our focus here is the tax implications of cryptocurrencies.”
Megan L. Jones: “Somebody was explaining to me how the crypto market was changing. Even though I already knew, I thought it was a bit coindescending. We’re going to make this interesting and fun even if its not in-person. Bitcoin burst dramatically around 2020. It was around $7,000 per Bitcoin on Jan. 1, 2020 but it jumped all the way to $29,051 on Dec. 31, 2020 at 11:59 p.m. In January 2021, it jumped to over $40,000 and dropping to the low 30’s when Treasury head nominee, who’s confirmed today, Janet Yellen announced an increase in bit currency should she be confirmed. She stated it is used for ‘illicit financing.’ It caused the market to drop down a little bit. Some of the other Biden nominees are maybe not crypto-favorable but very crypto-knowledgable.
Why else is cryptocurrency important right now? Coinbase, a major coin exchange, announced late in 2020 that it is going public. I saw an article today which said that there were six more big companies in the crypto space that are thinking of going public. PayPal now offers the option to buy and sell select cryptocurrencies. Right now, they have only four: Bitcoin, Ethereum, Bitcoin Cash and Litecoin. Kraken, another exchange, has been issued a bank charter as a special purpose depository institution in Wyoming. The IRS and other federal agencies continue to focus on cryptocurrency, even after 10 years, Bitcoin was released in 2009 and guidance remains lacking. Form 1040 now requires related reporting. Wow, cryptocurrencies are on fire and they are becoming a lot more mainstream and institutionalized. Not surprisingly, we’ve seen the government of the United States and various regulatory agencies really taking an interest in this area.”
What are virtual currencies and cryptocurrencies?
Megan L. Jones: “I’m going to start with the basics. I think given how evolving the industries are, it’s important that we at least address them. A virtual currency is a digital representation of value that functions as a medium of exchange. It does not have legal tender status in any jurisdiction. A cryptocurrency is a type of virtual currency that uses something called cryptography to provide functionality including security, verifications of transactions and also, let’s look at this word, anonymity. That’s one of the guiding principles behind cryptocurrency.
What’s a blockchain? I’m sure a lot of people in the audience have heard the terminology of blockchain before. That’s basically a decentralized ledger which is kind of a digital record of transactions. Individualized transactions called blocks are linked together in a single list called a chain and then there’s cryptocurrency transactions on that chain. I wanted to mention really quickly the difference between Bitcoin and Ethereum. Bitcoin is what most of us think of when we think of cryptocurrency because it’s the one that’s been around the longest. Basically, what it’s supposed to do is facilitate anonymous transactions globally. It’s supposed to be very low-cost and easy to do. The issue with Bitcoin is there’s only going to be a limited number of them issues. We’re kind of starting to head up against that ceiling. Ethereum is actually a global, open-sourced platform for decentralized applications. But they do have a currency called Ether.
What a wallet is…you have two keys. You have the public key, which is on the network—the blockchain. That’s what’s verified by people in the network. Then, you also have your private key. Your private key is held in a wallet. Sometimes that can be on your computer. I’m sure people have heard stories of computers getting hacked and private keys getting stolen. A lot of people actually have their wallet on a drive. That is called a cold wallet because it is not actually connected to the internet. If it is actually connected to the internet, that’s called a hot wallet. I read today that 11 percent of the U.S. population owns cryptocurrency.”
How is/was cryptocurrency created?
Megan L. Jones: “Cryptocurrency is created by code—an algorithm that relies on cryptography. The software is decentralized and then distributed. Basically, what happens is they are written to award coins to companies or individuals who add transactions to the blockchain and then they are recorded. That’s actually called mining. With mining, you actually have to solve a mathematical algorithm. There’s also something called staking. Part of the reason staking came about is because mining became a really big business. It became hard for an individual to compete with the companies that were doing the mining because of the processing power, the servers, the coolers that you needed to compete in that space. Staking is to add to the robustness to the network. With mining, it’s called proof of work and with staking, it’s called proof of stake. You can mine cryptocurrencies but you can also buy them through exchanges or ICOs (initial coin offerings).”
Who regulates cryptocurrencies?
Megan L. Jones: “Cryptocurrency is regulated by The Financial Crimes Enforcement Network and the Bank Security Act, the Office of Foreign Assets Control, the Office of the Comptroller of the Currency, The Securities and Exchange Commission, The Commodity Futures Trading Commission, The Internal Revenue Service, state authorities. I just want to note we are not going through the state tax issues of cryptocurrencies in this presentation. The state level is even tougher. For our purposes, we’re mostly going to address the IRS. Sometimes my clients ask me, ‘Why won’t the government embrace Bitcoin?’ I say, they hate the concept of proof of work. There is a really good report, if you’re interested, issued by the Dept. of Justice called ‘Cryptocurrency Enforcement Framework.’ It really sets out the different ways these agencies work together and the different reasons for their focus on cryptocurrency.”
A Preview of Tax Guidance to Date —
Megan L. Jones: “Currently, we have very limited guidance. It’s limited to three things: Notice 2014-21 which is six pages; Rev. Rul. 2019-2024 which is five and 2019 frequently asked questions (FAQs). There are no Internal Revenue Code sections or Treasury Regulations which specifically address cryptocurrencies. We have some limited guidance and we can also rely on basic tax principles. Just to kind of state in simple terms, we know that cryptocurrencies, according to the IRS, are property for tax purposes. It’s not a foreign currency, it’s not accepted as legal tender or ‘fiat’ currency in any country. It’s not any country’s valued and legal tender. It’s a digital representation of value and can be used as money in certain circumstances. But to date, although this might change, it has not been issued by a central bank, credit institution or other institution. Again, China is looking at creating their own, government-backed cryptocurrency.”
IRS offers some Guidance on Cryptocurrency —
Shahrooz R. Shahnavaz: “The core technology underlying cryptocurrencies, the very nature of cryptocurrencies, is premised on anonymity. There’s this constant tension between the nature of cryptocurrencies and what taxing authorities are trying to accomplish. Correspondingly, transactions involving virtual currencies are very difficult to trace. The IRS, on numerous occasions now over the past few years, commented that it views noncompliance in reporting cryptocurrency transactions, what little compliance it has provided, as a perceived abuse. Clearly, the IRS is concerned about taxpayer compliance with cryptocurrency transactions and the reporting thereof. What and how a taxpayer is reporting these transactions.
Steven Mnuchin, the now former U.S. Treasury Secretary, stated that he views cryptocurrency as ‘the next Swiss bank account.’ The IRS is really doing its best to avoid that. One can expect the current administration to take even a stricter view. So in other words, we should expect continued and increased government focus in this area with focus on educating the public and that focus now shifting to enforcement.
The IRS implies it is property for federal U.S. tax purposes. Notice 2014-21 was published by the IRS and released in March of 2014. At least we know, we need to approach the issue as a property transaction. The sale or exchange of cryptocurrency is a taxable transaction like any other transaction involving property. Taxpayers can have gain or loss on the sale or exchange of cryptocurrency. Realistically, a lot of these traders have small accounts and trade at low volume. As of today, there is no de minims exception so technically these rules apply to ever taxpayer trading virtual currencies. It’s difficult to trace larger trades, smaller trades are really difficult to trace. There are millions of them.”
Shahrooz R. Shahnavaz: “Another issue that has not been fully and definitely addressed is valuation while a service provided sort of preliminary comments on fair market value, it did not really address how valuation of cryptocurrency is to be done. That is another challenging issue. Stock prices are set, in many ways, by the stock market. But with virtual currencies, you have numerous exchanges and they are not regulated by a central depository. There is no set price or trading value and they trade 24/7. Doing a valuation seems utterly impossible point for any particular currency. It’s important to note what it did address and what it did not address.
The service did not address what property classification for virtual currency really means. We know its property but we don’t know if it’s a commodity or a security. Is it generally speaking IP (intellectual property)? Those issues were not addressed. The question remains whether categorizing them as one type of property… does that make sense when there’s a vast difference among the numerous types in terms of economic and other rights. The notice did not address the valuation issues surrounding virtual currencies other than to provide the transactions involving virtual currencies must be reported in U.S. dollars and taxpayers are required to determine the fair market value of virtual currencies in U.S. dollars as of the date of payment or receipt. The fair market value of the currency is determined by converting virtual currency into its dollar value on that date. But what if it’s not listed?
Notice 2014-21 was really a first step, the first step that has to be succeeded by many others. It really just provides a baseline for general rules pertaining to cryptocurrency transactions. The Notice in 2014 was focused on Bitcoin. It mentioned Bitcoin several times understandably so, that was then and probably is still today the most well known and famous cryptocurrency.”
IRS Notice 2014-21 states Cryptocurrency is taxable and must be reported to the IRS if:
-A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. It must be reported on Form Schedule D: Capital Gains and Losses.
-Wage, salary or other income paid to an employee using cryptocurrency is reportable by the employee as ordinary income, subject to federal income tax withholding, FICA and FUTA . It must be reported on Form W-2.
-Cryptocurrency received by a self-employed individual in exchange for services is ordinary income subject to self-employment tax
-Cryptocurrency received in exchange for goods or services by a business is reportable as ordinary income
-The basis of cryptocurrency is the fair market value of the cryptocurrency in U.S. dollars as of the date of receipt
-The sale of property held as a capital asset in exchange for cryptocurrency results in capital gain or loss
-The gain or loss on the exchange of cryptocurrency for other property is generally reported as gain or loss if the property is held as a capital asset and as ordinary income or loss if it is held for sale to customers in a trade or business
-Payments made in cryptocurrency are subject to information reporting requirements to the same extend as payments made in real currency or instruments denominated in real currency
-For a taxpayer who successfully “mines” cryptocurrency, the fair market value of the cryptocurrency as of the date of receipt is includable in gross income. It should be reported on Form Schedule C.
-If “mining” constitutes a trade or business (and the “miner” is not an employee) the earnings (net of allowable business expense deductions) are self-employment income and subject to self-employment tax
-A payment made using cryptocurrency is subject to information reporting to the same extent as any other payment made in property
-A payment of $600 or more in the course of a trade or business is required to be reported to the IRS and to the payee (Form 1099-Misc. Or W-2)
Examples: salaries, wages, rent, premiums, annuities and compensation to an independent contractor
Shahrooz R. Shahnavaz: “The IRS did a preview of things to come from a compliance and enforcement perspective. The IRS confirmed that taxpayers may be subject to penalties for failure to comply with tax rules including underpayments attributable to virtual currencies. The IRS highlighted that failure to timely and correctly report virtual currency transactions when required could be subject to information reporting penalties to Section 67-21 and 67-22.
Of course, there’s also backup withholding issues if a payee does not provide the payor, in a situation where payment is made with cryptocurrencies by a trade or business using cryptocurrencies, as payment if the payee does not provide a taxpayer identification number to the payor. The payor is required to withhold payments to the payee.
Notice 2014-21 provided that the cost basis of a unit of cryptocurrency received as payment for goods or services is equal to the fair market value of that unit in U.S. dollars on the date received. Again, we don’t know how fair market value is determined other than the trading price. If the cryptocurrency is traded on numerous exchanges with different values, it is unclear what guidance the taxpayer is to adhere to and what a reasonable approach is. In a sale transaction of virtual currency, the amount realized is equal to the sales price, minus any selling costs incurred in the transaction. So the taxpayer realizes gain or loss subject to loss limitations that may apply at the time of the sale. Whether the proceeds are kept in a bank account or not is irrelevant. Essentially, you sell cryptocurrency generally speaking you have gain or loss as you would in any property transaction.
The service is setting a baseline applying general tax principles in the concept of cryptocurrencies. Similarly, exchanges of cryptocurrency from other property can also result in taxable gain if the fair market value of the property received exceeds the taxpayer’s adjusted basis in the crypto and loss if the fair market value is less. For example, if you use cryptocurrency to purchase a tangible good, a phone or a TV, with Bitcoins, the amount realized will be equal to the fair market value of the property you acquired. In this case, the phone that you bought on that date. Here, the fair market value would be the market price of the phone purchased with virtual currency. The only sure way of avoiding any realization event is to hold the cryptocurrency without selling or exchanging. Notice 2014-21 addresses the character in a sale or exchange of cryptocurrency and provides that it really depends on the cryptocurrency in the hands of the individual taxpayer.
For investors that holds cryptocurrency for investment purposes and profit purposes, the gain would typically be capital gain. That gain would be long term if assets hold for more than one year or short-term if its held for a year or less. In other situations, the gain or loss could be ordinary. For example, if it’s held as inventory or if it’s part of a trade or business of the taxpayer. The notice hints at the general rule with respect to personal consumption and confirms that a person/taxpayer who utilities cryptocurrency exclusively for personal consumption would be required to recognize ordinary gain but would not be able to take deductions for any losses in excess of any gross income associated with the transaction because it was not entered in for profit. This is essentially the hobby loss limitation under section 183.
The IRS also clarified that the deductibility of losses would depend on multiple factors. In general, losses from the sale or exchange of cryptocurrencies for personal purposes are not deductible. Loss from the sale of cryptocurrency for investment are subject to general rules on losses. It took the service a whole five years to comment on the issue, the IRS released further guidance in the form of Revenue Ruling 2019-24.”
What does IRS Revenue Ruling 2019-24 mean?
Megan L. Jones: “In August 2017, the bitcoin blockchain ‘hard forked’ for the first time. The IRS defines it as ‘when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger.’ A hard fork can result in the creation of a new currency in addition to the old cryptocurrency. There’s a hard fork and a soft fork. A hard fork is basically when the people in the community disagree over a technology. A soft fork is when they agree over a change in the technology and how things are going to be done. If you have a hard fork, very often what happens is you get a split in that cryptocurrency. With a soft fork, you kind of have a change in how things happen on that blockchain but you still have the same currency. The holders of Bitcoin as of the day of the hard fork received the equal number of Bitcoin Cash and then in November there was another hard fork and they were able to get Bitcoin Gold. That’s where those two came from.
An air drop, just to simplify it, is a giveaway. It means that, according to the IRS, it is a ‘means of distributing cryptocurrency to the distributed ledger addresses of multiple taxpayers.’ This is where it gets complicated in a revenue ruling. A hard fork is not always followed by an air drop. One of the criticisms of this Revenue Ruling is the IRS maybe didn’t get that at the time that they wrote it. An air drop can be someone distributing out the same currency like giving you more Bitcoin or it can be a new currency. It could be something that’s random. There’s a lot of ambiguity, it makes it even more complicated when especially with a newer currency someone may not be able to access it.”
Megan L. Jones: “Two years after that first hard fork, the IRS came out with Revenue Ruling 2019-24 trying to address some of these issues. This basically provides guidance for hard forks and air drops of cryptocurrency and also has some frequently asked questions which provide guidance on these and other cryptocurrency issues. We do actually have guidance on mining, but we don’t have guidance on staking. If you remember, that was different ways of solving an algorithm. With the FAQs here, they address some of the other cryptocurrency issues but completely ignore others. A lot of what the FAQs do is basically reiterate that basic income tax controls cryptocurrency transactions. A lot of technical questions they really didn’t answer. I feel, and I think I’m not the only one, that these 2019 guidance really just reiterates and kind of adds a new twist to the earlier guidance.
Basically, the revenue ruling addressed two questions. First, whether hard fork of a cryptocurrency blockchain creates taxable income under IRC section 61 if the taxpayer does not actually receive the new cryptocurrency and the answer to that is no. Two, whether a hard fork or air drop creates taxable income when the taxpayer does actually receive the new cryptocurrency. The answer to that is yes. An important issue to the IRS in its revenue ruling is the applicability of dominion and control of cryptocurrency after a hard fork.”
Do you think Bitcoin will replace gold as an alternative asset class?
Megan L. Jones: “That’s a great question. It’s one of those things where we really don’t know what’s going to happen going forward. I would say that we have some trends, right? We have seen some large institutional investors start Bitcoin and other cryptocurrencies. Whereas before we had venture capitalists and more aggressive investors that were very gungho about Bitcoin in particular but also cryptocurrencies. I think we are seeing that institutional acceptance of Bitcoin. We have people accepting it—Overstock is not the only retail accepting it. Will it become an alternative asset class? It really could. Everyone else’s guess is as good as mine. I think it’s worth taxing seriously but I’m not an investment advisor.”
There have been many exciting announcements regarding Bitcoin since the USC Gould Tax Institute. First, Tesla Founder Elon Musk said the company purchased $1.5 billion of Bitcoin. The electric vehicle maker said it would accept Bitcoin as form of payment in the future. America’s oldest bank, BNY Mellon, said it would be the first global bank to create a “digital assets” service later in 2021. Credit card company Mastercard said it would figure out a way to accept Bitcoin as a form of payment. Former Presidential Candidate Andrew Yang said he would make New York City a “hub” for Bitcoin if elected mayor.
Special thanks to the great folks at the USC Gould School of Law for allowing me to watch their 2021 Tax Institute.