Digital assets continue to be a significant, but volatile, part of the financial system, with a market capitalization of approximately $1 trillion in 2023 (down from the $3 trillion value in November 2021) and an estimated 16% of adult Americans having purchased some form of digital asset. Given the magnitude of the area, multiple government agencies are tackling the impact of digital assets on everyday life.
There is a bipartisan group of senators sponsoring a bill, the Digital Asset Anti-Money Laundering Act, that would, among other provisions, expand FBAR (Report of Foreign Bank and Financial Accounts) filings to include digital asset holdings. Also introduced in the Senate is the Lummis-Gillibrand Responsible Financial Innovation Act, which includes a provision that states mining and staking rewards would not be included in gross income until the year they are sold or otherwise disposed of, essentially reversing current IRS guidance on the taxability of both validation mechanisms. On the other side of Capitol Hill, the House of Representatives would expand oversight and develop a regulatory framework of cryptocurrency in a bill passed out of the Financial Services Committee. The Securities and Exchange Commission and the Commodity Futures Trading Commission are each developing rules and jockeying for regulatory oversight responsibility around digital assets. Plus, even the Federal Bureau of Investigation has published two public service announcements around nonfungible tokens and cryptocurrencies.
However, while the world of digital assets continues to evolve, there is limited guidance on which taxpayers can rely in order to determine how their activity in this space is handled for tax purposes. This article covers material developments of digital asset taxation during the 2023 year, including various regulatory guidance, such as staking income and other clarifications. Please see our Sept. 6, 2023 alert on digital asset reporting for information on how brokers and taxpayers will be impacted by these proposed rules. Additionally, further details on the ever-changing world of digital asset taxation can be found in our 2022 year-end tax planning letter.
On July 31, 2023, the IRS issued guidance outlining its position on the taxation of staking rewards, stating:
“If a cash-method taxpayer stakes cryptocurrency… and receives additional units of cryptocurrency as rewards when validation occurs, the fair market value of the validation rewards received is included in the taxpayer’s gross income in the taxable year in which the taxpayer gains dominion and control over the validation rewards.”
Dominion and control, in this context, generally means the ownership or right to the validation rewards along with the power or authority to manage, regulate or oversee its use.
Blockchains use peer-to-peer networks to validate and record transactions. This validation is performed via one of two consensus mechanisms – proof-of-work (a process referred to as mining) and proof-of-stake (a process referred to as staking). In both systems, the user who correctly validates the transaction is rewarded with new cryptocurrency tokens. However, these validation processes are inherently different.
The recently issued guidance asserts the fair market value is determined at the time the taxpayer gains dominion and control over the validation rewards. The IRS makes clear that this concept applies to cryptocurrency staked both on a blockchain or through an exchange.
Though dominion and control usually transfer at the time the transaction is recorded on the distributed ledger, that is not always the case. Taxpayers are not considered to have dominion and control unless they have the ability to transfer, sell, exchange or otherwise dispose of the virtual currency.
Beginning with the 2020 tax year, Page 1 of Form 1040, U.S. Individual Income Tax Return has included a question regarding whether the taxpayer has transacted with virtual currency or digital assets during the tax year. For the 2023 tax year, the IRS appears poised to expand this question to other income tax returns, including Form 1120 (U.S. Corporation Income Tax Return), Form 1120-S (U.S. Income Tax Return for an S Corporation), Form 1065 (U.S. Return of Partnership Income), and Form 1041 (U.S. Income Tax Return for Estates and Trusts), based on draft versions of these forms.
In addition to the question on tax return forms, the IRS has also issued two Chief Counsel Advice (CCA) memoranda related to digital assets. While the advice contained in CCAs is not binding on the IRS and is subject to change without notice, they do offer a window into the IRS’s thinking on a particular issue. As a result, they can be useful in determining how a particular item or area should be handled for tax purposes.
In the first CCA, the IRS explains that a substantial reduction in cryptocurrency value is not eligible for a loss deduction unless there is evidence of a closed and completed transaction, a fixed and identifiable event and is actually sustained during the tax year. As a result, merely holding an investment in some form of cryptocurrency while waiting for a bankrupt exchange (i.e., FTX, Voyager, BlockFi, Celsius, Bittrex) to process itself through the courts does not entitle a taxpayer to a loss deduction on their tax return.
A second CCA issued in 2023 outlines the IRS’s position that a qualified appraisal is required for taxpayers who wish to claim a charitable contribution deduction for donations of cryptocurrency in excess of $5,000 in a taxable year. Additionally, the IRS states they do not believe that a taxpayer who determines the value of the donated cryptocurrency based on the value reported by the cryptocurrency exchanges on which the cryptocurrency is traded (rather than obtaining a qualified appraisal) will qualify for the reasonable cause exception.
In general, for contributions of property for which a deduction of more than $5,000 is claimed, the taxpayer must obtain a qualified appraisal of such property. There is an exception provided for donations of certain readily valued property, including publicly traded securities. The CCA acknowledges that cryptocurrency is not considered a “publicly traded security,” and does not meet any other exception provided. Taxpayers who fail to obtain a required appraisal and do not meet the reasonable cause exception may have their charitable contribution deduction denied.
Tax advisors are using the available IRS guidance, general tax principles and other tax law precedent to develop positions and report digital asset transactions. Any taxpayer who receives, buys, sells or gifts digital assets should consult with their Baker Tilly advisor on the tax and reporting implications prior to filing a return.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.