TAXATION

How the IRS is dealing with this virtual conundrum

When Bitcoin started in 2009, a single “coin” was nearly worthless. It subsequently reached parity with the U.S. dollar and rose to a high near $20,000 in 2017 before plummeting again. In 2020, to stave off economic disaster due to the pandemic, governments around the world poured money into their economies, creating potential financial insecurity in the value of their currencies. Amidst that uncertainty, investors turned to virtual currencies. By October 2020, the value of a single Bitcoin had again risen to over $16,000, and it peaked five months later at nearly $60,000 before settling in the mid-$40,000s in late summer 2021. While the long-term viability of cryptocurrencies is up for debate, it is clear that they have become mainstream. Bitcoin, Ethereum, Litecoin, Dogecoin and others all are working to

claim their place in the market. Many legitimate investors now view the currencies as a diversifying part of their portfolios, and many major corporations accept Bitcoin as payment. The IRS has had their eye on the use of virtual currencies for some time, but with the increased popularity comes greater scrutiny.

What is a cryptocurrency?

The terms “digital currency,” “virtual currency” and By Robert B. Teuber, JD “cryptocurrency” are often used interchangeably. However, technically they are not the same thing. Digital currency describes any electronic currency and includes virtual currencies and cryptocurrencies. The existing IRS guidance speaks in terms of virtual currencies and defines the term as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” The IRS is clear in distinguishing virtual currencies from “real currency.” A cryptocurrency is a type of virtual currency that uses algorithms and cryptography to validate and secure transactions that are digitally recorded on a blockchain ledger. Because of the secrecy provided by the cryptography, the government is committing substantial resources to tracking and identifying transactions and owners.

Why the IRS is interested in virtual currencies

The government’s interest in virtual currencies stems from the combination of the secrecy and security associated with cryptocurrencies. The blockchain ledger system used to keep track of the currencies provides security and near anonymity regarding ownership. These features make the use of cryptocurrencies appealing to bad actors dealing in illicit behavior such as drugs, terrorism, human trafficking, extortion and tax evasion. Yet most who deal in cryptocurrencies do not have such nefarious designs in mind. Hundreds of virtual currency exchanges now exist that can be used to buy, sell and trade the cryptocurrencies. But even legitimate transactions can be hard for the government to track. In 2016 the IRS issued “John Doe” summonses to the Coinbase cryptocurrency exchange and obtained information on transactions involving $20,000 or more. In the wake of this effort, the IRS issued a series of notices to the unmasked taxpayers, encouraging them to become compliant by amending prior-year returns. The IRS has continued the John Doe effort with other cryptocurrency exchanges. The IRS’s dedication to the cryptocurrency issue is demonstrated by adding to the 2020 Form 1040 this question: “Did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” The question appears front and center near the beginning of the return and is hard to miss. If a taxpayer answers the yes or no question incorrectly, the IRS will likely view the return as intentionally false.

How are virtual currencies taxed?

The limited IRS guidance (Notice 2014-211 and Revenue Ruling 2019-242) provides that virtual currency transactions are treated as transactions in property. As property, a transaction will trigger a gain or loss that is measured against the basis of the asset. Longstanding principles concerning the taxation of property should be consulted when working with taxpayers dealing in virtual currencies. But not all principles should be taken for granted, as was recently shown in an IRS Chief Counsel Memorandum, which appears to deny like-kind exchange treatment to pre-Tax Cuts and Jobs Act transactions.3 Virtual currencies can be used as payment for goods and services, be traded for other currencies and paid to an employee or contractor as compensation.

Purchased cryptocurrency: The basis of purchased virtual currency is equal to the amount spent to acquire the currency plus fees, commissions or other acquisition costs.

Cryptocurrency received as payment: When a virtual currency is received as a payment for goods and services, the fair market value of the currency on the date received must be included in the recipient’s gross income. If the currency is traded on an exchange, reference can be made to the established exchange rate to determine the fair market value and establish basis.

Cryptocurrency used to make payment: If cryptocurrency is used to make a payment, the transaction will typically be treated as an exchange of a capital asset and trigger a capital gain or loss. Holding periods and short- or long-term gain or loss are determined under traditional concepts. The gain or loss will be measured as the difference between the fair market value of the goods or services received and the adjusted basis of the cryptocurrency. Where the currency is held as inventory (as in the case of a cryptocurrency miner holding the currency for sale), the sale proceeds constitute ordinary income. In an arm’s-length transaction, the basis of goods received equals the fair market value of the property at the time.

Cryptocurrency as compensation: When cryptocurrency is received as compensation, the fair market value of the currency at the time is included in the gross income of the

1 Notice 2014-21, 2014-16 IRB 938, 3/25/2014. 2 Rev. Rul. 2019-24, 2019-44 IRB 1004, 10/09/2019. 3 Chief Counsel Advice 202124008, 6/18/2021.

The IRS has had their eye on the use of virtual currencies for some time, but with the increased popularity comes greater scrutiny.

recipient. If received in the conduct of a trade or business, the payment will be included in gross receipts, and the net earnings from self-employment will be subject to both income and self-employment tax. If the cryptocurrency is paid to an employee, the payment is subject to income and employment tax withholding. Compensatory payments must be reported on Forms 1099 or W-2 as appropriate.

Special circumstances: In addition to Notice 2014-21 and Revenue Ruling 2019-24, the IRS website includes a series of virtual currency Frequently Asked Questions4 addressing a series of special circumstances including “airdrops” and hard and soft “forks” through which those active in cryptocurrencies may receive additional currencies. Because of the potential volatility in cryptocurrency values, the timing at which cryptocurrency in an “air-drop” is received could be significant. The FAQs discuss this timing question and other circumstances, such as gifts, donations and how to identify the specific cryptocurrency units sold in a transaction.

The future

At this time, there remains limited guidance on the taxation of cryptocurrencies. Given the presence of cryptocurrencies in the news, it is likely only a matter of time before new legislation targeting cryptocurrencies is enacted. Reporting requirements by exchanges appears likely. Until then, it is best that tax professionals ask their clients about any virtual currency holdings and the nature of any transactions involving the currencies. It is also essential that we impress upon our clients the need to maintain records concerning the acquisition and disposition of all virtual currencies and the fair market value of the currency or property involved at the time of any transactions.

4 https://www.irs.gov/individuals/international-taxpayers/frequently-askedquestions-on-virtual-currency-transactions Robert B. Teuber, JD, is a shareholder at von Briesen & Roper s.c. His practice focuses on resolving federal and state tax audits, appeals and collection matters. Contact him at 414-270-2538 or rteuber@vonbriesen.com.

ATTENTION!

THE CURRENT CPE REPORTING PERIOD ENDS DEC. 31, 2021

Reporting Period: Jan. 1, 2020 – Dec. 31, 2021 CPE Requirement: 80 total CPE credits Ethics Requirement: 3 Ethics CPE credits

Visit wicpa.org/CPErequirements for more information about CPE requirements.

The Tax Section of von Briesen & Roper, s.c. is your resource for tax situations ranging from the traditional to the most complex including: State and Federal Voluntary Disclosures, FBAR/Foreign

Issues and State Tax Nexus Studies. Our knowledge and experience have positioned us to be your trusted solution on unique tax matters. The bottom line? We get results.

To learn more about our Tax Section, please contact Robert Mathers at rmathers@vonbriesen.com.