While the number of cryptocurrencies and other blockchain-based assets continue to grow, the IRS’s published guidance is inadequate in addressing how to tax these new digital assets and transactions involving them. Nevertheless, the IRS is taking cryptocurrency compliance seriously, and can impose both civil and criminal penalties on taxpayers who are out of compliance. When preparing returns or planning a new venture in the cryptocurrency space, taxpayers can minimize these potential penalties by (1) consulting with a tax professional about proper cryptocurrency compliance and (2) obtaining an opinion from a qualified tax professional regarding the reasonableness of any tax position taken on a return.
Cryptocurrencies and other digital assets have come a long way from Bitcoin’s initial release in 2009. Not only has Bitcoin reached a high of $69,000, the blockchain technology1 behind Bitcoin and other cryptocurrencies has been used to create a myriad of digital assets like stablecoins, tokens, and digital securities. Even Wall Street is trying to get in on the action through ETFs, bitcoin derivatives, and other financial products.
Despite giant leaps in technology, there has been relatively little tax guidance. The IRS has offered a few scant documents, which largely conclude that “virtual currencies”2 are to be taxed as property. Nevertheless, this guidance is inadequate compared to the large swath of transactions and activities investors are engaging in with these digital assets. For example, activities like mining3, staking4, crypto lending, creating and buying non-fungible tokens (NFTs), or trading in stablecoins can raise uncertainties and pitfalls for taxpayers.
Classification of assets
While a large majority of cryptocurrencies meet the definition of virtual currency and are treated as property for tax purposes, it may not be so clear-cut with other digital assets. The broad category of NFTs, for example, have attributes that are different from most cryptocurrencies. While cryptocurrencies like Bitcoin are more or less fungible5, NFTs link to a specific address on the blockchain and can offer exclusive rights and responsibilities. Each NFT is unique and cannot be duplicated or replicated. Due to these differences, the fundamental question becomes, “Are NFTs virtual currency?” If not, what tax rules apply? While reasonable minds will argue about mediums of exchange, units of account, and stores of value, the safest assumption is to treat NFTs like property for federal income tax purposes.
Another interesting quirk arises from this classification as property; taxpayers may not realize that making a purchase in cryptocurrency is a taxable disposition of that cryptocurrency. For example, most NFTs can only be purchased with other cryptocurrencies, like Ethereum. Because cryptocurrencies are treated like property, a taxpayer will recognize gain or loss on the disposition of a cryptocurrency used to purchase an NFT.
Identifying the correct taxpayer
Many taxpayers are exploring the cryptocurrency space alone; however, they sometimes join forces with others in hopes of creating a profit. An individual taxpayer may set up a mining operation with a friend or family member, or two teenagers may come together to create designs to sell as NFTs. Without even realizing it, these taxpayers may have just created a partnership for tax purposes. This new partnership comes with various reporting requirements and other obligations generally applicable to partnerships.
Classification of income
Digital assets can be used in ways that may not exactly fit the “buy-hold-sell” model applied by the IRS and may therefore generate types of income that are not at first obvious. For example, a non-U.S. taxpayer who rents the use of machines maintained in the United States for purposes of mining Bitcoin may be generating U.S. sourced income. As another example, if a U.S.-based third-party validator is delegated6 staking activities, the validator may have a withholding obligation on payments made to the beneficial owner of the token. Or a taxpayer may generate interest income by lending tokens to another party. This issue is centrally important because it can affect the rights and responsibilities taxpayers have under the Internal Revenue Code.
While these examples are only a small sample of the uncertainties and pitfalls surrounding cryptocurrencies and other digital assets, the important thing for taxpayers to know is that they must properly report their activities and holdings in line with what little guidance the IRS has provided.
Tax Return Positions
Due to the uncertainties of how to tax many cryptocurrency transactions, taxpayers and the IRS can take opposing positions on the tax treatment of a specific transaction and both can justify their positions with reasonable arguments. Once a taxpayer has taken a position, however, the taxpayer must be consistent in its application of that position. Even though it may be advantageous for a taxpayer to change positions from year to year, when guidance is unchanged, it is important for taxpayers to be consistent from year to year in how they report cryptocurrency activities.
The U.S. Department of the Treasury has indicated that cryptocurrency is a current focus of IRS compliance. To that end, the IRS has been aggressive in its push to collect data and analyze potential tax evasion. The IRS has issued various summonses, which force cryptocurrency exchanges to hand over information about their clients. As clients of a cryptocurrency exchange, any number of taxpayers may be caught up in one of these information requests. Without doing anything to call attention to themselves, taxpayers may become the subject of an IRS audit and have to prove their compliance or justify the positions they took on a tax return.
These actions are reminiscent of the early 2000’s when Swiss bank accounts (and the financial assets placed there by U.S. taxpayers) became popular targets for IRS information-gathering efforts. At that time, the IRS used information gathered from the Swiss banks to go after taxpayers, both criminally and civilly, for failure to report income and disclose foreign bank accounts.
Tax Return Disclosures and Criminal Evasion
In additional to gathering information from cryptocurrency exchanges, the IRS added a disclosure to 2020 income tax returns. Located on page one, taxpayers were required to answer the question, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” It is important to note that tax returns are signed under penalty of perjury, which can carry heavy criminal penalties. For example, failure to disclose an investment of cryptocurrency on a tax return is punishable by up to five years in prison and a fine of up to $100,000 if convicted.
Civil Tax Penalties
While prison time and a $100,000 fine is used for egregious tax evasion cases, the IRS has other civil penalties at its disposal. The IRS can impose various penalties depending on the situation like penalties for failing to file a return or pay a tax or accuracy-related penalties. The accuracy-related penalties in particular can be burdensome. They are imposed on underpayments of tax; the IRS can impose a maximum penalty at a rate of 20 percent on the portion of any underpayment of tax required to be shown on a return. Moreover, the IRS can charge interest on the underpayment. Penalties and interest can quickly diminish any gains realized from cryptocurrency trading.
Luckily, however, the accuracy-related penalties may be avoidable. To the extent an underpayment is due to reasonable cause, accuracy-related penalties will not apply. While a taxpayer is not automatically absolved of a penalty merely because they consult a tax advisor, reliance on a tax advisor’s advice may provide the reasonable cause necessary to avoid a penalty. A competent tax advisor can analyze the taxpayer’s situation, provide guidance on how to treat the taxpayer’s specific cryptocurrency transactions, and provide an opinion that outlines the facts and conclusions for the taxpayer’s situation, all of which increase the likelihood that the taxpayer can rely on the “reasonable-cause” exception from accuracy-related penalties.
While the IRS has provided inadequate guidance to address every transaction a taxpayer can engage in with regard to cryptocurrencies and other digital assets, the taxpayer is required to properly report this information to the IRS. Cryptocurrency tax compliance is nuanced and uncertain. However, a taxpayer can benefit from consulting a tax advisor. A knowledgeable tax advisor can analyze the situation and document the important facts and reasoning for the taxpayer’s positions taken on a tax return. This documentation can help the taxpayer justify their position during an IRS audit and avoid the assessment of accuracy-related penalties on any underpayments of tax.
1 The blockchain is a distributed database or ledger that is shared among the nodes of a computer network. The blockchain records the provenance of a digital asset.
2 A term used by the IRS and defined as “a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value.” Notice 2014-21.
3 Cryptocurrencies use a “consensus mechanism” to verify new transactions and add them to the blockchain. Under the Proof of Work consensus mechanism, mining is the process of solving a complex puzzle to verify blocks of transactions that are updated to the blockchain. The first miner to solve the puzzle generally receives a reward.
4 Under the Proof of Stake consensus mechanism, staking is the process of locking away a certain amount of tokens in order to earn the right to validate transactions and add them to the blockchain. For the service of validating transactions, the validator is given a reward.
5 Each Bitcoin has the same rights, responsibilities, and value as any other Bitcoin.
6 Because Proof of State validation requires technical knowledge, a beneficial owner of a token may delegate its tokens to a third-party validator. The third-party validator uses the delegated tokens to earn staking rewards and then pays over a contractually agreed portion of the rewards to the beneficial owner.
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