The Internal Revenue Service has fired its loudest warning shots yet across the bows of bitcoin investors. In late July, the agency started sending letters to more than 10,000 cryptocurrency holders, warning that they may have violated federal tax laws.
This should not have come as a surprise to anyone, but it’s surely creating headaches for taxpayers and tax professionals who haven’t been sweating the details on cryptocurrency for the last few years. The good news is, it’s not too late to get up to speed. The bad news is, the days of getting a pass by claiming ignorance on the finer points of cryptocurrency tax compliance have come to an end.
At first, confusion about how to deal with the tax side of virtual currency was understandable. At the end of 2013, right when the cryptocurrency hype cycle was starting and bitcoin was valued at roughly $650, major banks, tech companies and accounting firms were convening industry summits to figure out whether cryptocurrency would be taxed as a capital asset, like a stock or a commodity, and thus subject to capital gains rates, or as a fiat currency, such as dollars, euros and yen, for which gains are generally taxed as ordinary income.
By March of 2014, though, the IRS had issued clear guidance on virtual currencies, explaining that it will tax the digital assets as property, not currency. What followed was a five-year drumbeat of announcements and actions that made it clear the IRS was getting serious about crypto. In November of 2016, the agency filed a John Doe summons to the bitcoin trading platform Coinbase, asking for names and other information of everyone who is trading bitcoin. Then, in the summer of 2018, as the price of bitcoin had climbed above the $8,000 mark, the IRS’s Large Business & International Division launched a compliance campaign into how investors who own bitcoin are filing their taxes.
It should have been clear by then that what was once the Wild West was now being carefully monitored. Still, the IRS warning letters issued last month caught many recipients off guard. The reason, of course, is that many people — even tax professionals — still don’t really understand the details of how cryptocurrency is being taxed.
Sure, the IRS categorizes cryptocurrency as property, but keeping track of the tax basis for that piece of property is not as straightforward as many other assets. For one, the price is wildly volatile. This July, the price of bitcoin topped $12,000, which is more than three times its value in December of 2018. In order to accurately calculate gain or loss, anyone selling their bitcoin needs to keep track of its value the day they received it and the day they sold it, and also factor in different tax brackets and other variables that can impact the total amount owed to the IRS. For those who are transacting with bitcoin frequently, those calculations can become exponentially complicated.
Fortunately, the IRS’ steady ramp-up in enforcement acknowledges this complexity, and even those cryptocurrency holders who have received letters still have time to get their houses in order. To help them get started, the following is a general primer on how virtual currency taxes will affect the three primary types of cryptocurrency holders.
Many cryptocurrency miners are under the mistaken impression that they are only subject to tax on the amount it costs them to mine the bitcoin. However, according to the IRS, when a bitcoin is mined, the miner is supposed to keep track of what the asset was valued at on that day, and subsequently treat that value as income.
Miners that are engaged in a trade or business are subject to ordinary income, plus self-employment tax. The value of the coin becomes the tax basis, and if you trade or use that bitcoin later, then you have to include in income the value of what you get, minus that tax basis. That requires onerous record-keeping, which many bitcoin miners are not currently set up to do, but is vital to staying compliant with the IRS.
Vendors accepting bitcoin as payment
In May, AT&T announced it would begin accepting bitcoin, which could well be a harbinger of the future of e-commerce. But not all businesses are created equal. A huge corporation like AT&T has armies of accountants and accounting firms to keep track of these transactions. Most, if not all, small businesses don’t have that luxury.
Take, for instance, a small retailer or a consultant that may begin accepting bitcoin. When that small business receives the cryptocurrency, that value is included in the business’s income. But at that moment in time, they now need to track their tax basis in the bitcoin they receive.
For example, if a company sells something for $5,000 in bitcoin, but then uses the bitcoin to buy something else a year later when the price has climbed to $10,000, they now have a reportable gain of $5,000. It’s easy to see how confusing this can get for businesses that don’t have the resources to employ a full-time accounting team to track the daily value of their digital assets.
While there are many different types of cryptocurrency investors, the principle for them all is roughly the same: Investors have to track when they acquire and how they use the bitcoin.
If an investor is in the business of selling bitcoin, it will be taxed differently than if an investor is engaged in casual tinkering in the cryptocurrency market. The gain recognized by bitcoin sellers will be taxed at ordinary income rates (with a top rate of 37 percent). However, those not in the trade or business of selling bitcoins will benefit from lower capital gains rates (with a top rate of 20 percent).
Employers could also start using bitcoin to pay employees. If they do that, it will add another layer of complexity because the bitcoin would need to be reported on W-2 wages, income tax withholding, employment taxes, etc.
Whether you’ve already received one of these letters from the IRS or you do in the future, it’s undoubtedly unsettling. Frankly, it seems threatening. Rest assured, though, that it is just part of the forced education process the IRS is introducing to the cryptocurrency marketplace. The IRS is essentially putting cryptocurrency holders on notice: We know you have this, and you’re probably treating it improperly on your taxes. That’s why it’s so vital that practitioners help their clients get their ducks in a row. Tax professionals need to change their practice to make sure they are asking and tracking all relevant data. Otherwise, eventually those IRS warning letters will become audits.