Cryptocurrency Taxation: Understanding What the IRS Wants
Last year, right before taxes were due, the IRS came out with new guidance, reminding taxpayers that their income from virtual currency (or cryptocurrency) transactions needs to be reported on their tax returns. And although most people try to forget about taxes unless they are due, it is prudent to prepare ahead of time and understand IRS requirements to be able to deliver when the time comes in 2020. Here is our attempt to decipher what the IRS wants with respect to cryptocurrency.
The IRS issued Notice 2014-21 to introduce guidance on the federal tax treatment of cryptocurrencies. It defined cryptocurrency as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” It is important to understand; however, that this guidance applies only to convertible cryptocurrencies – those that have an equivalent value in real currency or that act as a substitute for real currency.
The IRS is very clear about convertible cryptocurrency being treated as property for tax purposes, not as foreign currency. As a property, cryptocurrency is subject to the same general rules, specifying inclusion in gross income, the character of gain or loss, or the basis of virtual currency, etc. One of the most common uses of convertible cryptocurrency transactions is investment. If someone purchases bitcoins, for example, for investment purposes, the tax treatment is similar to buying and selling stock.
The basis in the virtual currency is the adjusted basis (the cost basis plus commissions or other purchase fees). The holding period begins on the date one purchases the virtual currency. When individuals sell or exchange the purchased bitcoins, they should recognize a capital gain or loss and report it using Form 8949 and Schedule D (Form 1040).
Buying and selling virtual currencies as an investment is similar to buying and selling stocks. Yet, virtual currency is not a stock or a security. Therefore, the sales transactions will not be reported to the IRS and to the individual taxpayer on Form 1099-B.
Because they are not likely to receive information documents, it is especially important that those who invest in virtual currency maintain detailed records of their transactions in order. This will help to ensure that they properly report their gains or losses on their income tax returns.
Trade or Business
There is a growing number of people using cryptocurrency in new and existing businesses. However, even though many of these people are using virtual currency as a medium of exchange, the IRS treats virtual currencies as property, regardless of how they use it. Here is a common example. If self-employed taxpayers receive virtual currency as part of their trade or business, then the virtual currency is treated as self-employment income. Luckily, there are ways to determine if one is in a trade or business or whether an activity is a business or a hobby.
The IRS guidance indicates that someone who receives the cryptocurrency in exchange for services must include its fair market value on the date it was received. That fair market value is the basis of the currency. If the virtual currency is then exchanged for other goods, the taxable gain or loss will equal to the difference between the basis in the virtual currency and the fair market value of the property received.
Needless to say that those who receive cryptocurrency as a payment for services should retain records of the transactions, so they can later substantiate their income and basis. It is very difficult to try to remember or collect all the necessary numbers later, when the tax return is due.
Paying Employees and Contractors
If someone pays employees with crypto, the payment is still subject to social security tax, Medicare tax, and federal income tax withholding, as if it had been paid in US dollars. As usual, employers are required to report the payment of virtual currency on Form W-2. Employment taxes would need to be paid or remitted to the IRS in real currency like USD (not cryptocurrency).
In case someone needs to pay an independent contractor with virtual currency as compensation for services, the Form 1099-MISC would have to be issued. That is if the total fair market value of payments to the independent contractor for the year equals or exceeds $600.
According to the IRS, a cryptocurrency miner has to include the fair market value of the mined crypto in taxable income as of the date when the miner acquired it. Just like when investing, if a miner later disposes of the virtual currency, he or she will recognize a gain or loss. If someone is in the business of mining cryptocurrency, then his or her income will be subject to self-employment tax.
In terms of valuation, the fair market value is determined on the date of payment or receipt. If there is an established exchange that lists the cryptocurrency and it uses rates based on the exchange as established by market supply and demand, then the exchange price can be used. It remains unclear; however, how to value crypto that is not listed on an exchange. Either way, no matter which technique is used for valuation, it must be rational and consistent.
It is a good idea to keep all of the above in mind, while also looking out for another guidance from the IRS that may come out in the next few months to remind taxpayers yet again about what they need to do with respect to cryptocurrency.