The IRS announced a Virtual Currency Compliance campaign to address tax noncompliance related to the use of virtual currency through outreach and examinations of taxpayers. The IRS will remain 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 Internal Revenue Service began sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly. These efforts will continue.
This ebook is intended to provide an overview of the various tax and reporting obligations that might arise in the process of acquiring, disposing and engaging in Virtual Currency transactions. It is also will serve as a guide as to how to handle situations where the taxpayer may not have been aware of these tax and reporting obligations and how to resolve past issues.
Brief History of the Evolution of Cryptocurrencies & Key Definitions
Cryptocurrency (“crypto”) also referred to as virtual currency has been the subject of growing interest by government regulators including, the Internal Revenue Service (IRS ), the Department of Treasury, the Securities and Exchange Commission (SEC), the Department of Justice (DOJ) and the Federal Bureau of Investigation (FBI), the Financial Crimes Unit (FinCen), amongst others. Significant market activity, volatility, and investor interest in the crypto space has also sparked important interest to evaluate the value and use of these types of assets, including the federal and state taxation of cryptocurrencies.1
What is Cryptocurrency?
A cryptocurrency (e.g., bitcoin) is an electronic payment system that is based on cryptographic proof, permitting parties to exchange the cryptocurrency with each other using the blockchain technology. It does not require a third party clearinghouse to validate the transaction (such as, for example, a bank).2
What is Blockchain Technology?
A blockchain is a decentralized ledger of all transactions in a network. The blockchain technology permits participants in the network to confirm transactions without the need for a trusted third party intermediary. A distributed ledger in a blockchain allows every participant in the network to simultaneously access to view the information on the blockchain. Cryptography permits integrity and security of the information ensuring cryptographic functions. Consensus verification is achieved by participants confirming modifications with one another, thus, replacing the need to liaise with a third party to authorize transactions. Users who contribute computing power to a network are referred to as “miners.” Alternate coins are created through “mining” - a process of using computers to devise algorithm cryptographic hashes that support blocks in a blockchain.3
Bitcoin - A Type of Cryptocurrency
Bitcoin, a peer-to-peer electronic cash system, was first introduced in 2009 by an unknown person or group of persons using the pseudonym Satoshi Nakamoto. See Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, THE BITCOIN PROJECT (Nov. 1, 2008). Frustrated with the inadequate response of central bankers to the financial market meltdown and related global recession at that time, a number of fintech innovators emerged with the introduction of bitcoin as an alternative form of money to solving the problem of inadequate trust at the central bank levels. [190 T.M., I.].4
The terms “cryptocurrency,” “virtual currency,” and “digital currency” are used interchangeably. A “digital currency” refers to an internet-based medium of exchange with characteristics similar to physical currencies. “Virtual representation of value that is neither used by a central bank or public authority nor necessarily attached to a fiat currency, but is accepted by natural or legal persons as a means of payment and can be transferred, stored or traded electronically.” The term “cryptocurrency” is a subcategory of virtual currency in which encryption techniques are used to regulate the various generations of units of currency and verify the transfer of funds.5
A “wallet” refers to a platform where purchased cryptocurrencies from a digital currency exchange (a platform that permits users to trade their virtual currencies for conventional currencies with other users) are stored in a digital wallet, which in turn stores a public/private key (i.e., a digital address) that allows the owner to access, use or transfer the bitcoin. [See Notice 2014-21 ; 190 T.M., V.A.]. A virtual currency wallet is similar to a bank account, except it lives in a numerical address. The most common virtual currency is bitcoin. However, there are numerous others, referred to as “altcoins” including, ethereum, ripple, litecoin, dash, etc.6 See http:/coinmarketcap.com (08/03/18).
A cryptocurrency wallet is a software application (or other mechanism including a paper copy of data) that provides a means for holding, storing, and transferring bitcoin. A wallet holds the user’s public addresses, which allow the user to receive cryptocurrency, and his private keys, which allow him to transfer cryptocurrency. The wallet normally displays his bitcoin balance for the private keys held by that wallet.7
A wallet provider is a person (individual or entity) that provides the software to create and manage wallets, which users can download. A hosted wallet provider is a business that creates and stores cryptocurrency on behalf of the beneficial owner. Most hosted wallets also offer exchange and payment services to facilitate participation in a cryptocurrency system by users.
Means of Obtaining Cryptocurrency
A bitcoin future refers to a contract that a willing buyer enters into to purchase a bitcoin at a predetermined price on a future date. [190 T.M., III.A.]. A hard fork occurs where there is a change in the underlying protocol splitting the cryptocurrency in two (e.g., where bitcoin splits into bitcoin cash). A hard fork results in two blockchain coins. [190 T.M., V.C.] A cryptocurrency airdrop is when a blockchain distributes tokens or coins to the crypto community as a matter of protocol (i.e., without consideration). In general, to receive these coins, the taxpayer must already own cryptocurrencies from the relevant blockchain (i.e., bitcoins or ethereums). Lastly, an initial coin offering (ICO) refers to developers, businesses, and individuals using ICOs or token sales, to raise capital. Purchasers may use fiat currency (e.g., U.S. dollars) or virtual currencies to purchase virtual coins or tokens.
A bitcoin exchange allows users to purchase and sell virtual or cryptocurrencies with other virtual currencies or fiat currency. A cryptocurrency exchange is an online exchange platform that facilitates trading between cryptocurrencies, fiat currency, and other virtual currencies (e.g., bitcoins in exchange for U.S. dollars or ethereum in exchange for bitcoins). The exchange connects buyers and sellers respective to their “bid” and “ask” price. The users deposit fiat money with the exchange by sending funds (including money order, wire transfer, PayPal payment, or credit card) to the exchange prior to the execution of their trade. The exchange charges a transaction fee for x% of the value of the transaction.
Bitcoin’s attraction as a virtual currency derives from its self-verifying feature where users may transfer funds instantly to another person with a bitcoin wallet as though they were paying with cash. Some merchants accept bitcoins to purchase goods. See, e.g., www.overstock.com.
IRS Guidance on the Taxation of Virtual Currency
In March 2014, the IRS published Notice 2014-21 (the “Notice”) – the only guidance the IRS has published to date on taxation of cryptocurrencies. As a threshold matter, the IRS analyzed whether a cryptocurrency should be classified as a currency or property for U.S. income tax purposes. In general, a “virtual currency” is defined as a “digital representations of value that functions as a medium of exchange, a unit of account, and/or a store of value.” A convertible virtual currency is defined as a subcategory of a virtual currency or one “that has an equivalent value in real currency, or that acts as a substitute for real currency.” The Notice presumably, therefore, does not address the taxation of other forms of cryptocurrencies, such as for example, those with smart contract features (e.g., ethereum). Very generally, a “smart contract” refers to a computer protocol that automatically executes the terms of a bilateral or multi party agreement(s) without an intermediary. [190 T.M., II.A.].
How Are Virtual Currencies Taxed?
Virtual currency is treated as property for federal income tax purposes. General tax principles applicable to property transactions apply to transactions using virtual currency. Therefore, the rules applicable to foreign currency transactions under Subpart J of the Internal Revenue Code (“IRC”) are not applicable and thus virtual currencies cannot generate foreign currency gain or loss for U.S. federal income tax purposes. See Notice 2014-21.
A taxpayer who receives virtual currency as a payment for goods or services must include in its gross income the fair market value of the virtual currency measured in U.S. dollars, as of the date that virtual currency was received. See IRS Publication 525 , Taxable and Nontaxable Income for more information on miscellaneous income from exchanges involving property or services. Furthermore, the basis of virtual currency a taxpayer receives as payment for goods or services is the fair market value of the virtual currency in U.S. dollars as of the date of the receipt. [Notice 2014-21 ; 190 T.M., V.B.].
Tax lawyers and accountants have raised many issues that require further clarification. For instance, the meaning of the term “received” is an area which creates confusion. The American Bar Association (“ABA”) Tax Section in their comments to the IRS have asked whether a virtual currency (such as a bitcoin) is deemed received on the date earned or received when record ownership is transferred. [ABA Tax Section, “Comments on Notice 2014-21 ,” at 4 (“When is virtual currency received”) (Mar. 24, 2015)].
If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. Similarly, the taxpayer recognizes loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.
— In general, §1012 provides that a taxpayer’s basis in property is its cost. Section 1016 provides the rules with respect to adjustment to costs (i.e., stock splits, stock dividends, corporate reorganizations, etc.).
— In the context of virtual currencies, in determining basis or cost at the time of sale, careful review of the basis allocations is warranted. [ Notice 2014-21 ]
The character of the gain or loss will depend on whether the virtual currency is a capital asset (e.g., stock, bonds, and other investment property) in the hands of the taxpayer. Alternatively, a virtual currency that is not treated as a capital asset will yield either ordinary gain or loss to the taxpayer on its sale or exchange. Inventory and other property held for sale to customers or in a business are treated as property that is not a capital asset. [ Notice 2014-21 ; IR-2014-36 ; 190 T.M., II.A. ]
How Am I Taxed If I Pay for Goods or Services with Virtual Currency?
Virtual currency owners should be aware that using such currency to make payments is a taxable event. This means that if the value of the virtual currency has appreciated in the hands of the payor, then the payor would owe tax on the amount of that appreciation at the time the virtual currency is used to pay for goods or services. For example, if you purchase a bitcoin for $10,000 and use it to buy a vehicle for $12,000, you would owe taxes on the $2,000 increase in value. In other words, using virtual currency to pay for goods or services is taxed in the same way as selling the virtual currency for cash and then using the cash proceeds to pay for the goods or services.8
How Are the Activities of Miners Taxed?
A taxpayer who “mines” virtual currency realizes gross income upon receipt of the virtual currency at fair market value and as of the date of receipt. Furthermore, 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 Notice requires the net earnings from self-employment (gross income less allowable deductions) resulting from those activities to yield self-employment income subject to self-employment taxes.
Similarly, where an independent contractor performs services constituting self-employment income and receives virtual currency for performing services, the fair market value of virtual currency received from services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income, subject to self-employment taxes. The Notice is silent as to whether ordinary and necessary business expenses under IRC §162 associated with mining should be deductible. [Notice 2014-21 ; see also AICPA Comments on Notice 2014-21 (June 10, 2016); IR-2014-36 ; 190 T.M., V.D.]
Do the Wash Sales Rule Under §1091 Apply to Cryptocurrencies?
The application of the wash sale rules under IRC §1091 to cryptocurrencies is uncertain. Very generally, a wash sale is a transaction where an investor sells stock or securities at a loss and then repurchases the same identical stock or securities back within a 30-day window. §1091 . Congress, to ensure that a taxpayer isn’t able to claim a loss on essentially a phantom loss that has been created without any change in economic substance, enacted §1091 to disallow the loss. In addition, for §1091 to apply, the loss must be that of “stock or securities” and related contracts or options to acquire or sell “stock or securities.” §1091 . In the context of cryptocurrencies, it is difficult to assess the application of the wash sale rules as the classification of a cryptocurrency or virtual currencies for purposes of these rules remain open. [190 T.M., III.C.].
Do the Straddle Rules Under §1092 Apply to Cryptocurrencies?
Very generally, the straddle rules under IRC §1092 address offsetting positions in personal property that is actively traded. IRC Section 1092(c)(2)(A) defines offsetting positions to mean “positions with respect to personal property if there is a substantial diminution of the taxpayer’s risk of loss from holding any position with respect to personal property by reason of his holding one or more other positions with respect to personal property.” Provided, (i) a virtual currency is treated as personal property for which there is an established market and (ii) there are offsetting positions that may result in substantial diminution of risk of loss for that property; §1092 straddle rules may be applicable to cryptocurrencies. In the context of virtual currencies, the straddle rules may provide planning opportunities by deferring the recognition of losses and modifying the holding period of disposed property as per the rules. [§1092(a)(1) ; Reg. § 1.1092(b)-1T, Reg. § 1.1092(b)-2T ; 190 T.M., III.B.].
What Are the Accounting Method Rules Relating to Virtual Currencies?
What accounting method is most appropriate for the disposition of cryptocurrency? This seemingly straightforward question remains unanswered by the IRS, and additional guidance is needed in this area.Generally, there are three acceptable methods for computing gains and losses—First In, First Out (“FIFO”), Last In, First Out (“LIFO”), and Specific Identification. Which approach should be used for virtual currency? This can be a particularly important issue if the IRS takes the position that the exchange of one cryptocurrency for another does not qualify for a like-kind exchange.
For stock transactions, the IRS automatically assumes stock is sold on the FIFO method.9 If a taxpayer wants to sell shares in an order other than FIFO, he should provide his broker with specific written instructions, detailing which actual shares should be sold. For virtual currency, although not treated as stock, FIFO is probably the method the IRS would want the taxpayer to follow—especially in a rising market. This would create more income in an increasing market and would produce less income in declining market.
LIFO is what clients want if they purchased virtual currency over a prolonged time period in a rising market with different purchase prices. This way, the higher basis assets would be sold or exchanged first. However, the taxpayer should document this approach in writing or use a segregated wallet. Of course, documenting virtual currency sales in writing could be difficult, particularly when no mechanism to do so regularly exists with the currency exchange used. A contemporaneously prepared letter or memorandum to oneself or the exchange may suffice as documentation.
The American Institute of CPAs (“AICPA”) suggests specific identification is needed in the absence of specific guidance 10 , but for the IRS to accept the identification, it would need to be supported by appropriate recording keeping or segregated accounts. For some, this may be impossible given the level of sales activity. Until specific guidance is issued, a reasonable, well documented and consistent approach for accounting should be used and this should be acceptable to the IRS.
Could One Virtual Currency Be Exchanged for Another in a Tax Free Exchange Prior to January 1, 2018?
Effective for exchanges completed after December 31, 2017 the non-recognition of gain or loss on a “like- kind exchanges” is only permitted on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property. Prior to the 2017 tax act, §1031 treatment was available to the exchange of one virtual currency for another virtual currency. For example, a taxpayer may have exchanged bitcoin for ethereum and vice-versa.
Section 1031 is a non-recognition provision that provides an exception to the rule that all realized gains must be recognized. The underlying principle for a “like-kind” exchange is that the exchange of one asset for another does not trigger any economic gain. The assets are essentially swapped.
The only limitation to the provision as provided in the regulations is that the definition of “like-kind” refers to “the nature of character of the property and not its grade or quality.” [Reg. § 1.1031(a)-1(b) ]. However, there are some nuances to the statute. For example, real property situated in the United States and real property situated outside of the United States is not deemed “like-kind.” §1031(h)(1) . In the context of commodities, the exchange of silver bullion with gold bullion does not meet the requirements of §1031 ; however gold bullion may be exchanged with gold bullion. [ Rev. Rul. 82-166 ]. The IRS has not provided guidance as to the treatment of cryptocurrencies in the context of “like-kind” exchanges pre-2017 tax act. However, taxpayers who maintain a “like-kind” exchange position in the context of cryptocurrencies should ensure that they are fulfilling the reporting and disclosure requirements, including filing Form 8824 , Like- Kind Exchanges.[ 190 T.M., III.F.]
How Are Capital Gains and Losses From Virtual Currencies Tracked?
The IRS has not addressed how to track the computation of capital gains and losses (basis and fair market value) in the context of “convertible” virtual currencies. A “convertible” virtual currency (e.g., a bitcoin) is one that can be freely exchanged into another virtual currency without regulatory oversight. When a virtual currency is used to purchase goods or services, a transaction occurs where parties are required to track the fair market value (FMV) of the currency at the time of the transaction. The taxpayers cost or basis will determine whether a gain or loss has occurred as well as its duration (short-term or long- term transaction). [190 T.M., III.J.].
In addition to the above, practitioners have suggested the IRS should provide a de minimis rule for taxpayers who may have a minimal amount of virtual currency transactions or small transactions (e.g., purchasing coffee).
What Valuation Methods Are Used to Value Virtual Currency?
Under IRS guidance, transactions using virtual currency must be reported in U.S. dollars. In addition, taxpayers will be required to determine the FMV of the virtual currency in U.S. dollars as of the date of payment of receipt. In addition, the IRS has provided that “if a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.” [Notice 2014-21 , Q-5, A-5].
Observation: The IRS fails to consider how taxpayers should value, for example, tokens issued by companies not listed on an exchange with an established exchange rate. In addition, the IRS does not address the fact that there are numerous published exchanges and the values reported on those exchanges fluctuate. For example, Coindesk, Blockchain, Xapo, Google, Gemini, Winkdex, Bitstamp, and Kraken, all report bitcoin with slight variations. [AICPA letter 05/30/18]. The American Institute of CPAs has recommended using an average of different exchange provided they are consistent in how they calculate valuation. [AICPA Letter, 05/30/18, Q-2-Q-7; 190 T.M., II.A.].
What Is the Application of Virtual Currency and Tokens in the Context of Charitable Giving, Gifts, Trusts and Estates?
Notice 2014-21 has confirmed that virtual currency should be treated as property for federal income tax purposes. However, because of the volatility and valuation issues pertaining to ascertaining the FMV of a cryptocurrency, most estate planners and fiduciaries exercising the “prudent investor rule” have been hesitant to structure cryptocurrency assets (transfer in trusts or as gifts). Queries surrounding valuation, determining how to claim lost tokens, and how to report cryptocurrencies on an estate tax return, among others, remain open issues. In addition, the IRS has not provided more robust guidance in terms of transfer of virtual currencies in the context of charitable donations. According to the Fidelity Charitable 2017 Report, donations made to Fidelity Charitable using bitcoin grew to $9 million in the first half of 2017. However, absent IRS guidance, investors who have made charitable contributions to a
§501(c)(3) organization may face capital-gains taxes for the cryptocurrencies they cashed. The investor may also “gift” the cryptocurrency directly to the charity without cashing the asset first and deduct the value of the donation, provided the assets were held for longer than one year.
Observation: Very generally, subject to a limited exception involving “readily valued property” such publicly traded stock, a charitable contribution of property with a value more than $5,000 requires a qualified appraisal from a qualified appraiser as well as an acknowledgement letter from the charity and a completed Form 8283 , Noncash Charitable Contributions. In the context of cryptocurrencies, such as bitcoins, the IRS requires a taxpayer to provide valuation as provided in established markets. In the context of cryptocurrencies, established markets fluctuate in terms of price and value on any given day. Practitioners have suggested a rule that would allow taxpayers to rely on an average of two established virtual currency markets and the substantiation requirements of §170(f) , however the IRS has not provided any specific guidance to date on this score. In the absence of reliable guidance from the IRS, taxpayers should follow the rules for donated property. [See AICPAs Letter to the IRS, 5/30/18 and 6/10/18].
How Are Cryptocurrency Initial Coin Offerings (ICO’s) Taxed?
In general, a company may wish to issue a token to either (i) raise capital or (ii) use the company’s platform to purchase goods and services. For marketing purposes, a company may also wish to air drop tokens (give away tokens for free) to raise awareness of its platform. Other tokens may have equity-like features, such as right to dividend-like payments based on the issuer’s predefined performance objectives. Some tokens’ underlying utility maybe blurred between debt and equity and the purpose of the investor (redeem to use on the company’s platform or hold for appreciation in value).
• While Notice 2014-21 provides guidance with respect to the IRS’s views that convertible virtual currency is treated as property – and not as currency – for tax purposes; the IRS has not provided any guidance with respect to the tax treatment of a cryptocurrency issuer. More specifically, the following issues require further study and evaluation:
— What are the tax treatments of Initial Coin Offerings (ICOs)?
Token issuances, also referred to as ICOs took an unprecedented rise in 2017 across the globe. An ICO permits a company to raise capital without issuing traditional debt or equity as well as using the tokens to purchase goods and services. Each token has its own specific feature and functionality (i.e., authorized as a payment system for purchase of goods and services). In addition some tokens have equity-like features permitting its holder to dividend payments based on the issuer’s preference or objectives.
— What are the federal income tax treatment of tokens?
The federal income tax treatment of tokens depends on the issuer’s location, onshore or offshore, as well as how the token is initially structured. The IRS has stated that it views a convertible virtual currency as property (and not as currency) for tax purposes. However, it has yet to provide guidance on the tax treatment of a crypto issuer. The first query is to analyze whether a crypto token is treated as debt or equity for federal income tax purposes. [Dixie Dairies Corp. v. Commissioner, 74 T.C. 476 (1980), listing 13 factors]. The second query is to determine whether the issuing company is a domestic or foreign corporation. If the issuing company is a foreign corporation, careful analysis with respect to the federal income tax rules pertaining to taxation of a controlled foreign corporation (“CFC”), Passive Foreign Investment Company (“PFIC”), and the international tax nuances enacted in the 2017 tax act is warranted.
Observation: An offshore foreign corporation with U.S. owners that meets the requirements of the CFC rules may be faced with subpart F and global-intangible low-taxed (GILTI) income includible in the U.S. taxable income of any direct or indirect U.S. shareholder. Under the 2017 tax act, U.S. shareholders of a CFC must include U.S. taxable income their annual pro rata share of GILTI. [§951A(a)]. In the context of issuance of tokens by a foreign corporation that meets the requirements of a CFC [§957(a) , §958(a) , §958(b) , §951(b)], a tax practitioner should estimate the amount of GILTI a CFC will likely produce in a token sale and parse through the requirements of §951A(a) , et al.
Tax Treatment of Cryptocurrency Hard Forks
Cryptocurrencies are digital tokens, the ownership of which is recorded on a decentralized ledger. Cryptocurrencies are held in “wallets,” which may be a type of hardware (e.g., a device similar to a USB drive) or a type of software. Hardware wallets must be physically available to access certain security keys stored on the hardware that are required to control the disposition of the relevant cryptocurrency. Software wallets are just that: software stores the security keys that are required to control the disposition of the relevant cryp- tocurrency. Software wallets may be hosted in a variety of ways, including on the cloud, a desktop computer, or a mobile phone.11
The security keys necessary to transfer cryptocurrency consist of a public key and a private key. Both are large strings of numbers that are mathematically linked to the wallet address. The private key is used to generate a “signa- ture” for each blockchain transaction a user sends out. The private key is used to mathematically derive the public key, which is transformed with a hash function to produce the address that other people can see.
Cryptocurrencies generally may be traded for other cryptocurrencies or fiat currencies, for example the U.S. dollar, on exchanges that function much like stock exchanges. Cryptocurrency exchanges may also provide a software wallet in which users can store security keys for relevant cryptocurrencies. Trading on these platforms occurs in a manner analogous to trading in “street name” when an owner has an account with a large brokerage. That is, the exchange controls the owner’s security keys and conducts batch trades for multiple users. This is a high-level description of how some intermediaries operate, though there are numerous variations.
Because the software that runs the ledger generally is open-source, and the network of computers that verify transactions generally operates via con- sensus, the software can be modified if enough participants on the network agree to do so. Hard Forks, sometimes also known as “Chain Splits” or “Coin Splits,” are one example of such modifications. When a Hard Fork occurs, a new “branch” splits from the original ledger and is thereafter separately maintained. This means that the network of computers separates into sub- groups, which separately verify transactions on the original ledger and the split or forked ledger.
Those people whose ownership of a cryptocurrency was recorded on the original ledger maintain their ownership of the original cryptocurrency, but they are also entitled to claim ownership of the crypto- currency maintained on the forked ledger. When an owner holds a cryptocur- rency wallet directly (rather than through a custodial wallet), the owner does not actually receive anything new in a Hard Fork. Instead, the owner—once he or she has taken the necessary steps (as described below)—is able to use the same private key to transact on each of the ledgers. If the owner uses his or her private key to transact in the original cryptocurrency, the network par- ticipants verifying transactions on the original ledger will add it to that ledger, but the network participants verifying transactions on the forked ledger will not recognize it. This enables the owner to use his or her private key separately to transact in the forked coin and the original coin. The ownership history of both the original and forked cryptocurrency trace back to the same block on the blockchain, but going forward, the ledger of each cryptocurrency is independent (i.e., they are not interchangeable).
It may be helpful to compare Hard Forks with “soft forks,” which are more similar to a software upgrade. In a soft fork, the same blockchain is maintained (there is no split or branching), but some changes to the related software are made such that the blockchain functions somewhat differently after the soft fork. By analogy, a soft fork is more similar to the release of a new version of an existing variety of word processing software, for example, Microsoft Word. The new version typically recognizes documents created using the original version, but the original version may not recognize documents created using the new version unless the original software is updated.
There are many reasons for network participants to agree to Hard Forks. For example, one reason for Hard Forks is that users of the network agree that a fundamental upgrade to the ledger software is required. For example, on August 1, 2017, Bitcoin split into bitcoin (BTC) and bitcoin cash (BCH).12 The purpose in creating BCH was to allow for a quicker generation of forked coins, as well as other improvements. Nonetheless, both BCH and BTC remain in existence, and both enjoy considerable trust of the cryptocur- rency community. In contrast, some forks are a response to user mistrust in the original coin. For example, in 2016, the Ethereum blockchain was split into two in response to a hacking attack that affected the original ledger. In that case, the value of the original coin (Classic Ethereum) and the volume of trading in it plummeted due to the loss of user trust, while the forked coin (Ethereum), which is viewed more favorably by the market, essentially usurped the original coin. Even though the original owners of Ethereum owned both the original and forked coins on the day of the split, the original coins became nearly worthless in comparison on that day (though both still trade and the original coin has since reached a greater price than it had prior to the fork).
In the case of a Hard Fork, an owner of the original coin must take active steps in order to transact in the forked coin. An owner that holds the original coin in a basic wallet (whether hardware or software), generally must download new software to a computer to use the forked coin. This requires some level of technological sophistication and is inconvenient, but is not unduly burdensome for a reasonably experienced computer user. An owner that holds the original coin through certain other types of wallets is not required to download the software because the wallet service provider downloads the software, thus “supporting” the forked coin created in the Hard Fork. This is much easier for the average owner, but means that owners who use a custodial wallet service depend on the wallet service provider to permit them access to the forked coin.
For example, a few days before the BCH Hard Fork, Coinbase sent an email to its customers stating that Coinbase has “no plans to support the Bitcoin Cash fork . . . . Customers will not have access to, or be able to withdraw, bitcoin cash.”13 Only three days after the Hard Fork happened, Coinbase announced that it would support BCH, and would credit their customers’ accounts accordingly.14 Similarly, Xapo announced that customers had until December 14, 2017 to transfer or convert their BCH to BTC, or they would automatically convert it.15 Many owners and wallet service providers take no action to claim the forked currency until the security risks have been sufficiently evaluated and mitigated. Nonetheless, it is generally possible for an owner to transfer the original coin from one wallet that will not support a Hard Fork and into another wallet that will support the Hard Fork prior to the occurrence of the Hard Fork. In that manner, the owner generally should be able to go through the processes necessary to claim the forked coin, at least if the owner is aware that a Hard Fork is going to occur.
Potential Tax Treatments of Hard Forks
Hard Forks raise the question of whether owners of an original coin who become entitled to use a forked coin by reason of a Hard Fork, realize income. We believe reasonable arguments may be made both ways because Hard Forks may be analogized to existing taxable and nontaxable events.
A. Hard Fork as a Realization Event
The Supreme Court in Commissioner v. Glenshaw Glass16 liberally construed the term “gross income” as “instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion,” reflecting Congress’ intent to tax all gains except those specifically exempted. One could argue that the ability to use the forked coin in addition to the original coin represents such an accession to wealth.
In Eisner v. Macomber, the Supreme Court considered whether a pro-rata stock dividend paid to a common shareholder by a corporation with one class of stock constituted income. In holding that it did not, the Court distin- guished taxable “gain derived from capital” from unrealized—and therefore nontaxable—“gain accruing to capital or a growth or increment of value in the investment.”17 The pro-rata stock dividend in Macomber fell into the latter category because it was simply an additional piece of paper evidencing the increased worth of the taxpayer’s original investment in the company—the shareholder has received nothing out of the corporation’s assets for his use and benefit, and the corporation has not experienced a change in its aggregate assets or its outstanding liabilities.18 In contrast, the Court defined a taxable “gain derived from capital” as “something of exchangeable value proceeding from the property, severed from the capital . . . [and] received or drawn by the [taxpayer] for his separate use, benefit and disposal.”19
In Macomber, the receipt of additional stock was a consequence of own- ing the original stock, and the same could be said for forked coins, such as BCH, received in a Hard Fork. However, unlike in Macomber, BCH has unique properties, and it is unrelated to BTC except by the shared historical ownership. Thus, unlike the taxpayer in Macomber, one could argue that an owner of BTC who received BCH at the time of the fork received a new and different asset of exchangeable value for the owner’s separate use rather than something representing an increase in the underlying value of the previously held BTC.
The regulations under section 1001 20 define a realized gain or loss as, inter alia, one from “the exchange of property for other property differing materially either in kind or in extent.”21 The Supreme Court in Cottage Savings Association v. Commissioner defined materially different properties as those where “their respective possessors enjoy legal entitlements that are different in kind or extent.”22 Although there was not an exchange of BTC for BCH at the time of the Hard Fork, such that Cottage Savings is not precisely on point, the definition is useful in determining whether a holder of BTC at the Hard Fork received something materially different than the previously held BTC. One might argue that the upgrade reflected in the forked cryptocurrency represents a significant change in the protocol that mattered to users (otherwise the fork would not have been permanent), thus representing a material change. Although the forked cryptocurrencies share a pre-split transaction history, a Hard Fork represents a permanent split in the blockchain. Thereafter, transactions on the original blockchain are valid only in BTC, but invalid in BCH, and vice versa. In addition, BTC and BCH are traded separately, each with its own value.
Timing of realization
As mentioned above, the Supreme Court in Commissioner v. Glenshaw Glass defined taxable income as “instances of unde- niable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.”24 It is the last part of this definition—complete dominion—that raises an issue as to the timing of realization with regard to Hard Forks.
One possible argument is that realization happens at the time of the Hard Fork. At that point, an owner of the original coin becomes (at least in theory) unconditionally eligible to claim the forked coin, and he or she therefore must include the value of the forked coin at that time. However, when an owner holds an original coin in an account maintained by an intermediary such as Coinbase, the timing of realization becomes murky. In that case, a financial intermediary—whether the owner’s agent or not—is preventing the owner from controlling the forked coin, which arguably may prevent the owner from experiencing a realization event.25 On the other hand, cryptocurrencies are virtual currency and can be transferred to other intermediaries or the owner relatively easily and quickly. Consequently, it can be argued that the owner has voluntarily failed to meet the conditions under which the forked coin can be claimed and is in constructive receipt of it.26
Amount Realized. Assuming realization, one must determine the amount realized, meaning, the value of the forked coin when realization occurs. Given the complexities in the cryptocurrency market, valuation is as much a problem of administrability and predictability as it is of consistency with existing U.S. federal income tax law.
After a Hard Fork occurs, there is a process of market price discovery. However, this process often takes place on multiple exchanges that do not “talk” to each other. As a consequence, the same type of cryptocurrency— even established cryptocurrencies such as BTC—may have different values on different exchanges at the same time. Thus, even though market values for a forked coin may emerge quickly (though, in some cases, a market may fail to materialize), the same coin may have different market values on different exchanges even within the same country at any point in time. Nonetheless, at the moment that a Hard Fork occurs—the first moment at which an owner of the original coin may obtain an interest in the forked coin—the forked coin arguably has no market value because it has not been previously traded and it is not clear whether a market will emerge for the coin.
We note that in some instances (such as in the case of BCH), an exchange may permit futures contracts in a forked coin to be traded before a Hard Fork occurs. However, to the best of our knowledge, no such websites constitute an “established market”—a concept to which many provisions in the Code refer as a method for determining market price—and therefore should not be used as a definitive source for determining the value of the underlying property (i.e., the forked coin) for tax purposes.27
If one determines that realization occurs when an owner first has clear control over the forked coin resulting from a Hard Fork, then it is reasonable to argue that the fair market value of the forked coin must be determined at that time. It is reasonable to argue that in the case of third-party exchanges that also function as a wallet provider (e.g., Coinbase), the amount realized would be the U.S. dollar value of the forked coin on that exchange at the time it is credited to an owner’s account (i.e., the first moment that the intermediary elects to recognize the forked coin on behalf of the owner). As a result, the owner would report the fair market value of the coin at the time of crediting as ordinary income, since the forked coin was not received in a sale or exchange, and would take a basis in the forked coin equal to its fair market value at that time.
However, an owner who holds the forked coin through another wallet provider or technological method that recognizes the forked coin and credits it to an owner’s account at the moment of the Hard Fork may include a very different amount in ordinary income due to the different timing of the realization event (i.e., when the user obtained clear control over the forked coin). The owner may also be able to select the most favorable exchange rate by shopping the various exchanges. This is not necessarily a problem of fairness given that the owner has a choice regarding how he or she holds the original coin involved in the Hard Fork, but it is a problem of predictability and administrability (and an opportunity for taxpayers to attempt to game the U.S. federal income tax system).
B. Hard Fork as a Non-Realization Event
Given that a forked coin resulting from a Hard Fork shares transactional and ownership histories with the original coin, one could also argue that the original coin has always included the future potential to create a forked coin. For example, one could argue that part of the potential of BTC has always been the creation of additional coins (such as BCH), and that such a possibility is capitalized into the market value of BTC. In other words, the forked coin is like the stock dividend in Macomber in that it simply repre- sents part of the value of the original coin and therefor is more in the nature of a change in the form of ownership than a realization event.28 In this way, a Hard Fork is arguably similar to the birth of young from pregnant livestock, which generally has not been treated as a realization event. Notably, the fact that BCH has modestly different properties from BTC should not be seen as conclusively establishing that a realization event has occurred; a calf has dif- ferent properties from the cow that gives birth to the calf, and stock received in a nontaxable stock dividend need not be identical to the stock on which the dividend is paid.
If this position is accepted, the creation of BCH should not be treated as a realization event until the disposition of BCH by the owner (and taxed as a capital gain if the cryptocurrency is held as a capital asset). This position is supported by a reduction in price of BTC that happened at the time of the Hard Fork with BCH.29 One could argue that the reduction of BTC value was attributable to the split with BCH, the value of which was no longer integrated with the value of BTC. It is difficult, however, to empirically prove that the prices of BTC and BCH are so associated due to the volatility of both currencies.
Alternatively, one may view the forked currency as not materially different than the original currency under the standard of Cottage Savings Association v. Commissioner. The owner continues to use the same private key that permit- ted the owner to spend BTC prior to the Hard Fork to access BCH after the Hard Fork, and each are verified by a subset of the same network of comput- ers. In addition, the ownership history of both BTC and BCH trace back to the same block on the blockchain; any changes emerge only going forward.
Even if one accepts the position that a Hard Fork is not a realization event, an important question remains. Specifically, one has to decide how to divide the basis between the original coin and the forked coin. One possible approach would be to adopt rules similar to those used in stock distributions, in which the basis is split based on the fair market value of the original and distributed stock. However, in such a case, it will be necessary to determine the value of the forked coin at the time of the Hard Fork. As discussed above, there are real practical difficulties with determining the value of a forked coin.
Is There Tax Relief If the Taxpayer Misplaces the Private Key or Losses the Password?
One of the key attributes of virtual cryptocurrency is anonymity, except for the owner whose virtual currencies are protected by a private digital key that is unique and secured by a password only known by the owner.
If the owner (an individual) misplaces the private key or loses his password, the virtual currency is inaccessible and forever lost. Section 165(c)(3) allows noncorporate taxpayers a deduction for certain losses arising from fire, storm, shipwreck, or other casualty, or from theft, incurred with respect to property that is neither used in a trade or business nor held in a transaction entered into for profit. For tax years beginning in 2018 through 2025, an individual’s otherwise deductible personal casualty and theft losses generally are deductible only to the extent that they are attributable to a federally declared disaster. Prior to the enactment of the 2017 tax act, casualty losses under §165 were allowable.
While the IRS and the Notice have not provided any guidance on this issue as it relates to virtual currencies, it is unlikely that the IRS would permit a casualty loss deduction prior to the 2017 tax act with respect to virtual currencies for merely misplacing a private key. [190 T.M., V.F.].
What If the Taxpayer’s Cryptocurrency is Stolen?
In 2014, a virtual currency exchange platform referred to as Mt. Gox lost millions of dollars’ worth for its investors. See, e.g., Mountain of Trouble Twice-Burned – How Mt. Gox’s Bitcoin Customers Could Lose Again, Reuters (11/16/2017).
A few years later, nearly 120,000 bitcoins were stolen from customer accounts at Bitfinex, an exchange platform in Hong Kong. See, e.g., Bitcoin Worth $72 Million Was Stolen in Bitfinex Exchange Hack in Hong Kong, Reuters (Aug. 2, 2016).
The IRS has not provided guidance as to whether taxpayers could deduct virtual currencies that would meet the requirements of §165 prior to the 2017 tax act or for years before 2018. As with the theft of other financial assets, if the virtual currency was acquired in a transaction entered into for profit, a theft loss would be deductible.
Several Open Questions Regarding Funds Remain
Several remaining questions have arisen regarding the tax consequences of cryptocurrencies in the context of funds, and more specifically, trading, investing and mining of cryptocurrencies.
For example, is the raising of funds recognized as income?
What is the difference between stock offerings versus sale of goods and services? Does the 3.8% net investment income tax apply to virtual currencies?
What is the treatment of restricted tokens provided to employees as additional compensation under §83? Should they be treated akin to the treatment of receipt of restricted stock?
Until the IRS offers clarity, these issues will remain unanswered.
Recent Litigation Regarding Cryptocurrency
On November 17, 2016, the IRS and the DOJ requested permission from the U.S. District Court for the Northern District of California to serve on Coinbase, Inc. (“Coinbase”) a John Doe summons (“Coinbase Summons”). See United States v. Coinbase, Inc. , No. 17-cv-01431-JSC, 2017 BL 248202 (N.D. Cal. July18, 2017). Coinbase, a company based in San Francisco, is an exchange platform that facilitates the trading of cryptocurrencies. Customers may purchase, trade, and store cryptocurrencies (e.g., bitcoin or ethereum) on its platform. From 2013 through 2015, Coinbase maintained over 4.9 million wallets in 190 countries with 3.2 million customers served and $2.5 billion exchanged. United States v. Coinbase, Inc. , No. 17-cv-01431-JSC, 2017 BL 248202 (N.D. Cal.July 18, 2017).
The Coinbase Summons initially requested “information regarding United States persons who, at any time during the period January 1, 2013, through December 31, 2015, conducted transactions in a convertible virtual currency as defined in IRS Notice 2014-21 .” United States v. Coinbase, Inc. , No. 17- cv-01431-JSC, 2017 BL 248202 (N.D. Cal.July 18, 2017). As a result of the large number of potential customers that would fall within this broad spectrum, the request was later modified to Coinbase users who “bought, sold, sent or received at least $20,000” worth of cryptocurrency in a year. United States v. Coinbase, Inc. , No. 17-cv-01431-JSC, 2017 BL 248202 (N.D. Cal.July 18, 2017). On November 28, 2017, the Court granted DOJ’s petition to enforce. [ 190 T.M., I.A.2. ]
Reporting and Compliance Obligations
Tax Reporting and Filing Requirements
In general, §6001 provides record keeping requirements for income tax purposes. The Code requires for each person to keep adequate records. Consequently, proper record keeping is required to substantiate a position on a return for income, loss, and basis amounts. In the context of virtual currencies, a payment made using virtual currency is subject to information reporting. Critical to accurate reporting is maintenance of adequate records to accurately measure virtual-currency related income.
All federal insurance contributions including Federal Insurance Contributions Act (FICA) tax must be reported on Form W-2 , Wage and Tax Statement. Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. A payor must solicit a Taxpayer Identification Number (TIN) from a payee. In the absence of a TIN, a payor must backup withhold from a payee prior to payment if the payor receives notification from the IRS that backup is required. Thus, employer payments with virtual currencies as a form of payment for services constitute wages for employment tax purposes and are subject to federal tax withholding. [See Notice 2014-21 ; see also IR-2014-36 ; 190 T.M., II.A.]
Very generally, credit card intermediaries are subject to specific information reporting, if in a calendar year more than 200 transactions are settled for the merchant and gross proceeds payments made to the merchant exceed $20,000. These third-party settlement organizations (TPSO) are required to report payments made to a merchant on Form 1099-K , Payment Card and Third Party Network Transactions, if the above conditions are met. Notice 2014-21 provides that payments made in connection with bitcoin transactions or other virtual currency may be reportable on Form 1099-K . For reporting purposes, the value of the virtual currency is the fair market value of the virtual currency in U.S. dollars on the date of payment. See also IR-2014-36 .
Observations: The Notice fails to consider information reporting requirements of virtual currency transactions in exchange for property or cash that are not reportable on Form 1099-K .
— The Notice provides a catch-all provision where taxpayers will be subject to penalties for failure to comply with tax laws, including virtual currency transactions.
— The Notice provides that underpayments attributable to virtual currency transactions may be subject to penalties, including accuracy-related penalties under §6662 .
— Failure to correctly report virtual currency transactions may also subject the taxpayer to information reporting penalties under §6721 and §6722 .
— The Notice provides relief under reasonable clause for failure to file an information return.
To avoid the above penalties, taxpayers engaging in virtual currency transactions should ensure they have a record keeping system to track the basis and gains or losses of each transaction. In particular, it would be prudent to keep track of all acquisition and sell dates, and any other cost basis information. It is unclear, at this time, whether taxpayers will be required to record all transactions on Schedule D, Form 8949 , Sales and Other Dispositions of Capital Assets. For example, issuers of virtual currency may wish to create a tracking system or inventory for each currency issued. Similarly, retailers accepting virtual currencies should retain documentation on the amount of their sales. Documentation should be stored to provide substantiation or verify the value of the virtual currency at the time of the transaction in U.S. dollars.
It is unclear at this time whether U.S. persons are required to report gifts of virtual currency from a non-U.S. person or distributions from a non-U.S. entity (e.g., a foreign trust) on Form 3520 , Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
Taxpayers are, generally, required to report cash payments exceeding $10,000 received in a trade or business on Form 8300 , Report of Cash Payments Over $10,000 Received in a Trade or Business. Cash payments are defined to include U.S. currency, foreign currency, cashier’s checks, money orders, and other similar instruments. See §60501(a) and related regulations. Given that Notice 2014-21 provides that virtual currencies are not currency, presumably Form 8300 reporting does not apply to virtual currencies.
State Tax Considerations
Virtual currencies raise two notable sales and use tax issues: (1) whether the purchase or exchange of virtual currency itself is taxable; and (2) how transactions in which taxable items are purchased with virtual currency are taxed.
States that have addressed the first issue have generally determined the purchase or exchange of virtual currency to be nontaxable. Sales and use tax generally applies to transactions involving tangible personal property and enumerated services. Virtual currencies are commonly treated as intangible property and thus, are not subject to sales and use tax.
Retailers that accept virtual currencies as a form of payment method with respect to a taxable transaction must be mindful that sales and use tax will likely apply to the transaction akin to using traditional payment methods (e.g., cash or credit card). If the transaction is subject to sales and use tax, documentation should be maintained for the tax collected, converted to U.S. dollars.
A number of states have clarified that they will treat virtual currencies as cash equivalents, and tax purchases made with virtual currencies the same as purchases made with cash. This raises the issue of how to determine the taxable sales price of the item sold. One approach taken is to use the fair market value of the taxable item. When other identical items are sold for a price in U.S. dollars, this would seem to be a fairly straightforward determination. However, in the case of unique items, valuation may become a point of contention with departments of revenue.
Several states have directed that the sales price be based on the value of the virtual currency at the time of the transaction. This approach is fraught with its own complications. Which market’s exchange rate will be deemed authoritative? Should the exchange rate at the time the transaction is initiated be used or the exchange rate at the time the transfer of the virtual currency clears? Given the volatility of virtual currency values and the fact that transfers may sometimes take a day or more to clear, the value may vary significantly between these two approaches. In those states whose sales tax takes the form of a gross receipts tax imposed on the seller, an argument may even be made that the tax should be based on the value of the virtual currency when it is converted to U.S. dollars.
Observation: States’ sales and use tax requirements with respect to virtual currency are an evolving area of the law. Given the uncertainty and disparate treatment, businesses should carefully review state tax law prior to engaging in transactions involving virtual currencies. See Bloomberg Tax’s Sales and Use Tax Navigator, at Sections 17.6 and 31.6.
Another state taxation area that remains open for review is the interplay between sale of marijuana or cannabis and blockchain and cryptocurrencies (i.e., excise taxes).
International Tax Considerations
Information Reporting Offshore
The Notice did not provide any guidance as to whether owners of virtual currencies must fulfill international reporting requirements. In general, United States citizens, lawful permanent residents, or persons with substantial presence in the United States (i.e., U.S. persons) must file a Foreign Bank Account Report (“FBAR”) with the Treasury Department’s Financial Crimes Enforcement Network (“FinCen”) if the person has a financial interest in, or authority over, any financial account outside of the United States where the aggregate maximum value of the account(s) exceeds $10,000 at any time during the calendar year. For purposes of FBAR reporting requirements, a reportable “financial account” includes the following:
— Banks accounts (e.g., savings accounts), checking accounts, time deposits or any other account maintained at a financial institution;
— Securities accounts such as brokerage or custodial accounts;
— Commodity futures or options accounts;
— Insurance policies or annuity contracts;
— Mutual funds or pooled funds; and
— Some pension funds and retirements accounts (excluding those under §401(a) , 403(a) , or 403(b)). [190 T.M., VI.D.].
Very generally, a “U.S. person” has a “financial interest” where: (i) the U.S. person is the beneficial owner of the account or has legal title to the account; or (ii) the holder of the account is a person acting as an agent, nominee, attorney, or otherwise a person acting on behalf of the U.S. person with respect to the account. [190 T.M., VI.D.].
Observation: It is currently unclear whether a taxpayer holding cryptocurrencies on a foreign cryptocurrency exchange (e.g., Xapo.com or Binance.com) or in a foreign virtual wallet (e.g., Blockchain.com) is required to report the account(s) on an FBAR as the classification of cryptocurrencies may fall within the definition of the above types of accounts. Taxpayers may wish to report as a cautionary matter before formal guidance has been issued by the government.
In addition to the above, U.S. persons must also provide a Form 8938, Statement of Specified Foreign Financial Assets, annually with their income tax return regarding a “specified foreign financial asset.” See §6038D and Reg. § 1.6038D-0 through and including Reg. § 1.6038D-8. The financial assets that must be reported on the Form 8938 is broader than what is required to be reported on an FBAR, and includes among other categories, “any financial account . . . maintained by a foreign financial institution” and “any interest in a foreign entity.” See Instructions to Form 8938 , Part I and V. [190 T.M., VI.C.].
For example, a taxpayer holding cryptocurrencies in physical form (i.e., not in cash), on a foreign virtual currency exchange (e.g., Xapo.com) or a wallet (e.g., Blockchain.com) would presumably be required to report the accounts for purposes of Form 8938 given that the taxpayer is holding a financial account (the wallet) maintained by a foreign financial institution (the exchange). Additionally, a Form 8938 reporting requirement may apply to the extent a U.S. person owns “an interest [the cryptocurrency] in a foreign entity [a cryptocurrency exchange or wallet that is formed under the laws of a foreign country].”
— Contrast those examples with, for example, virtual currency exchanges formed in the United States (e.g., Coinbase.com, Gemini.com) where those assets would not be classified as “specified foreign financial assets” and thus normally not subject to Form 8938 reporting.
— To assist taxpayers with accurate reporting of cryptocurrencies for purposes of Form 8938 , it would be helpful if the IRS issued a notice clarifying a taxpayer’s reporting requirement for cryptocurrencies held offshore on an exchange or wallet that is formed outside of the United States. However, at this time, lacking guidance, taxpayers should proceed with caution and err on the side of reporting to ensure that penalties would not be assessed against them for failure to report.
At this time, the government has not provided guidance as to whether taxpayers who own (i) an account on a foreign digital exchange, (ii) a foreign digital wallet, or (iii) a foreign private key should report any of these interests on an FBAR and Form 8938 .
Another area where guidance is lacking from the government is whether or not U.S. persons are required to reports gifts of virtual currency from a non-U.S. person or distributions from a non-U.S. entity on Form 3520 , Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
On July 21-22 2018, the G-20 finance ministers and central bank governors met in Buenos Aires, Argentina to discuss a number of international tax topics, including among them the expansion of cryptocurrencies and the need for government regulatory oversight. More specifically, the group restated its previous position for FATF to clarify the standards applicable to crypto-assets.
The IRS began sending letters to virtual currency owners advising them to pay back taxes, file amended returns; part of agency’s larger efforts.
Last year the IRS announced a Virtual Currency Compliance campaign to address tax noncompliance related to the use of virtual currency through outreach and examinations of taxpayers. The IRS will remain 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 Internal Revenue Service began sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly.
“Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest and penalties,” said IRS Commissioner Chuck Rettig. “The IRS is expanding our efforts involving virtual currency, including increased use of data analytics. We are focused on enforcing the law and helping taxpayers fully understand and meet their obligations.”
The IRS started sending letters to taxpayers in 2019. By the end of August, 2019, more than 10,000 taxpayers will receive these letters. The names of these taxpayers were obtained through various ongoing IRS compliance efforts.
For taxpayers receiving a letter, there are three variations: Letter 6173, Letter 6174 or Letter 6174-A, all three versions strive to help taxpayers understand their tax and filing obligations and how to correct past errors.
Taxpayers are pointed to appropriate information on IRS.gov, including which forms and schedules to use and where to send them.
IRS Targets Crypto Users Who May Have Misreported Transactions
The IRS has begun to take action against people they expect aren’t correctly reporting the income and tax they owe on virtual currency transactions.30
Where is the IRS getting its Information?
The IRS was able to get its hands on a wealth of information about virtual currency users through its successful summons on Coinbase Inc., one of the world’s largest cryptocurrency wallets. The company challenged the summons in court, but a judge in 2017 ruled in the IRS’s favor.
IRS officials have recently said they’re using data from the summons to direct the agency’s enforcement actions.
The focus on virtual currency users is controversial given the lack of guidance the IRS has provided in that space. So far, the agency has issued one notice, in 2014, on the taxation of virtual currencies that fails to answer many important questions, according to practitioners and taxpayers. IRS Commissioner Charles Rettig has said more guidance will be released soon.
The advocacy group Coin Center and several lawmakers continue to press the agency to release rules sooner rather than later and have expressed dismay at the IRS’s enforcement push in the absence of more clarity.
IRS Exam Teams Beginning to Work Cryptocurrency Tax Cases
The IRS is beginning to audit taxpayers with cryptocurrency assets, an IRS agency official said.31 “In our exam operations, we’re starting to work those cases,” Mary Beth Murphy, commissioner of the Internal Revenue Service Small Business/Self-Employed Division (“SB/SE”), said June 20 at a tax controversy forum hosted by the New York University School of Professional Studies.
She also said that SB/SE is coordinating with the agency’s Large Business and International (“LB&I”) Division in determining how to proceed in cryptocurrency-related audits because more of those cases are cropping up.
The IRS has identified a number of cryptocurrency tax cases using its document matching program—a tool that helps detect taxpayers who underreport or fail to report their income. Murphy said the agency is preparing to send out notices to taxpayers that have been identified.
Murphy also said SB/SE is conducting work related to the Bank Secrecy Act stemming from information the IRS received in its summons on Coinbase Inc., one of the world’s largest cryptocurrency exchanges. That act requires U.S. financial institutions to collaborate with the U.S. government in cases of suspected money laundering and fraud.
New tax guidance on cryptocurrency transactions should be out soon, Murphy said, echoing prior statements from IRS Commissioner Charles Rettig.
Criminal Investigations are Ongoing
Virtual currency is an ongoing focus area for IRS Criminal Investigation. IRS Notice 2014-21 states that virtual currency is property for federal tax purposes and provides guidance on how general federal tax principles apply to virtual currency transactions. Compliance efforts follow these general tax principles. The IRS will continue to consider and solicit taxpayer and practitioner feedback in education efforts and future guidance.
The IRS anticipates issuing additional legal guidance in this area in the near future.
Taxpayers who do not properly report the income tax consequences of virtual currency transactions are, when appropriate, liable for tax, penalties and interest. In some cases, taxpayers could be subject to criminal prosecution.
DOJ Tax Division Targeting Crimes Across Economic Spectrum
The Justice Department’s Tax Division is going after crime across the economic spectrum—from cases involving low- to moderate-income individuals to those involving the very wealthy, a department official said.32
“It’s important for the public to know the IRS and the Department of Justice are focusing on all the economic strata so that there isn’t a perception that one particular economic strata will have a free pass,” said Richard E. Zuckerman, principal deputy assistant attorney general in the DOJ Tax Division.
The top of the spectrum includes cases involving wealthy individuals with foreign bank accounts and cryptocurrency assets, Zuckerman said June 21 at a tax controversy forum hosted by the New York University School of Professional Studies. He said there are criminal crypto cases pending at the department.
A second tier includes employment tax cases where businesses pocket the money they withhold from employees’ paychecks. A third tier includes cases involving tax return preparers and identity theft tax refund fraud cases.
Zuckerman said the Tax Division’s priorities “are consistent” with the Internal Revenue Service’s Criminal Investigations (“CI”) division.
Zuckerman and Don Fort, chief of CI, discussed the role that data and analytics play in prioritizing and selecting cases, especially in the employment tax area. “We’ve had a lot of success letting data drive where we’re going,” Fort said.
Summary and Conclusions
The IRS has begun its Virtual Currency Compliance campaign to address tax noncompliance related to the use of virtual currency through outreach and examinations of taxpayers.
The Internal Revenue Service began sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly. These efforts will continue. As a taxpayer, you must become aware of the various tax and reporting obligations.
Freeman Tax Law handles both the legal and accounting complexities associated with engaging in Virtual Currency transactions. In addition to providing tax compliance services we also provide representation to those involved in IRS Criminal Investigations and Civil Audits regarding tax and crypto issues. We recommend that if you receive a letter from the IRS outlining your reporting obligations, that you do not ignore this letter and hire counsel to help you respond. Failure to take the letters seriously or respond properly could mean big penalties for taxpayers. There are several ways taxpayers can avoid penalties when they’ve failed to file or pay their taxes on time—for example, they can prove they had reasonable cause or are first-time offenders. These are very complex laws that involve both Tax and Bank Secrecy Laws and you must work with experienced legal counsel to resolve these issues. Call our office for a consultation!
Jeffrey S. Freeman, Attorney
Jeffrey S. Freeman has personally represented and counseled hundreds of clients throughout the United States in both civil and criminal tax matters. His approach is to handle complex tax matters efficiently, creatively, and strategically. His goal is to educate his clients about their options in resolving their issues with the government.
In addition to representing taxpayers involved in IRS criminal tax investigations, facing criminal tax and Bank Secrecy Act charges, Mr. Freeman has skillfully handled voluntary disclosures to report undisclosed offshore bank accounts (i.e., IRS Offshore Voluntary Disclosure Program (OVDP) and Streamlined Disclosure Programs), representing clients during IRS audits, disclosing previously undisclosed Crypto Currency transactions, and resolving collection matters for delinquent tax liabilities with the U.S. and State governments (i.e., Offer in Compromise, removal of tax liens and levies, sales tax and payroll trust fund tax assessments, innocent spouse relief claims and the removal of penalties). Freeman Tax Law also has a robust tax compliance practice.
Mr. Freeman holds a Masters of Law in Taxation (LL.M.) from Georgetown University Law Center in Washington, D.C. and Juris Doctor (J.D.), Cum Laude, from the Michigan State University College of Law and a Bachelor of Arts in Accounting, with honor, from Michigan State University where he was a member of the Beta Gamma Sigma Business Honor Society and the Phi Kappa Phi Academic Honor Society. Further, he is a member of the Criminal Taxation Section of the American Bar Association and Michigan Bar Association, where he served as a past chair of the Tax Practice and Procedure Committee. In addition to the state courts in Michigan, Jeff is admitted to practice before the United States Federal Court, United States Court of Appeals, U.S. Bankruptcy Court and in the U.S. Tax Court.
With national recognition for his work and commentary, Jeff has appeared on the Frank Beckman Show, Fox News, and has been quoted in The Motley Fool, Business Week, the Detroit News, Detroit Free Press, Crain’s Business, and Detroit Business. Over the years, he has authored numerous articles for various professional journals.
He has been named a “Top Lawyer” by Detroit’s dbusiness magazine and was recently the keynote speaker about the Foreign Account Tax Compliance Act (FATCA) at the American Chamber of Commerce in Shanghai, China among his many public speaking engagements.
Burton S. Roth, Attorney and Former IRS Special Agent
Burton Roth is a criminal tax attorney with over 35 years of experience in resolving both criminal and civil tax controversies with the IRS. He spent 13 years as a Special Agent with the IRS Criminal Investigation Division. He worked on many cases in a supervisory role and trained Special Agents on the intricacies involved in tax fraud cases. His years of government service and legal experience in representing taxpayers have provided him with an intimate understanding of the inner workings of the IRS.
Sandra Kouzy, Law Clerk
Sandra is a Law Clerk at Freeman Tax Law and is currently pursuing her Juris Doctor at the University of Detroit School of Law.
Footnotes and References
1. Bloomberg Law, Practice Guides & Checklists, Industry: Taxation of Cryptocurrencies
4. Bloomberg Law, Practice Guides & Checklists, Industry: Taxation of Cryptocurrencies
7. Bloomberg Law, Practice Guides & Checklists, Industry: Taxation of Cryptocurrencies
8. See article Taxation of Virtual Currency Transactions by Soheila Shahidi, Bahar A. Schippel and Matthew P. Chiarello
9. Reg. §1.1012-1(c).
10. See AICPA Comments on Notice 2014-21, dated June 10, 2016.
11. ABA Section of Taxation, Comments on the Tax Treatment of Hard Forks
12. Other examples of Bitcoin chain splits include bitcoin gold in October 2017, bitcoin dia- mond in November 2017, and super bitcoin, bitcoin hot, and lightning bitcoin in December 2017.
13. David Farmer, Update for customers with bitcoin stored on Coinbase, The Coinbase Blog (Jul. 27, 2017), https://blog.coinbase.com/update-for-customers-with-bitcoin-stored-on- coinbase-99e2d4790a53.
14. David Farmer, Update of Bitcoin Cash, The Coinbase Blog (Aug. 3, 2017), https://blog. coinbase.com/update-on-bitcoin-cash-8a67a7e8dbdf.
15. Xapo Bitcoin Cash Update, https://support.xapo.com/xapo-bitcoin-cash-update [Xapo Bitcoin Cash Update, https://support.xapo.com/xapo-bitcoin-cash-update-december-2017].
16. 348 U.S. 426, 431 (1955).
17. 252 U.S 189, 207 (1920). This case involved a number of Constitutional issues that are not relevant here. Rather, we cite the case for the proposition that realization is an important element of income.
18. Id. at 210-11.
19. Id. at 207.
20. References to a “section” are to a section of the Internal Revenue Code of 1986, as amended (the “Code”), unless otherwise indicated.
21. Reg. § 1.1001-1(a) [“either in kind or in” substituted for “in either kind or” in original].
22. 499 U.S. 554, 555,  (1991).
23. Other possible analogies to taxable transactions include dividends of property ([I.R.C.]§§ 301, 316), found property or treasure trove (Reg. § 1.61-14(a); Cesarini v. United States, 296 F. Supp. 3 (N.D. Ohio 1969)), awards (Hornung v. Commissioner, 47 T.C. 428 (1967)), or free samples (Haverly v. United States, 513 F.2d 224 (7th Cir. 1975)).
24. 348 U.S. at 431.
25. See, e.g., Maryland Casualty v. U.S., 251 U.S. 342 (1920). Even if the owner does not hold an original coin through a third-party wallet, he or she may still take no action to claim the forked currency until the security risks have been sufficiently evaluated and mitigated.
26. Reg. § 1.451-2. If the value of the forked currency is included in income immediately upon the fork, but the modifications to the blockchain are ultimately not adopted by partici- pants on the network so that the fork is not permanent and the blockchain re-merges, the owner should arguably be able to take a loss equal to its adjusted basis in the forked currency. I.R.C. § 165(c)(2).
27. See, e.g., Reg. § 1.1.1273-2(f ) [§ 1.1273-2(f )] (determining issue price for purposes of determining original issue discount).
28. See, e.g., Metz v. United States, 10 AFTR 2d 5443 (E.D. Ky. 1962); Gamble v. Commis- sioner, 68 T.C. 800 (1977); Rev. Rul. 86-24, 1986-1 C.B. 80. Other possible analogies to nontaxable transactions include the sale of minerals extracted (Reg. § 1.61-3(a)) or timber cut from land (cf. I.R.C. § 631(a)), the partition of property (Reg. § 1.61-6(a)), or the severance of a joint tenancy (Rev. Rul. 56-437, 1956-2 C.B. 507).
29. Laura Shin, Bitcoin Cash Skyrockets, Bitcoin Price Drops As Civil War Continues, Forbes (Nov. 12, 2017), https://www.forbes.com/sites/laurashin/2017/11/12/bitcoin-cash-skyrock- ets-bitcoin-price-drops-as-civil-war-continues/#3968e99135b5.
30. IRS Targets Crypto Users Who May Have Misreported Transactions, Bloomberg Law
31. IRS Exam Teams Beginning to Work Cryptocurrency Tax Cases, IRS Practice Adviser Report (BNA)
32. DOJ Tax Division Targeting Crimes Across Economic Spectrum, Tax Management Weekly Report (BNA)