Taxing Cryptocurrency: What You Need to Know

by Annabelle Gibson

Cryptocurrency taxation is uncharted territory and requires deep research and analysis to ensure the most effective tax strategy is being implemented and to ensure compliance.

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The cryptocurrency market, including things such as Bitcoin, has undergone explosive growth and is now estimated at over $200 billion. Yet, despite this wildly popular and disruptive new marketplace, the federal government has been largely silent on its tax treatment, with the exception of a 2014 Internal Revenue Service Notice. This lack of guidance, coupled with government agencies such as the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) stepping in to provide regulatory guidance for the cryptocurrency market, has made gaining clarity on the tax treatment a difficult task.

This article is intended to answer the most common questions related to the taxation of cryptocurrency. It is not intended to provide legal, accounting, or tax advice for any purpose, nor is this article an exhaustive overview of the many nuances surrounding cryptocurrency taxation. Cryptocurrency taxation is uncharted territory and requires deep research and analysis to ensure the most effective tax strategy is being implemented and to ensure compliance. 

What is Cryptocurrency? 

Cryptocurrency is an open source, peer-to-peer, decentralized virtual currency. Cryptocurrency uses encryption techniques to regulate the various generation of units of currency and verify the transfer of funds. Cryptocurrency is stored in “wallets” – similar to bank accounts – that allow owners to access, use, or transfer the cryptocurrency. Since its introduction in 2009, cryptocurrency has been used as an alternative form of money, as well as a new strategy for investors and traders. While it is used as a substitute for money, cryptocurrency itself is not legal tender. 

Classifying Cryptocurrency: Property or Commodity?

Is cryptocurrency a property or a commodity? The answer is: it depends. 

If you ask the Internal Revenue Service (IRS), cryptocurrency is treated as property. But if you ask the CFTC, it is considered a commodity. In response to a Bitcoin exchange that was offering derivative contracts or options on the value of the cryptocurrency, in September 2015, the CFTC officially defined Bitcoin a commodity. Last year, a Federal judge upheld the CFTC’s position that cryptocurrency is a commodity and can therefore be regulated by the CFTC. 

So where does that leave financial executives left wondering how to classify cryptocurrency for tax purposes?  

As a general rule of thumb, the classification will overshadow other tax considerations. In other words, tax rules may operate differently depending on whether it is treated as property or as a commodity. As a financial executive, this means you must look at the transaction involved as a guide to determine the proper classification. Here are some high-level considerations. 

When Classified as Property 

General tax principles applicable to property transactions apply to transactions using virtual currencies. Taxpayers receiving cryptocurrency as payment for goods and/or services must include the fair market value (FMV) of the cryptocurrency in U.S. dollars (based on the FMV as of the date the cryptocurrency was received) in their gross income. However, the realization of income can get tricky when chain splits are involved.

When Classified as a Commodity 

When considered a commodity, tax principles applicable to commodity transactions will apply. For example, tax provisions used to determine gain or loss from wash sales, straddles, or short sales could apply to dispositions of cryptocurrency. Unique tax accounting considerations are typically necessary to adequately monitor when dispositions or transfers of virtual currency have been made.

How do you Properly Identify Cryptocurrency Dispositions?

Guidance on how to track the computation of gains and losses in the context of a “convertible” virtual currency like Bitcoin is murky. A “convertible” virtual currency is defined as one that can be freely exchanged into another virtual currency without regulatory oversight. 

Transactions using virtual currency must be reported in U.S. dollars. In addition, taxpayers are required to determine the FMV of the virtual currency in U.S. dollars as of the date of payment. However, the IRS fails to address how taxpayers should value tokens issued by companies not listed on an exchange. In addition, the IRS does not address the fact that there are numerous published exchanges, and values reported on those exchanges fluctuate. Adding to the confusion is the fact that the IRS and CFTC classify cryptocurrency differently. 

This lack of guidance can be an issue when tracking cryptocurrency transactions. Some have suggested that the use of Section 1012 tracking methods under FIFO (First In, First Out), LIFO (Last In, Last Out), or the method used for stocks sold through an exchange could simplify recordkeeping. But whichever route you take, it is important to document which method is used and why. If you are ever in an audit situation, this will help substantiate your position. 

What are Cryptocurrency Reporting and Filing Requirements?

Taxpayers working with cryptocurrency must keep adequate records and comply with information reporting requirements. 

For example, a person or business, who in the course of a trade or business makes payments with cryptocurrency valued of $600 or more, is required to report the payment to the IRS and the payee using Form 1099-MISC. Similarly, any virtual currency used as employee compensation must be reported on Form W-2. 

Failure to comply with reporting and filing requirements can result in significant penalties. Accurate records are key to accurate reporting. To avoid penalties, it behooves cryptocurrency taxpayers to implement best practices that track basis, gains, and/or losses of each transaction, including all acquisition and sell dates, and other relevant information. 

Achieving Tax Compliance Success

At this time, it is unclear if and when the IRS will provide additional guidance on the tax issues surrounding cryptocurrency. However, as the cryptocurrency market continues to gain momentum, additional regulation is likely to follow. In the meantime, organizations need a plan to ensure tax compliance. Without clear guidance, applying general tax principles most applicable to the transaction involved will be the most prudent approach. In addition, using automated tracking tools like curated news feeds and industry reports can help businesses stay on top of the dynamic cryptocurrency market, while expert guidance can help develop a feasible roadmap for tax compliance success.  

Annabelle Gibson, Esq. is the Managing Editor at Bloomberg Tax.