Since the launch of Bitcoin in 2009, it and other virtual currencies are gaining popularity. As of February 2019, there were over 17.53 million bitcoins in circulation with a total market value of approximately $63 billion. Even as cryptocurrency builds momentum in the business world as a viable form of payment, many businesses, consumers, employees and investors are still confused about the tax implications. However, the Internal Revenue Service (IRS) is ready to crackdown.
In a statement released on July 26, 2019, the IRS announced it was sending over 10,000 educational letters to digital currency holders who may have failed to pay the appropriate taxes or incorrectly reported taxes on their digital assets. The letters will reach thousands of taxpayers by the end of August and should not be disregarded. IRS Commissioner Chuck Rettig declared, “Taxpayers should take these letters very seriously…The IRS is expanding our efforts involving virtual currency…we are focused on enforcing the law and helping taxpayers fully understand and meet their obligations.”
The statement further explains that taxpayers who fail to properly report income taxes related to virtual currency are liable, when appropriate, for tax, penalties and interest. In more extreme cases, criminal prosecution is an option.
With the IRS stepping up enforcement efforts, it is vital to understand what cryptocurrency is and how to stay compliant with the law.
What’s in this article
What is cryptocurrency?
First and foremost, cryptocurrency is digital or virtual currency which utilizes cryptography for security. Due to the enhanced security, it is extremely difficult to counterfeit. Many forms of cryptocurrencies are decentralized systems based on blockchain technology. One of the most alluring components of digital currency is its organic nature. This means it is not issued by a central authority; rather, it is essentially immune to government interference or manipulation.
Virtual currency has an equivalent value in actual currency. It is obtained through cryptocurrency ATMs or online exchanges and is digitally traded between users. The currency is then used to pay for goods or services using “bitcoin wallet” software.
Bitcoin was the very first blockchain-based virtual currency. There are no physical bitcoins, rather balances are kept on a public ledger in the digital cloud. These balances are verified by an exorbitant amount of computer power generated by a network of computers.
While Bitcoin remains the most popular and most valuable cryptocurrency, thousands of alternative virtual currencies have emerged in the last 10 years. The alternative currencies offer a variety of functions or specifications. Some are copies of Bitcoin. Others are forks – meaning a new cryptocurrency that split from a previously existing one. Popular alternatives to Bitcoin are Litecoin and Ethereum.
Below is a short video that summarizes how Bitcoin works and why it is important.
Who uses cryptocurrency?
Primarily, a growing number of large retailers and online businesses are accepting bitcoin payments. By allowing bitcoin payments businesses can avoid transaction fees instituted by credit card companies and online payment providers like PayPal.
Businesses are also able to pay employees or independent contractors with digital currency. Small businesses generally do not accept cryptocurrency payment; however, as popularity continues to surge, significant change may follow.
How does the IRS handle cryptocurrency taxes?
The IRS issued guidance on the treatment of virtual currency and bitcoin under tax laws. It explains that the sale or exchange of virtual currencies, paying for goods or services, or holding bitcoins as an investment qualifies as a tax liability.
The most notable piece of information from Notice 2014-21 is that the IRS treats cryptocurrency as property for federal tax purposes. Thus, general tax principles that apply to property transactions are applicable to cryptocurrency exchanges as well. Therefore, we have three moments in time that are critical for the taxation of any type of property – including virtual currency.
These moments are:
- Acquisition of the property
- The length of time you hold the property
- Selling, giving away, trading or otherwise ridding of the property.
As such, the IRS explains that taxpayers are required to recognize gains or losses on the exchange of virtual currencies for cash or other property – including other cryptocurrencies. From the buyer’s perspective, a purchase made using virtual currency is dubbed a taxable gain if the fair market value of the property exceeds the buyer’s adjusted basis in the currency exchanged. Conversely, a tax loss is incurred if the fair market value of the property received is less than its adjusted tax basis.
What are the cryptocurrency tax reporting requirements?
How the gains or losses are recognized depends considerably on the type of transaction conducted and the length of time involved.
1. Settled for Cash or Exchanging for Other Coins
Cryptocurrency gains from trading bitcoin held as capital assets are treated as investment income by the IRS. As such, the same capital gains rules apply. This means a taxpayer selling their cryptocurrency for cash must report a capital gain on Form 8949, “Sales and Other Dispositions of Capital Assets”. If the virtual currency was held for one year or less, it is considered a short-term gain and taxed at ordinary tax rates. On the other hand, if the virtual currency was held for longer than one year, it is treated as a long-term capital gain.
In the event that a taxpayer exchanges one virtual currency for another (i.e. trading Bitcoin for Litecoin), the exchange is still subject to the same capital gains and losses rules as other property transactions.
***Whether through selling or exchanging cryptocurrency, the disposition of property is reported on your tax return using Schedule D and Form 8949 or Form 4797, “Sale of Business Property”. Each of these forms require “showing your math” when calculating a gain or loss.
2. Cryptocurrency Mining
Most importantly, if you acquire any part of bitcoin or other virtual currency through mining, that value is taxable immediately. No exchange or sale is necessary to generate a tax liability.
Notice 2014-21 explains that when taxpayers successfully mine cryptocurrency, the fair market value of the currency is includible in gross income. Furthermore, an individual mining cryptocurrency as a trade or business is subject to self-employment tax on the income derived from those activities. The amount of self-employment income equals the market price of the cryptocurrency on the day it was awarded on the blockchain. In addition, the amount also becomes the miner’s basis in the currency going forward and is used to calculate future gains and losses.
3. Payment for Goods and Services
The IRS notice offers guidance on cryptocurrency received as employee wages, independent contractor payments for provided services, and other payments for goods and services.
Wages paid using virtual currency are taxable to employees and must be reported by employers on W-2 forms. They are subject to federal tax withholding and payroll taxes. These amounts are based on the fair market value of the property on the day of receipt.
Payments made to independent contractors using digital currency are subject to income tax and self-employment tax. Income is required to be reported on Form 1099-MISC. Like employee income taxes, the taxable amount is established by the fair market value of the cryptocurrency on the day it was received.
All in all, any taxpayer receiving virtual currency as payment for goods or services, either as an employee or an independent contractor, must include the fair market value of the cryptocurrency in their reported taxable income.
4. Donating Cryptocurrency
Donating cryptocurrency directly to a charity (rather than selling it and donating the after-tax proceeds) has significant tax advantages. First, the tax deduction is equivalent to the fair market value of the virtual currency and the donor does not pay tax on the gain. This also results in a larger donation because instead of paying capital gain taxes, the charity receives the full value of the donation. In order to make this work, the donor must have held the cryptocurrency for longer than one year.
What can I do next?
The IRS is without a doubt taking a more aggressively monitoring taxable cryptocurrency events. In addition to the 2014 notice and the August 2019 educational letters, the agency also began an audit initiative to address virtual currency noncompliance. It has also explicitly stated cryptocurrency taxes are an ongoing focus area for criminal cases.
Whether you make a mistake or purposefully neglect to report virtual currency taxes, the IRS is not going to take pity. It is best to stay educated on the topic. There are a plethora of resources at your fingertips. For instance, there are software tools for tracking bitcoin, such as Lukka and CoinTracking. Additionally, there are documentaries on the subject to better understand cryptocurrency and how it is evolving. One such documentary is Bitcoin: Beyond the Bubble, which is available HERE in full on YouTube.
Regardless, you shouldn’t have to tackle your cryptocurrency tax questions on your own. We at Squar Milner take pride in staying abreast of the issues and the evolution of technology. Our tax professionals are here to address any of your concerns and provide you with the answers you need. Contact us today to find out more about how we can help you.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.