Busayo Ogunsanya is the CEO of AMUS Inc., an artificial intelligence tax platform, and the managing partner of BigAppleTaxReturn, a CPA firm in New York.
The following article is an exclusive contribution to CoinDesk's Crypto and Taxes 2018 series.
Many cryptocurrency investors have made a fortune the past several years selling high-flying bitcoin and other cryptocurrencies for cash. Unfortunately, far too many of them in the U.S. did not report this taxable income to the IRS.
The agency figures hundreds of thousands of U.S. residents did not report income from sales or exchanges of cryptocurrency and it might be able to collect several billion dollars in back taxes, penalties, and interest.
In just a taste of what’s to come: After a two-year battle with the IRS, Coinbase, one of the largest cryptocurrency exchanges, recently turned over information about 13,000 customers who had traded more than $20,000 worth over a two-year period.
Fortunately, the IRS has issued guidance – labeling cryptocurrency an “intangible asset” for investors subject to capital gains and loss treatment using the realization method.
Nevertheless, when it comes to cryptocurrency, most investors are uncertain about the tax consequences.
To help navigate this minefield, here are answers to some frequently asked questions from investors on bitcoin and other cryptocurrencies:
How is virtual currency treated for federal tax purposes?
As property. General tax principles applicable to property transactions apply to transactions using virtual currency.
Among other things, this means that virtual currency is not treated as currency that could generate foreign currency gain or loss.
Must a taxpayer who receives virtual currency as payment for goods or services include in computing gross income the fair market value of the virtual currency?
Yes. The value must be measured in U.S. dollars, as of the date that the virtual currency was received.
How is the fair market value of virtual currency determined?
If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.
Does a taxpayer have a gain or loss upon an exchange of virtual currency for other property?
Yes. If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has a taxable gain. The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.
What type of gain or loss does a taxpayer realize on the sale or exchange of virtual currency?
The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
If it is, a taxpayer generally realizes a capital gain or loss on the sale. If not, the taxpayer realizes an ordinary gain or loss. The distinction is more than academic. Ordinary gains are taxed at the top marginal income tax rate of 37 percent, while capital gains tax rates run as high as 15 percent depending on the tax bracket.
For example, stocks, bonds, and other investment property are generally capital assets, which produce capital gains or losses. Inventory and other property held mainly for sale to customers in a trade or for businesses are examples of property that is not a capital asset and therefore would produce ordinary gains or losses.
What are tax consequences of mining bitcoin and other cryptocurrencies?
When a taxpayer successfully mines virtual currency, the fair market value of the virtual currency generated as of the date of receipt is includable in gross income.
Further, if a taxpayer’s mining of virtual currency constitutes a trade or business, and the mining activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business, less allowable deductions) resulting from those activities constitute self-employment income and are subject to the self-employment tax.
What about an independent contractor who gets paid in cryptocurrency for performing services?
Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on by the individual as other than an employee.
Consequently, the fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax.
If an employer pays workers for their services in virtual currency, is that considered taxable wages?
Yes. Generally, the medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes.
Consequently, the fair market value of virtual currency paid as wages is subject to federal income tax withholding and federal insurance contributions.
Is a payment made using virtual currency subject to information reporting?
Yes, to the same extent as any other payment made in property.
For example, a person who in the course of a trade or business makes a payment of “fixed and determinable income” using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee.
Examples of payments of fixed and determinable income include rent, salaries, wages, premiums, annuities, and compensation.
What about paying an independent contractor with cryptocurrency?
Generally, a person who in the course of a trade or business makes a payment of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment to the IRS and to the payee on Form 1099-MISC.
Are payments made using virtual currency subject to backup withholding?
Yes – again, to the same extent as other payments made in property.
Therefore, payors making reportable payments using virtual currency must solicit a taxpayer identification number (TIN) from the payee. The payor must backup-withhold from the payment if a TIN is not obtained prior to payment or if the payor receives notification from the IRS that backup withholding is required.
Are there IRS information reporting requirements for a person who settles payments made in virtual currency on behalf of merchants that accept such currency from their customers?
Yes, if certain requirements are met.
In general, a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third party settlement organization (TPSO). A TPSO is required to report payments made to a merchant on a Form 1099-K, Payment Card and Third Party Network Transactions, if, for the calendar year, both (1) the number of transactions settled for the merchant exceeds 200, and (2) the gross amount of payments made to the merchant exceeds $20,000.
When completing Boxes 1, 3, and 5a-1 on the Form 1099-K, transactions where the TPSO settles payments made with virtual currency are aggregated with transactions where the TPSO settles payments made with real currency to determine the total amounts to be reported.
When determining whether the transactions are reportable, once again the value of the virtual currency is the fair market value of the virtual currency in U.S. dollars on the date of payment.
Word to the wise
Yes, that’s a lot of information to process, but ignoring these questions can be hazardous. The IRS is going to come after investors who are not reporting their realized gains.
Complicating matters, most cryptocurrency platforms do not issue a Form 1099 (Form 1099 is one of several IRS tax forms used in the United States to prepare and file an information return to report various types of income other than wages, salaries, and tips).
I recommend investors use software that keeps track of their cost basis, unrealized gains and losses to accurate report their investment gains.
If you stay ready, you don’t have to get ready when the IRS issues an audit on your tax return for unreported income.
April 2018 calendar image via Shutterstock