Authored by Michelle Hobbs and Brad Polizzano
When the Internal Revenue Service (IRS) first issued tax guidance on virtual currency, a single Bitcoin was worth approximately $573. At the time of this writing, that value has increased to over $55,000. As a result, the IRS and other federal government agencies continue to expand efforts to enforce reporting compliance for taxpayers that transact in virtual currency. In fact, Congress is currently negotiating stricter reporting requirements on the part of brokers and other handlers of virtual currency in the infrastructure and reconciliation bills. Furthermore, the Department of Justice indicated in a legal filing that there could be instances where virtual currency may not always be considered property for federal tax purposes. This article summarizes key recent developments as well as information to assist taxpayers with proper reporting on 2021 tax returns and other filings.
The largest revenue-raiser included in the infrastructure bill, estimated to generate $28 billion over 10 years, results from increased enforcement on cryptocurrency transactions. Reporting requirements to the IRS for brokers would now include virtual currency transactions, including purchases, sales, transfers and transactions exceeding $10,000.
Specifically, the bill would expand the definition of the term “broker” to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” In addition, the definition of specified securities would include “any digital asset.” The bill states, “Except as otherwise provided by the Secretary, the term ‘digital asset’ means any digital representation of value that is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.” Since reporting would not be required until 2023, brokers would have some time to update systems in order to comply with the proposed rules.
There are no new requirements for individual holders of cryptocurrencies. However, once effective, taxpayers could expect to receive detailed reports of their digital asset transactions such as sales price, basis, and dates purchased and sold. The projected revenue increase is a result of the IRS’ ability to “match” the information reported by the broker to what is disclosed on an individual tax return (as they currently do with W-2s, 1099s, etc.). Presumably, Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, would be modified or replicated in order to collect this information.
This provision received significant pushback from the cryptocurrency industry. The main complaint being an expansive definition of broker could have unintended consequences, subjecting rigid reporting requirements to nonfinancial intermediaries, including crypto miners, who may not have the ability to comply. Despite a last-minute bipartisan attempt to narrow the scope of this provision (excluding certain crypto and clarifying the definition of “broker”), the proposed changes did not make it into the final bill. These scope adjustments may instead be brought into the reconciliation bill.
While there may or may not be upcoming legislative changes to virtual currency reporting, the IRS remains committed to examining these transactions in an effort to determine the identity of taxpayers and their related unreported federal income tax. Given the sheer number of virtual currency types and their increasing usage, the IRS has been targeting certain cryptocurrency exchanges requesting specific data about a subgroup of their account holders in order to locate those taxpayers who are underreporting the tax on their transactions. A provision in the Internal Revenue Code allows the IRS to ask a court’s permission to obtain tax-related information when the taxpayer’s identity may not be known, otherwise referred to as a John Doe summons. However, in order to protect taxpayers, a John Doe summons generally must be narrowly tailored to meet the IRS’ specific needs. While not all John Doe summons are successful, the IRS has received, in the past few years, authority to investigate the Coinbase exchange as well as the Circle Internet Financial and Kraken exchanges.
Data requested by the IRS in these John Doe summonses, specific to virtual currency, typically includes six categories of records on U.S. account holders with accounts worth at least $20,000, between specific years:
In certain cases, courts have stipulated further narrowing of the above categories before allowing the IRS to proceed. These John Doe summonses permit the IRS to order these virtual currency exchanges to provide the specified information. The IRS then contacts the respective taxpayers, usually starting with CP 2000 letters. Taxpayers then respond by filing amended tax returns or through IRS examination. In some cases, criminal investigations are started.
Furthering the government’s priority of enforcing virtual currency reporting and taxation, the IRS has rolled out “Operation Hidden Treasure.” Personnel from the agency’s civil office of fraud enforcement and the criminal investigation unit have been jointly tasked with examining tax evasion among users of virtual currency. These agents will concentrate on taxpayers that omit such income from their tax returns. Areas of focus include:
The IRS is also working with consultants to analyze blockchain activity in an effort to ascribe virtual currency connections to the appropriate taxpayers. The IRS will consider civil and criminal penalties as well as other actions on those taxpayers omitting such data from their tax returns. In some cases, civil penalties could equal 75% of the understatement of tax.
Nonfungible tokens (NFTs), a quickly growing digital asset, function similarly to virtual currency but instead represent or link to tangible assets such as art, music, videos (including GIFs or sports highlights), collectibles and other physical collector’s items. NFTs are bought and sold using a blockchain (most often on the Ethereum blockchain). They are created from digital objects representing tangible and intangible items and convey exclusive ownership rights.
While the IRS has not specifically addressed the taxation of NFTs, given their proximity to virtual currency, they too are likely being taxed as property. Depending on its characteristics, certain NFTs could be classified as collectibles and therefore subject to the higher 28% long-term capital gains rate.
Slightly modified from 2020, the 2021 draft Form 1040 asks the following question on Page 1: At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency? The question appears underneath the name and address fields.
In December 2020, the Financial Crimes Enforcement Network (FinCEN) announced its plans to propose regulations that amend the rules implementing the Bank Secrecy Act. FinCEN intends to include virtual currency as a type of account reportable on a Report of Foreign Bank and Financial Accounts (FBAR) on FinCEN Form 114.
At this time, FinCEN has not yet issued those proposed regulations nor is it clear whether any anticipated guidance would be effective for 2021. Also unknown is whether the definition will include virtual currency held in “cold storage” wallets under self-control on a hard drive and assets held on a virtual currency exchange located outside of the United States. Furthermore, how the value of the accounts should be measured for FBAR reporting purposes when the assets are not held in U.S. dollars is not defined.
Additional information will be provided on the impact of FBAR reporting after FinCEN issues the proposed regulations.
On Dec. 18, 2020, FinCEN proposed U.S. anti-money-laundering regulations that would expand the application of U.S. anti-money-laundering rules to virtual currency. Expected to be finalized in November 2021, the regulations would impose reporting and record-keeping requirements on banks and money services businesses (MSBs), including many virtual asset service providers, that facilitate transactions in convertible virtual currencies and legal tender digital assets with self-hosted wallets and hosted wallets held in jurisdictions identified by FinCEN as primary money laundering concerns.
More specifically, the two main components of the proposed regulations require banks and MSBs to (1) report certain virtual currency transactions with unhosted wallets and otherwise covered wallets exceeding $10,000; and (2) maintain internal records for certain virtual currency transactions with unhosted wallets and otherwise covered wallets exceeding $3,000.
The IRS defines “virtual currency” as a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), which functions as a unit of account, a store of value or a medium of exchange.
A transaction involving virtual currency includes:
Virtual currency can operate similar to coins and paper money as used in the United States but generally does not have legal tender. Some forms of virtual currency have an equivalent value in real currency. A taxpayer’s basis in virtual currency is the fair market value (as measured in U.S. dollars) as of the date of receipt. Fair market value is determined by a virtual currency exchange or a real currency exchange that can be converted into U.S. dollars.
Virtual currency continues to be taxed as property. Basically, this means when property is acquired in exchange for virtual currency, the taxpayer recognizes a taxable gain if the fair market value of the property exceeds the adjusted basis in the virtual currency used to effect the transaction. However, as noted earlier in this article, there may be some potential changes from the Justice Department implying virtual currency could be taxed as something other than property. This could be a seismic change in how virtual currency is taxed and reported in certain, as yet undefined, circumstances.
Payments for services to employees and independent contractors in virtual currency are taxable (valued at fair market value and measured in U.S. dollars at the date of receipt) and subject to the same withholding, self-employment tax and reporting rules as amounts paid in real currency. In on-chain transactions, this value is determined on the date (and time) the transaction is recorded on the distributed ledger.
If a taxpayer exchanges property for virtual currency and the fair market value exceeds the taxpayer’s basis in the virtual currency, the taxpayer has a taxable gain. The character of such gain depends on whether the virtual currency is a capital asset in the hands of the taxpayer. Sales of virtual currency will likely result in recognizable capital gain or loss, subject to the same tax rules as traditional property. However, the wash sale rules do not apply at this time. Virtual currency held for more than one year prior to sale or exchange will result in long-term capital gain or loss treatment. The holding period begins on the day after acquisition and ends on the date of the sale or exchange. Gain or loss is the difference between the adjusted basis and the amount received in exchange for the virtual currency.
The IRS has a FAQ page on virtual currency, available here.
Following is a glossary of certain terms used in the cryptocurrency world:
For more information on this topic, contact our team.
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.