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Bitcoins

  • 7720. What is bitcoin?

    • Bitcoin and other crypto-currencies[1] are a type of virtual currency that has an equivalent value in real currency (and can often act as a substitute for real currency) so that it is often referred to as a convertible virtual currency. It can be digitally traded between users or converted into other types of currencies (including U.S. dollars).

      Crypto-currencies are not “legal tender” of public debt in virtually all jurisdictions worldwide, specifically including the U.S.A.  However, in late 2018, a web-based cryptocurrency tax payment portal, using third-party vendor BitPay (who converts Bitcoins to US dollars), was set up by the Ohio State Treasurer to facilitate the payment of corporate taxes to the State of Ohio.[2] Less than ten months later in late 2019, a new Ohio State Treasurer halted the initiative and closed down the website portal, explaining that the prior Treasurer had not followed the proper Ohio processes to acquire the third-party vendor, lack of use of the process by taxpayers, and absence of an opinion from the Ohio Attorney General that such a procedure was proper.[3]

      Crypto-currency regulation has varied across worldwide jurisdictions, ranging from none to extensive. US regulation has stepped up significantly, since then SEC Chairman Jay Clayton’s “Statement on Cryptocurrencies and “Initial Coin Offerings” (ICOs) on December 11, 2017. In fact, to better clarify the regulatory agencies to be charged with the statutory authority for the regulation of digital assets (cryptocurrency), a bill, the “Crypto-Currency Act of 2020”, was introduced in March, 2020.[4] The bill is unlikely to be addressed any earlier than 2021 in light of the pandemic and presidential election.


      [1]. See generally for background information on bitcoins and other cryptocurrencies, www.wikipedia.org/wiki/Bitcoin.

      [2]     See e.g., https://www.dispatch.com/news/20181126/ohio-to-accept-bitcoin-for-tax-payments.

      [3]      See e.g.,  https://blockchaintd.com/posts/ohio-state-stops-accepting-tax-payments-in-bitcoins.

      [4]      See HR 6154,  introduced March 9, 2020 (Rep Paul Gosar).

  • 7721. How is bitcoin and other forms of “virtual currency” taxed?

    • Until late 2019, the IRS had released very little guidance on the tax treatment of what it refers to as “virtual currency” except Notice 2014-21, which defined virtual currency as “property,” like collectible coins and antiques, which can appreciate in value. Therefore, virtual currency can be included in taxable income and taxed based the sale or exchange of such property. “Convertible virtual currency” is virtual currency that is convertible into real currencies (e.g., US dollars), or as a substitute for a real currency.  Notice 2014-21 provides the basic tax rules that currently apply to bitcoin, Ethereum and other cryptocurrency transactions.

      Under Notice 2014-21, the IRS generally treats bitcoin and other forms of virtual currency as property (and not currency that is legal tender in the United States or elsewhere). In the IRS’ own words, “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency.” This means that it is typically subject to capital gains treatment upon sale, exchange or other disposition under the general rules applicable to property dispositions, including intangible property (e.g., stocks, bonds, and collectibles).

      A taxpayer who receives bitcoin in exchange for goods or services must include the fair market value (measured in U.S. dollars) of the bitcoin received in gross income. Therefore, if the fair market value of property or currency received in exchange for the bitcoin exceeds the taxpayer’s adjusted basis in the bitcoin, the taxpayer will recognize capital gain (or loss if the fair market value of property received is less than that of the bitcoin).[1] The generally applicable holding period rules can be used in determining whether the gain or loss is long-term or short-term (Q 699). Similarly, the $3,000 capital loss limitation that can be applied against ordinary income also applies.

      If the bitcoin is held by the taxpayer as inventory or property held for sale to customers in the ordinary course of trade or business (i.e., so that the property is not treated as a capital asset in the hands of the taxpayer), the gain or loss will be treated as ordinary gain or loss in accordance with generally applicable rules. In keeping with this position, the IRS Counsel indicated in a late 2020 internal Tax Advice Memorandum that cryptocurrency paid for providing micro-services, like completing an on-line survey, processing data or reviewing images, is taxable ordinary income to the recipient, and may even be subject to self-employment taxes, depending on the circumstances.[2] Every taxable event involving a taxpayer’s cryptocurrency holdings must be reported on IRS Form 8949, Cryptocurrency Tax Form.

      While these rules seemed clear-cut, a recent letter from members of Congress to the IRS indicated that there was much uncertainty still remaining in the rules and procedures for taxing bitcoin transactions.[3] Perhaps in part as a consequence, on October 9, 2019, the IRS released Revenue Ruling 2019-24 and a set of new FAQ.

      Rev. Rul. 2019-24 and FAQ

      Revenue Ruling 2019-24 defines and addresses the income recognition of certain crypto-currency transactions/events. In doing so, it introduces two new terms into our tax vocabulary; (1) “hard fork”, and (2) “airdropped”. The ruling outlines the taxability resulting from a hard fork when a new crypto-currency is airdropped to the holders of existing crypto-currency. A “hard fork” for tax purposes occurs when crypto-currency on a ledger undergoes a protocol change that results in a permanent diversion from the legacy or existing distributed ledger. An “airdrop” is a vehicle of distributing crypto-currency to the distributed ledger addresses of multiple taxpayers.

      The IRS outlines two scenarios of hard fork ledger protocol change situations:

      (1) A hard fork ledger protocol occurs, but there is no airdrop of new cryptocurrency to current holders as part of the transaction.  Hence, the IRS indicated there is no tax event generated because no new property is received increasing a holder’s wealth (see FAQ 21).

      (2) A hard fork occurs but there is an airdrop of new cryptocurrency to the holders in connection with the hard fork. As a consequence, there is reportable ordinary income generated for a holder because of the receipt of new cryptocurrency (property) at the time of the airdrop.

      Taxability in these situations appears to be based upon the recipient-holder’s “dominion and control” over the property- the receipt of and ability to transfer, sell, exchange, or otherwise dispose of the new cryptocurrency created by the hard fork.[4] The ruling indicates that “[a] taxpayer does not have receipt of cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency.” Moreover, the ruling indicates that a hard fork is not considered a sale or exchange of a capital asset; therefore, it generates ordinary income and not capital gain.


      Planning Point: A hard fork, coupled with an airdrop, followed by a drop in value of the holder’s existing cryptocurrency, has the potential to create a wealth decrease in the aggregate for the holder with ordinary income generated at the front end and capital loss at the back of the transaction. Holders with substantial holdings might find themselves stuck with significant taxable ordinary income but an unusable capital loss. Given the likelihood of more hard forks for cryptocurrency holders, anticipatory planning is in order to prevent or ameliorate this potential outcome for the taxpayer.


      The set of IRS FAQs[5] that accompanied Revenue Ruling 2019-24 offered some useful information as well on the taxation of cryptocurrency transactions. In general they appear to reinforce the application of the basic income tax principles applicable to cryptocurrency. Although they cover various types of convertible virtual currency that are currently used as a medium of exchange, they do not address the treatment of contracts for the receipt of virtual currency.

       Cost Basis Methods: As to some specifics, the FAQs allows only two cost basis assignment methods when selling or exchanging cryptocurrency of the same type that was acquired at different times and for different prices

      • They require a taxpayer to use “first-in first-out” (FIFO) cost basis assignment methods; unless,
      • The taxpayer can specifically identify the cryptocurrency being sold or exchanged.[6]

      Prior to this guidance, taxpayers were potentially using five different methods of cost basis assignment (See Q 7723).

      Fair Market Value: The FAQs clarify that a taxpayer is required to look at the specific exchange for pricing data if the cryptocurrency was purchased on an exchange. As evidence, the IRS will accept the fair market value as determined by a cryptocurrency or blockchain “explorer” that analyzes worldwide indices of cryptocurrency and calculates the value at an exact date and time, if the transaction was not facilitated by a cryptocurrency exchange, or the taxpayer engages in a peer-to-peer transaction not involving an exchange. The FAQ does not specify which index or data source should be used. The FAQ allows the taxpayer to establish the fair market value under general valuation principles in lieu of using an explorer value. Finally, per the guidance, the fair market value of the cryptocurrency is the fair market value of the property or services exchanged for the cryptocurrency in the case of a cryptocurrency not traded on any exchange and that does not have a published value.[7]

      It is important to note that in 2019 the IRS announced[8] that it would begin sending letters to holders of various forms of cryptocurrency, including bitcoin, informing those taxpayers of potential misreporting (or failure to report) on virtual currency transactions. The IRS sent out another set of letters in August 2020.[9] The IRS advised taxpayers who receive such a letter to review past tax filings to uncover any errors or underreporting, and amend those returns in order to pay back taxes, interest and penalties as soon as possible.


      Planning Point: The IRS has recently been sending out CP2501 letters to individuals with cryptocurrency holdings.  If a client receives one of these letters, it’s important to act quickly to avoid potential penalties.  The CP2501 letter provides a taxpayer with notice that the IRS has noticed a discrepancy between reported information and other information that the IRS has received.  Any client with a discrepancy could receive a CP2501 letter.  Employers, cryptocurrency exchanges and other entities report information to the IRS.  When that information varies from what the client reports on a tax return, the IRS may issue a CP2501 letter.  These letters do not always include an amount that the taxpayer owes to the IRS.  In some cases, the taxpayer may not owe additional tax.  However, it’s important to respond by the letter’s due date to avoid a penalty.  Clients receiving CP2501 letters should review information, such as Forms 1099-B, 1099-K, 1099-MISC and any W-2s to determine whether their reporting was correct.


      These letters are part of a larger campaign designed by the IRS to crack down on misreporting or underreporting of virtual currency transactions. The IRS also announced a new Schedule 1 (to Form 1040) with a controversial, prominent Yes/No question about crypto-currency holdings and transactions for tax year 2019 returns, and doubled down by moving the question to nearly the top of page 1 of Form 1040 for 2020 tax year.[10]

      This IRS campaign to impose inclusion and taxation on virtual currency transactions has already developed a significant litigation challenge.[11] All this activity suggests the high IRS focus on income tax compliance of cryptocurrency transactions, and the need to carefully comply with IRS reporting and tax calculation guidance. Finally, it seems likely that a “yes” answer to cryptocurrency question in the 2019 or 2020 return will increase a taxpayer’s chances of incurring an audit.


      [1].     Notice 2014-21, 2014-16 IRB 938.

      [2]   See TAM 202035011 (Aug. 28, 2020).

      [3].     Letter from Rep. Jared Polis and Rep. David Schweikert to Commissioner John Koskinen, dated June 2, 2017.

      [4]  Rev. Rul. 2019-24. Also see FAQs 21-24.

      [5]   Published October 9, 2020.

      [6] See FAQs on Virtual Currency, QQ. 36-38 for details, available at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions.

      [7]  See FAQs on Virtual Currency for details, available at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions.

      [8]   IR 2019-132 (July 27, 2019).

      [9]   IRS Ltr. 6173, 6174 and 6174-A.

      [10]  See Draft Form 1040 for tax year 2020, released August 18, 2020.

      [11]  See https://blockchain.news/news/coinbase-user-sues-irs-illegal-seizure-of-crypto-records reference Harper v. Com’r, (USCT, NH July 15, 2020).

  • 7722. When is the fair market value of bitcoin used in a sale or exchange transaction determined?

    • For purposes of determining the value of bitcoin received that must be included in gross income, the fair market value is determined as of the date the bitcoin is received by the taxpayer. As in other property transactions, this fair market value forms the “basis” of the bitcoin as of that date.1 The taxpayer must determine the value of the bitcoin in U.S. dollars. This means that the basis of bitcoin will typically be its acquisition cost. In the case of a gift or inheritance of bitcoin, the basis of the bitcoin in the hands of the donor will presumably apply (this issue has not yet2 been formally addressed in official guidance).


      Planning Point: As of early 2021, proposals would require taxpayers to report cryptocurrency transactions with a fair market value of $10,000 or more.  As of the date of this publication, these proposals have not become law, but are expected to be a part of any broader initiatives to increase tax compliance.


      In some cases, virtual currency such as bitcoin will be listed on an exchange, in which case the exchange rate listed on that exchange must be used to convert the value into U.S. dollars (or some other “real” currency that can be converted to U.S. dollars).

      Late in 2019, the IRS released a set of FAQ answering questions about the tax treatment of bitcoin and other virtual currency.  One issue that commonly arose was determining how exchanges of virtual currency for other virtual currency or property were taxed.  The FAQ provide that when virtual currency is exchanged for other virtual currency, the taxpayer’s gain or loss is the difference between the fair market value of the currency received and the adjusted basis of the property disposed of.  If the property exchanged is a capital asset, capital gain or loss tax treatment will apply.  If the property exchanged is not a capital asset, ordinary income tax treatment will apply.

      When a taxpayer receives virtual currency through an exchange, the fair market value is the amount recorded by that exchange in U.S. dollars.  If virtual currency is received in a peer-to-peer transaction, fair market value is determined as of the date and time the transaction is recorded on the distributed ledger.  The IRS notes that it will accept as evidence of fair market value certain values determined by a cryptocurrency or blockchain explorer that analyzes worldwide virtual currency values. If the taxpayer does not use an explorer value, the taxpayer is responsible for establishing that the value used is an accurate reflection of the virtual currency’s value.3


      1 .Notice 2014-21, 2014-16 IRB 938.

      2. As of the date of the last review of this publication in 2020, advisors should check for any updates as guidance is coming more rapidly now as cryptocurrencies have gained more popularity.

      3. See FAQ on Virtual Currency Transactions, available at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions.

  • 7723. How does a taxpayer identify which bitcoin or other virtual currency are involved in a sale, exchange or other disposal of the virtual currency?

    • In many cases, taxpayers own multiple pieces, or units, of the same type of virtual currency that were acquired at different times and at different costs.  When a taxpayer does not dispose of all units of the type of virtual currency, the 2019 FAQ on virtual currency transaction provides that taxpayers are entitled to choose which specific pieces of virtual currency will be deemed part of the transaction.

      This election can be made either by (1) documenting the specific currency unit’s unique digital identifier such as a private key, public key, and address, or (2) by records showing the transaction information for all units of a specific virtual currency, such as bitcoin, held in a single account, wallet, or address.

      The information provided must generally include:

      (1) the date and time each unit was acquired,

      (2) basis and the fair market value of each unit at the time it was acquired,

      (3) the date and time each unit was sold, exchanged, or otherwise disposed of, and

      (4) the fair market value of each unit when sold, exchanged, or disposed of, and the amount of money or the value of property received for each unit.

      For taxpayers unable to specifically identify pieces of virtual currency involved in a transaction, a first-in, first-out (FIFO) accounting method must be used (see Q 7722).[1]


      [1] See FAQ on Virtual Currency Transactions, available at https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions.

  • 7724. How does a taxpayer report a transaction in which bitcoin or other virtual currency is involved?

    • Editor’s Note: For the first time ever, the IRS asked about cryptocurrency transactions on taxpayers’ 2020 Form 1040 federal income tax returns.  The IRS’s question asks the taxpayer if they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency at any time during 2020.  However, the IRS also released guidance clarifying that taxpayers who purchased cryptocurrency with “real” currency are not required to answer the question with a “yes” if they had no other cryptocurrency transactions during the tax year because a taxpayer who merely owns cryptocurrency is not taxed on any gains or losses until they sell or otherwise exchange the cryptocurrency.  In other words, there has been no realization event that would trigger tax liability.

      Dispositions of bitcoin as property must be reported to the IRS in the same manner as any other intangible property transactions, meaning that the taxpayer will be required to complete and file Schedule D and Form 8949, or Form 4797, to report the transaction in accordance with the instructions to those forms. The reporting requirements do not vary because the property transferred is bitcoin.[1] Each bitcoin trade should be reported separately.


      Planning Point: Taxpayers who trade in various types of cryptocurrencies should be reminded that each trade is a taxable event.  Further, IRS guidance has confirmed that pre-2018 exchanges of Bitcoin, Ether and Litecoin do not qualify for Section 1031 exchange treatment under pre-2018 law (post-tax reform, Section 1031 is limited only to exchanges of real property).  The IRS’s rationale is that these were not exchanges of like-kind property and so were taxable even prior to tax reform.  The IRS found that Bitcoin and Ether each played special roles in cryptocurrency trading because if taxpayers wanted to trade in other types of virtual currency, they had to first exchange the other currency into or from Bitcoin or Ether.  Therefore, exchanges between Litecoin and Bitcoin/Ether did not qualify as “like kind”.  Further, the IRS identified differences in design, intended use and actual use of Bitcoin and Ether.  While this guidance currently only extends to exchanges involving Bitcoin, Ether and Litecoin, it is possible that the IRS could extend the rationale to other types of cryptocurrencies.

      Taxpayers who trade in cryptocurrency under current tax rules should remember that these trades are taxable events.  For many taxpayers, the pre-2018 three-year statute of limitations may have expired if the return was filed on time.  However, a special six-year limitations period applies if taxpayers fail to report more than 25% of their income, meaning that taxpayers with substantial cryptocurrency gains in earlier years may remain exposed to tax liability, interest and penalties.[2]


      As discussed in Q 7726, employers that pay employees in bitcoin are required to report those payments as taxable compensation on Form W-2, and employers that pay independent contractors in bitcoin are required to report those payments on Form 1099-MISC.

      While the treatment of bitcoin or other virtual currencies for U.S. taxpayers with foreign accounts who are required to file FinCen Form 114, Report of Foreign Bank and Financial Account, is unclear following guidance allowing its exclusion in 2013 only, these individuals should include bitcoin unless they have a clear reason to exclude it.

      [1].     Notice 2014-21, 2014-16 IRB 938.

      [2]      GCM 202124008.

  • 7725. What considerations apply when an employer pays employees or independent contractors using bitcoin or other virtual currency?

    • If a taxpayer receives bitcoin as compensation for services provided as either an employee or an independent contractor, the value of that bitcoin is treated as either wages or self-employment income, depending upon the circumstances. The fair market value on the date of receipt will be subject to withholding (including FICA and FUTA taxes) and treated as any other compensation received by an employee (and must be reported on Form W-2). Payments can become subject to backup withholding in the same manner as when payment is made in U.S. dollars.[1] In keeping with this position, the IRS Counsel indicated in a late 2020 internal Tax Advice Memorandum that cryptocurrency paid for providing micro-services, like completing an on-line survey, processing data or reviewing images, is taxable ordinary income to the recipient, and may even be subject to self-employment taxes, depending on the circumstances. [2]  Every taxable event involving a taxpayer’s cryptocurrency holdings must be reported on IRS Form 8949, Cryptocurrency Tax Form.

      Similarly, the fair market value of any bitcoin received by an independent contractor will be subject to self-employment tax. The fair market value must be measured in U.S. dollars on the date of receipt.[3]

      If an employer makes a payment in bitcoin to an independent contractor that exceeds $600 in value (on a combined annual basis), the employer is required to report the payment to the IRS on Form 1099-MISC in the same manner as if the payment were actually made in “real” currency. Bitcoin transactions must be included when an independent contractor calculates estimated tax payments.


      [1].     Notice 2014-21, 2014-16 IRB 938. See also, IRS Publication 1281, “Backup Withholding for Missing and Incorrect Name/TINs”.

      [2]      See TAM 202035011 (Aug. 28, 2020)

      [3].     Notice 2014-21, 2014-16 IRB 938.

  • 7726. What are some of the advantages and disadvantages of using bitcoin or other virtual currency?

    • As with any other type of transaction, there are advantages and disadvantages to using bitcoin or other virtual currency as a method of payment. With bitcoin, transaction costs for transferring the virtual currency can be lower than costs charged by a financial institution or credit card company. Further, bitcoin can be transferred internationally with few complications, and without many of the fees that can apply when converting currency.

      Bitcoin can also be useful in developing countries that lack a secure banking system or stable currency. As discussed below, bitcoin can be volatile, but it is also possible that the virtual currency will be less volatile than the currencies existing in many developing nations.

      Despite this, individuals should be aware that the value of bitcoin can be volatile, and unlike currency deposits, bitcoin value is not protected by federal deposit insurance. Bitcoin is also not universally accepted—many retailers do not accept bitcoin as valid payment. Bitcoin is currently not strictly regulated, meaning that it may be difficult to challenge suspected fraudulent transactions and security may become an issue. This lack of consumer protection has made it difficult for bitcoin to enter the mainstream as a mode of payment.

  • 7727. Are there any issues that individuals or entities using bitcoin should be aware of when engaging in transactions that involve bitcoin or other virtual currency?

    • It is important that individuals or entities that use bitcoin maintain complete and accurate records of all bitcoin transactions in order to ensure that income and loss is properly accounted for. These records should include the dates that the bitcoin is acquired and disposed of, especially if the taxpayer wishes to use identification accounting. Taxes on bitcoin transactions must be paid in U.S. dollars, not bitcoin, so it is important that the taxpayer have a system in place to convert bitcoin into dollars. The IRS has now specified that absent the ability to use identification accounting, the Taxpayer must use the “First-in First-Out” (FIFO) method (see Q 7723) must be used in bitcoin transactions. Therefore, these records can be extremely important to establishing a taxpayer’s basis in the bitcoin for income tax purposes.


      Planning Point: Advisors should be aware that the value of bitcoin and other cryptocurrencies can fluctuate like any other investment, and at times can be very volatile.  Presently, advisers should probably consider a cryptocurrency investment to be a highly speculative investment. They may also wish to advise clients who already own such currencies to consider converting bitcoin to dollars on a fairly regular basis if they are not interested or able to take the risks associated with cryptocurrency price volatility. As discussed in Q 7725, most traditional consumer protection systems do not apply to bitcoin transactions, increasing the risk of fraud associated with these transactions, and regulators in the United States and worldwide are taking note. Advisors should proceed very cautiously in recommending investing in such virtual currencies.1


       


      1. The SEC and state securities regulators in the USA, and many foreign securities regulators are warning investors about cryptocurrencies, especially ICOs  – Initial Coin Offers – (so called initial coin offers in new virtual currencies.  In January 2018, the State of Texas (TSSB) took action against US_-Tec Limited (BitConnect) under Texas Blue Sky laws with an emergency cease-and desist order and later an action for a fraudulent securities issuance in connections with a first so-called ICO in the USA. Other states are taking similar steps toward regulation of virtual currencies and ICOs.  Treating the cryptocurrency as a “security” covered by the jurisdiction’s securities laws (Federal and state) seems to be the clear directions of the date of this publication in 2020.