The prevalence of cryptocurrency—or what the Internal Revenue Service (IRS) refers to as “virtual currency”— in investing and financial transactions has increased significantly in recent years. While the IRS and other government agencies have been clear about their focus on the future oversight of these transactions, taxpayers continue to lack clear guidance in evolving areas of the industry.
This article discusses U.S. federal tax consequences for businesses and individuals that hold or transact in virtual currency, including for U.S. investors in foreign companies that engage in these transactions, as well as newly proposed U.S. information reporting requirements. Taxpayers should consider their cryptocurrency transactions when planning for their 2021 tax liabilities and reporting compliance.
Taxation of Cryptocurrency
IRS Notice 2014-21 provides that virtual currency is treated as “property” (not “currency”) for U.S. federal tax purposes. As such, the general tax principles that apply to property transactions also apply to transactions using cryptocurrency. Common cryptocurrency transactions include:
- Earning cryptocurrency through “mining” or “staking”
- Receiving cryptocurrency as payment for goods or compensation for services
- Using cryptocurrency to pay for goods or services
- Exchanging one cryptocurrency for another cryptocurrency
- Converting cryptocurrency to or from “fiat currency,” including the U.S. dollar
According to IRS guidance, the following general rules apply when determining how to treat transactions involving cryptocurrency for federal tax purposes:
- A taxpayer that receives cryptocurrency as payment for goods or services, or through mining or staking, must include the fair market value (FMV) of the cryptocurrency received in its gross taxable income. The FMV of the cryptocurrency is measured in U.S. dollars as of the date of receipt and becomes the taxpayer’s basis in the cryptocurrency.
- If the FMV of property received in exchange for cryptocurrency exceeds the taxpayer’s adjusted basis in the cryptocurrency exchanged, the taxpayer has taxable gain. Conversely, the taxpayer has a loss if the FMV of the property received is less than the cryptocurrency’s adjusted basis. This general rule also applies when one cryptocurrency (e.g., bitcoin) is exchanged for another cryptocurrency (e.g., litecoin).
- Most taxpayers realize capital gain or loss on the sale or exchange of cryptocurrency. Certain specified taxpayers (such as dealers of cryptocurrency) realize ordinary income or loss on the sale or exchange of cryptocurrency.
- There are no immediate tax consequences when a taxpayer purchases cryptocurrency with cash.
For example, if an investor purchases a bitcoin for $30,000 and later exchanges the bitcoin for litecoin at a time when the bitcoin trades at $35,000, the investor recognizes a $5,000 capital gain on the exchange. Similarly, if an investor purchases a bitcoin for $30,000 and later uses the same bitcoin to purchase a car worth $40,000, the investor recognizes a $10,000 capital gain. The gains and losses are reported on Form 8949, Sales and Other Dispositions of Capital Assets.
U.S. International Tax Considerations
Foreign Personal Holding Company Income
A U.S. shareholder of a controlled foreign corporation (CFC) is subject to U.S. taxation on the “Subpart F” income generated by the CFC. A U.S. shareholder is defined as a U.S. person owning 10% or more of the vote or value in a CFC. A CFC is any foreign corporation if more than 50% of the stock by vote or value is owned by U.S. shareholders.
Subpart F income consists of several categories of income, one of which is “foreign personal holding company income” (FPHCI). FPHCI is defined under Section 954 of the tax code and includes gains from transactions involving commodities – although “commodity” is not specifically defined. However, the Section 954 regulations note that the term commodity “includes tangible personal property of a kind that is actively traded or with respect to which contractual interests are actively traded,” and the IRS has stated that virtual currency is treated as property for federal income tax purposes. Additionally, in the preamble to the final Section 954 regulations, the IRS rejected the argument that the regulations should apply only to commodities that are actively traded on a regulated exchange and, instead, stated that Section 954 is intended to apply broadly to any type of commodity that is actively traded.
Concluding that cryptocurrency is a commodity for purposes of Section 954 may mean that the related income, gain or loss is FPHCI. However, exceptions may apply for:
- Active business gains and losses from the sale of commodities, if substantially all the commodities of the CFC constitute active business property; and
- Income, gain and loss derived by a “regular dealer,” as defined under Section 954, that would ordinarily be treated as FPHCI.
Passive Foreign Investment Companies
Generally, a foreign corporation is considered a passive foreign investment company (PFIC) if it satisfies either an income test or an asset test, subject to certain exceptions. The income test is satisfied if at least 75% of its gross income for the tax year is passive income (generally, dividends, interest, rents and royalties). The asset test is satisfied if at least 50% of the average percentage of assets held by such corporation during the tax year (measured by reference to gross asset values at the end of each quarter) are assets that either produce or are held for the production of passive income.
If a foreign corporation or foreign fund holds or trades in virtual currencies, there is a risk that it may be a PFIC, which would likely trigger certain U.S. federal income tax consequences and strict reporting obligations for U.S. owners.
Foreign Currency Gain or Loss
Section 988 of the tax code outlines the rules governing the treatment of the exchange gain or loss from transactions denominated in a currency other than a taxpayer’s functional currency (foreign currency gain or loss). For transactions using cryptocurrency, Notice 2014-21 provides that cryptocurrency is not treated as currency that could generate foreign currency gain or loss. However, since the guidance in Notice 2014-21 was based on a law in force at that time, it leaves open the possibility that foreign currency gain or loss could apply to virtual currencies in the future.
Other Tax Considerations for Cryptocurrency
Taxpayers that hold or transact in cryptocurrency should also consider the following:
- Capital losses from sales of cryptocurrency should be eligible to offset capital gains from other transactions.
- Charitable taxpayers may be able to lower their tax bills through donations of cryptocurrency. If the cryptocurrency has been held for more than one year, a deduction is allowed for the FMV of the cryptocurrency at the time of the donation. If the cryptocurrency has been held for less than one year, the deduction is the cost of the cryptocurrency.
- The “wash sale” rule generally disallows a deduction for a loss on the sale of stock or securities when the taxpayer purchases the same stock or securities 30 days before or 30 days after the sale that triggered the loss. Although there is no clear guidance as to whether the wash sale rule applies to cryptocurrency, there are reasonable arguments that the wash sale rule should not apply to cryptocurrency transactions because cryptocurrency is neither considered a stock nor a security for tax purposes. However, considering there may be potential for abuse, taxpayers who want to take advantage of the wash sale rules on their cryptocurrency transactions should be aware of the risks of penalty and are encouraged to consult with their tax advisors.
Cryptocurrency Information Reporting Requirements
Cryptocurrency exchanges and brokers have applied inconsistent approaches when reporting cryptocurrency transactions that take place on their platforms. These approaches include:
- Filing Form 1099-B to report details of cryptocurrency transactions, much like how stock transactions are reported;
- Filing Form 1099-K, which only discloses the gross amount of payments, leaving out many of the transaction details; or
- Doing nothing as far as reporting cryptocurrency transactions, asserting that none of the current tax reporting requirements apply to them.
Due to the lack of detailed reporting and the continued difficulty in identifying taxpayers with cryptocurrency transactions, in 2016 the IRS began issuing “John Doe summonses” to cryptocurrency exchanges to obtain cryptocurrency information, a practice that has been upheld in court.
In addition, since 2020, individuals have been required to answer on page 1 of Form 1040 whether they received, sold, sent, exchanged or otherwise acquired any financial interest in any virtual currency during the taxable year.
Failure to timely or correctly report cryptocurrency transactions may be subject to accuracy-related or information reporting penalties.
Information Reporting Proposals
On August 10, 2021, the U.S. Senate passed the “Infrastructure Investment and Jobs Act,” which would impose information reporting requirements for brokers or any person who is responsible for regularly providing any service effectuating transfers of digital assets, including cryptocurrency, on behalf of another person. The measure would also add digital assets to current rules that require businesses to report cash payments over $10,000. These provisions would apply to returns required to be filed after Dec. 31, 2023. The House is expected to take up the bill in late August.
In addition, it is worth noting that the Biden Administration has proposed providing $80 billion to the IRS to collect unreported taxes, pointing to cryptocurrency as a big area of concern. The Administration’s proposal aims to double the IRS workforce over the next 10 years. If passed into law, individuals who make more than $400,000 a year likely will face a higher risk of tax audit, including audits of cryptocurrency investments and transactions.
The cryptocurrency industry is still in its infancy. As the industry continues to evolve, our team will monitor and keep you up to date on the impacts it may have on your taxes. If you have any questions regarding your tax planning, reach out to your trusted advisor or start here.
This article originally appeared in BDO USA, LLP’s Tax Strategist (August 2021). Copyright © 2021 BDO USA, LLP. All rights reserved. www.bdo.com