The first IRS tax guidance for cryptocurrencies was introduced March 2014, few CPAs have done comprehensive analyses of the record-keeping and enforcement challenges that will arise from the IRS designation of Bitcoin as property rather than currency.
The sale or exchange of a convertible virtual currency has tax implications, the nature of which depends on the investment and business activity.
If you hold cryptocurrencies as a capital asset, you must treat them as property for tax purposes. General tax principles applicable to property transactions apply. Long-term gains and losses will be taxed at the taxpayer’s applicable capital gains rate which are much more favorable than ordinary income rates.
If the coins are held as a capital asset any gain or loss from the sale or exchange of the asset is taxed as a capital gain or loss. Otherwise, the investor realizes ordinary gain or loss on an exchange.
This is favorable for miners and long-term investors, since they will capture a much more favorable marginal rate. Active traders who have short-term capital gains may still face ordinary income rates.
This categorization is also unfavorable to investors with trading losses since it will be much more difficult to write off losses due to their categorization as a property rather than currency. The IRS limits the amount of property losses that can be claimed on personal tax returns to $3,000 per year for both married and single filers. Short-term trading losses in excess of this amount will be carried forward for future years.
WHAT IS MY COST BASIS FOR MY CRYPTOCURRENCIES INVESTMENTS?
Reporting and enforcement regarding the taxation for cryptocurrencies presents many challenges for the IRS and taxpayers. The IRS requires that taxpayers report the fair-market value of their coins on the date that the currency is received. Taxpayers must determine fair-market value in a “reasonable manner which is consistently applied”.
Generally, the fair-market value reported by a taxpayer disposing of cryptocurrencies should serve as the additional cost basis for the new taxpayer acquiring the currency. This is a classic example of “easier said than done” since there is no way to ensure consistent reporting, and many taxpayers may report conflicting cost basis that maximize personal tax advantages. Often it may not be possible to accurately determine a fair cost basis especially for newly created currencies.
In early IRS rulings, the agency provided guidance separating traded “convertible” virtual currencies such as Bitcoin from other virtual currencies, noting that only convertible virtual currencies that have an “equivalent value in real currency, or that acts as a substitute for real currency” will be considered taxable.
There are generally two tests to determine a virtual currency’s convertibility. First taxpayer’s should determine whether a currency is “listed on an exchange and the exchange rate is established by market supply and demand,” which would make it convertible to another “real currency” like the U.S. dollar.
This presents a gray area for virtual currencies that are thinly traded on exchanges and only trade with respect to other convertible virtual currencies. Be aware the IRS has made it clear it plans to tax gains on successful convertible virtual currencies retroactively.
The second test is to determine whether taxpayers can buy anything tangible with the currency, or if its value is instead driven by speculation. The IRS outlined, “The sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.” If a currency isn’t valuable in commerce there is a true question as to whether this will be treated by the IRS as convertible.
Traders are permitted to calculate their cost bases using different methodologies. Since currencies are considered private property from a tax perspective, investors have the option to sell their assets on a first-in-first-out (FIFO) basis, a last-in-first-out (LIFO) basis, or to sell those specific tax lots that are most efficient under the “specific share identification” method used for stocks. The choice of cost basis directly impacts long-term and short-term capital gains tax liabilities.
Trading platforms may automatically incorporate FIFO or LIFO tracking methods but neither of these options may present the most tax efficient method for a taxpayer. Generally specific share identification offers the greatest tax planning opportunities and benefits.
This is most likely the tax advantaged approach to tracking a taxpayers cost basis but it currently costly to do and often times not possible. Even the top exchanges and hosted wallets currently lack the accounting software needed to ensure trades are executed in on a share by share basis. Individuals must track their own sales which creates a high level of complexity and time commitment.
CRYPTOCURRENCIES AND WASH SALES
Since cryptocurrencies are generally classified as property, wash sale regulations should not currently be a concern for investors. This means investors can sell an investment to realize a tax loss, only to buy it back immediately thereafter at a bargain. Today, wash sales only apply to stocks and securities, so traders are operating in a gray area for now until further IRS clarification is issued.
Since cryptocurrencies have not been labeled a stock or security, the IRS can only tax traders for non-economic substance transactions under property rules. These transactions are similar to wash sales, considering the volatility of crypto markets and the potential argument that investors made late trades in response to market-moving news as opposed to tax motivations, traders have a legitimate position on the matter.
HOW CRYPTOCURRENCY MINERS CAN MINIMIZE TAX EXPOSURE AND PROTECT THEIR ASSETS
Cryptocurrency miners have two separate tax exposures. The first is the tax at the fair market value of the virtual currency on the day that it is mined into gross income. Generally, the net earnings from this activity will be exposed to self-employment tax.
The second is the capital gains which are due on the sale of bitcoins viewed as a capital asset. The basis price for the coins will be the fair market value on the date of acquisition. Capital gains will be due on the difference between that basis price and the eventual sale price.
When a miner sells their cryptocurrencies that they have mined, they will have to pay capital gains tax on any profit that they have made while owning them. The exception here is if bitcoins aren’t viewed as capital assets, but are instead viewed as inventory. This would be the case if a miner’s core business is selling cryptocurrencies. In that case, any gains on the bitcoins would be taxed as an ordinary gain or loss.
IRS Notice 2014–21 clarifies the treatment for bitcoin miners. Specifically, miners must recognize income for each bitcoin mined during the taxable year. The amount of income is equal to the market price of bitcoin on the day it is awarded on the blockchain. This also becomes the miner’s basis in the bitcoin going forward and will be used to calculate gain/loss in the future when the bitcoin is sold.
Mining expenses, such as electricity, would not be included into basis. Instead, they would be deductible in the taxable year as an expense. Miners will need to determine if their mining activity rises to the level of a trade or business, which is a highly factual determination. Maintaining proper documentation is essential.
Your choice of entity and tax treatment for your business is one of the first decisions that you will make regarding your company, and it should be with care. Like any business decision, the key to making the right choice is having the right information.
The first major step in choosing your tax treatment is selecting a business entity for your operations. You have four main choices:
• Sole proprietorship
• C corporation
• S corporation
To determine whether the S corporation is the right entity structure for your business, you have to know how it compares to your other options. The two main benefits of operating your business as an S-Corporation is relief from double taxation, and savings on employment taxes. If you are simply looking for liability protection, then single member LLC can be a less costly and complicated alternative.
If you own a C corporation, the government taxes both you and your corporation. First, the corporation pays income tax at corporate rates. Second, you as a shareholder pay tax on the dividend you receive from the corporation. S corporations pay taxes only once. An S corporation is a pass-through entity, which means that the S corporation does not pay taxes. Instead, the income, deductions, and tax credit items skip the layer of corporate tax and flow through to taxpayers via a K-1, onto their individual tax returns.
The main reason businesses or individuals choose an S-corporation tax structure is to realize tax savings on employment taxes. This is particularly valuable for miners. When you operate your business as an S corporation, you are both a corporate employee and a shareholder. As an employee, you receive a wage or salary to compensate you for the work you perform. As a shareholder, you receive distributions for your ownership stake in your S corporation. The salary paid to you as an employee is subject to employment tax. Your shareholder distributions are not. Since you set your own salary as the owner of the S-Corporation, you determine how much of the income generated by your business is subject to employment tax.
Tax planning and industry financial expertise is critical in this area. Setting your salary too low exposes you to risk of IRS examination which can result in payment of unpaid employment taxes and hefty penalties and interest. Setting your salary too high leads overpaying taxes. Over the course of your business’ life, the over-payments of tax and lost investment opportunities can cost you hundreds of thousands of dollars.
S corporations offer significant tax benefits to business owners and investors, but impose extra costs onto owners which must be considered when assessing the S-Corporation tax structure for your business. To obtain the tax benefits of an S-corporation structure, you will have to work closely with a CPA during the year on tax planning to ensure you are taking the correct measures to minimize your taxes. As previously mentioned, an annual in-depth analysis of reasonable compensation is required to substantiate your wage levels in the corporation. Additionally, S corporation tax returns are more time intensive and complex than a personal tax return and S corporations create extra tax-related paperwork each time you take money out of the corporation, so this is an additional administrative cost to consider.
TAX IMPLICATIONS FOR CRYPTOCURRENCY EARNINGS AND PAYMENTS
If you are an employer paying with a cryptocurrency, you must report employee earnings to the IRS on W-2 forms.
You must convert the cryptocurrency value to U.S. dollars as of the date each payment is made and keep careful records. Wages paid in virtual currency are subject to withholding to the same extent as dollar wages.
Employees must report their total W-2 wages in dollars, even if earned as cryptocurrency. Self-employed individuals with cryptocurrency gains or losses from sales transactions also must convert the virtual currency to dollars as of the day earned, and report the figures on their tax returns.
The best entity structure for individuals in this regard has been covered in previous articles regarding entity structure choices: https://www.camusocpa.com/tax/is-s-corporation-structure-right-for-your-business/#/