Contributing Author: James C Young
In Notice 2014–21 (2014–16 I.R.B. 938), the Internal Revenue Service (IRS) provided some basic answers to questions taxpayers were asking about virtual currency (also called cryptocurrency) like Bitcoin or Ethereum. Although virtual currency operates like “real” currency in some environments (e.g., the coin and paper money of the United States), it does not have legal tender status in any jurisdiction.
In its guidance, the IRS indicates that Bitcoin is not currency; rather, virtual currency is treated as property for U.S. Federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency. Among other things, this means that:
- Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W–2, and are subject to Federal income tax withholding and payroll taxes.
- Payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply. Payers are subject to the same information reporting requirements as any other payer (so, for example, a Form 1099–MISC must be issued to an independent contractor if Bitcoin payments exceed $600 per year).
- The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
- A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
PwC has an excellent primer on blockchain and cryptocurrency (including links to other reading materials). In addition, a variety of articles have been written about the topic including in the Wall Street Journal (in June 2016, August 2017), September 2018, January 2019, and September 2019) and Wolters Kluwer (CCH). The AICPA also has been active (sending a letter to the IRS asking a variety of questions) in pursuing related tax issues.
In October 2019, the IRS expanded its frequently asked questions about virtual currency. Among other things, the revised FAQs note that:
(1) A taxpayer selling virtual currency must recognize capital gain or loss on the sale. (FAQ 4)
(2)Virtual currency received in exchange for performing services is ordinary income. (FAQ
(3)A taxpayer receiving virtual currency in exchange for performing services must report income equal to the fair market value of the virtual currency (in U.S. dollars) when received. In a cryptocurrency transaction that occurs on the blockchain (an on-chain transaction), virtual currency is received on the date and time the transaction is recorded on the distributed ledger. (FAQ 11)
(4)In an arm’s length transaction, a taxpayer’s basis in virtual currency received in exchange for services is the fair market value of the virtual currency (in U.S. dollars) when the virtual currency is received. (FAQ 12) The basis of property exchanged for virtual currency is the fair market value of the property at the time of the exchange. (FAQ 17)
(5)When exchanging property for virtual currency, the gain or loss is the difference between the fair market value of the virtual currency when received and the adjusted basis of the property exchanged. (FAQ 19)
(6)The fair market value of virtual currency obtained through a cryptocurrency exchange is the amount that is recorded by the cryptocurrency exchange for that transaction in U.S. dollars. (FAQ 25)
(7)The fair market value of virtual currency obtained through a peer-to-peer transaction (not through a cryptocurrency exchange) is the fair market value of the cryptocurrency on the date and time the transaction was recorded on the distributed ledger (on-chain transaction) or, if the transaction is not recorded on the distributed ledger (off-chain transaction) when the transaction would have been recorded on the ledger if it had been an on-chain transaction. (FAQ 26)
(8)Taxpayers can use a cryptocurrency or blockchain explorer (a web browser that is used to track virtual currency transactions) to substantiate the fair market value of virtual currency (explorer value). Taxpayers who don’t use an explorer value must establish that the fair market value they used to report their virtual currency transactions is an accurate representation of the cryptocurrency’s fair market value. (FAQ 26)
(9)When selling or exchanging virtual currency, taxpayers with multiple units of virtual currency that were obtained at different times and that have different basis may choose which units of virtual currency were sold, exchanged or otherwise disposed of if they specifically identify which unit or units of virtual currency were involved in the transaction and substantiate the basis in those units. (FAQ 36)
(10)A specific unit of virtual currency can be identified either by documenting the specific unit’s unique digital identifier such as a private key, public key, and address, or 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. This information must show (a) the date and time each unit was acquired, (b) the taxpayer’s basis and the fair market value of each unit at the time it was acquired, (c) the date and time each unit was sold, exchanged, or otherwise disposed of, and (d) 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. (FAQ 37)
(11)Taxpayers who do not specifically identify units of virtual currency that are sold, exchanged or otherwise disposed of, are deemed to have sold the units on a first-in-first-out (FIFO) basis. (FAQ 38)
In addition to expanding their FAQs, the IRS issued Revenue Ruling 2019-24 answering questions from taxpayers and tax practitioners regarding the tax treatment of a cryptocurrency “hard fork, soft fork, and airdrop.”
As cryptocurrency transactions increase, the IRS is faced with enforcing these rules. Earlier this year, the IRS announced that it had begun sending letters to more than 10,000 virtual currency owners asking about non-reported virtual currency transactions. In addition, a revised draft of Schedule 1 (Form 1040) asks whether the taxpayer has engaged in cryptocurrency transactions.
Classroom Discussion
1.Have your students read the items referenced above and come to class prepared to discuss these items.
2.Here are some discussion questions:
(a)What is virtual currency (e.g., Bitcoin)? What is its purpose? How is it used?
(b)What are the tax issues regarding virtual currency? Summarize the IRS position in Notice 2014-21. What are the implications of the IRS position?
(c)Summarize the revised IRS frequently asked questions and compare it to the AICPA’s request for guidance. What tax issues regarding virtual currency remain unresolved? How do these open issues affect taxpayers and tax planning?
(d)The AICPA asks that a de minimis rule be established to exclude a small amount of virtual currency gains. Based on the AICPA letter, ask your students to define de minimis. Ask them how a de minimis rule could simplify reporting (and put taxpayers at ease) without significantly impacting Federal revenues.
SWFT CHAPTERS:
SWFT Individuals: Chapters 1, 14, 15, and 16
SWFT Comprehensive: Chapter 1, 13, and 14
SWFT Essentials: Chapter 1, 7, and 8
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