The Taxation of Crypto Virtual Currencies – IRS Enforcement Initiative
Data from CoinMarketCap.com shows that the market capitalization for all crypto virtual currencies is currently at approximately 300 billion dollars. Of that amount Bitcoin’s market share represents about 158 billion dollars, and the second largest cryptocurrency, ethereum/ether has about a 50 billion dollars market share. Furthermore, virtual currency (ex. Bitcoin, ethereum/ether) trading and the related block chain trading technology platforms have been dominated by retail investors which has played a significant role in pushing cryptocurrencies to record highs in 2017. In that regard, Coinbase, the world’s largest on line crypto wallet, adds about 100,000 new users every week.
It is estimated that millions of U.S. taxpayer Bitcoin/transactions have occurred, yet the IRS has stated that only 800 to 900 taxpayers had reported their Bitcoin gains from 2013 through 2015 by electronically filing IRS Form 8949 – the IRS form used for reporting sales and other dispositions of capital assets. (https://www.thestreet.com/story/14257905/1/bitcoin-investors-must-report-gains-to-the-irs.html)
Taking notice of what appears to be widespread tax noncompliance, the IRS is pursuing enforcement actions, and the IRS Criminal Investigation Division believes that virtual currency has increasingly become a tax evasion issue. Consequently, the tax defense community can expect more enforcement actions in the future.
In that regard, on November 29, 2017 the IRS in connection with its investigation of allegedly underreporting of income and failure to pay taxes on crypto currency transactions caused the U.S. District Court for the Northern District of California U.S. v. Coinbase 17-01431 to issue an order enforcing a “John Doe Summons” to the Coinbase virtual currency exchange. Coinbase, as one of the world’s largest platforms for exchanging virtual currencies, has approximately 5.9 million customers and has facilitated approximately $6 billion exchanged to Bitcoin. The Coinbase summons seeks a wide variety of records including, for example, taxpayer identities for all of its customers who have bought, sold, sent or received crypto currency worth $20,000 or more in any tax year from 2013 to 2015, transaction logs, and correspondence. Accordingly, taxpayers using virtual currency transactions involving Coinbase who are not in tax compliance should consult experienced criminal tax counsel as soon as possible for advice.
With respect to the substantive tax aspects of crypto virtual currency, the IRS addressed emerging issues of the growing digital economies and how existing fundamental U.S. federal income tax principles apply to transactions using virtual currency to pay for goods or services, or held for investment when it issued IRS Notice 2014-21.
IRS Notice 2014-21 begins by acknowledging that virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as convertible virtual currency. Bitcoin is one example of a convertible virtual currency – Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.
The Notice goes on to state that in general, the sale or exchange of convertible virtual currency or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction has tax consequences that may result in a tax liability.
Specifically, the IRS has taken the position for federal tax purposes, that virtual currency should be characterized as property, not as a foreign currency recognized by any government.
Accordingly, when using Bitcoins for example, to purchase products, if the Bitcoin appreciated in value since it was acquired, there may be tax owed on the gain if the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency.
The character of the gain or loss depends on whether the virtual currency is a capital asset in the hands of a taxpayer. 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. For example, stocks, bonds, and other investment property are generally capital assets. A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. Investors and other property held mainly for sale to customers in a trade or business are example of property that is not a capital asset. Thus, since characterized as property, normal tax consequences flow. Therefore, if an employer pays an employee in virtual currency the employee must report the fair market value of the virtual currency measured in U.S. Dollars as compensation income as of the date of the virtual currency payment and the employer must report that value on a Form W-2. Moreover, the fair market value of virtual currency paid as wages is subject to federal employment taxes paid by the employer and income tax withholding (FICA) and FUTA. Similarly, if virtual currency is received by a business in exchange for goods or services, then any such payments received are reportable as ordinary income.
When a taxpayer successfully “mines” virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain public Bitcoin transaction ledger), the fair market value of the virtual currency as of the date of receipt is includible in gross income.
Also, if a taxpayer’s “mining” of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment resulting from those activities constitute self-employment income and are subject to the self-employment tax.
As to crypto currency and information reporting requirements, payments made in virtual currency appear to be subject to the same information reporting requirements as payments made in property, real currency or instruments denominated in real currency. For example, gains and losses attributable to virtual currency transactions may need to be reported on Form 8949 which is attached to Schedule D of Form 1040; payments made by a person engaged in a trade or business to an independent contractor using a virtual currency for the performance of services may require reporting of such payments to the IRS and to the payee on Form 1099 MISC.
Many questions though remain unanswered such as for example, whether virtual currencies need to be reported on FBARs foreign bank account reports – a U.S. taxpayer’s accounts at a foreign binary Bitcoin options exchange or a foreign Bitcoin options exchange could be reportable on an FBAR as a foreign financial account, and on IRS Form 8938, and whether the exchange of crypto currencies can qualify as Section 1031 like exchanges.
Unfortunately, the IRS has not issued any further guidance up to date beyond IRS Notice 2014-21, but instead is pursing enforcement actions. Furthermore, State tax authorities will no doubt adopt the IRS’ characterization of crypto currency as property with resultant state tax consequences and concerns.
If you have invested in, traded, and/or spent convertible virtual currency, we encourage you to contact the Firm.