Sunday July 22, 2018
Article of the Month
IRS Tax Treatment of Cryptocurrency
IntroductionCryptocurrency is an encrypted form of digital virtual currency which has grown in prominence, as its most popular variant, Bitcoin, has exploded in value in recent years. With increased popularity comes increased curiosity as to the tax treatment of cryptocurrency. Many cryptocurrency owners have held onto this unique asset for a number of years, amassing enormous growth. Programming changes have left many cryptocurrency owners holding several forms of digital assets. These owners now wonder how their digital currency will be taxed if they transfer it and whether charitable solutions exist similar to those for gifts of cash or appreciated property.
The IRS addressed several questions related to the taxability of virtual currency when it issued Notice 2014-21. However, certain questions remain unaddressed by the Service. This article will explore the basic function of cryptocurrency and the tax treatment surrounding transfers of cryptocurrency.
What is Cryptocurrency?While Bitcoin may, at times, seem to be virtually synonymous with "cryptocurrency," it is merely the most prominent member of its class. Other cryptocurrencies, such as Litecoin, Ethereum and Ripple have become major players in the world of virtual currency. The rise in popularity of cryptocurrency has led to questions about what it is and how (or even whether) it is taxed.
In 2014, the IRS took a first step toward addressing the taxation issues surrounding virtual currencies. In Notice 2014-21, the IRS defines virtual currency as "a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value." Virtual currency has been touted in recent years as a potential replacement for standard currency. Whereas standard currency is issued and regulated by a governmental entity, virtual currency is usually decentralized and is not issued by any government.
Cryptocurrency is a subset of virtual currency. It is distinguished by its use of cryptography for security. Cryptocurrency transactions are recorded on a digital ledger known as a blockchain. As its name suggests, each transaction for the cryptocurrency creates a new block in a chain of transactions. The ledger is stored in various places and contains cryptographic identifiers, known as hashes. Each block in the chain contains its own hash and that of the previous block. The presence of these identifiers and the wide distribution of the ledger greatly reduce the blockchain's susceptibility to tampering.
How is Cryptocurrency Treated by the IRS?According to Notice 2014-21, cryptocurrency is treated as property. A taxpayer who acquires virtual currency as a payment for goods or services has a cost basis equal to the fair market value of that virtual currency on the date of transfer. Any gain or loss related to the sale of cryptocurrency is treated the same as a sale of other appreciated or depreciated property.
The type of gain or loss the taxpayer must recognize upon disposition of virtual currency "depends on whether the virtual currency is a capital asset in the hands of the taxpayer." Notice 2014-21 notes the difference in the tax treatment of capital assets, such as stocks and bonds, from non-capital assets, such as inventory. Therefore, if the taxpayer holds the virtual currency in a manner consistent with the capital asset rules, it will be taxed in the same manner as a capital asset upon disposition.
Bitcoin, for example, was created in 2009 using an algorithm that limits the total number of possible Bitcoins in existence to 21 million. New Bitcoins are discovered through a process called mining. The mining process involves the use of particular software to solve a complex equation. As more Bitcoins are discovered, the difficulty of the equations increases. In Notice 2014-21, the IRS explained that a taxpayer who has mined Bitcoins or other virtual currency has generated ordinary income through the mining activity.
If an individual holds Bitcoins or other virtual currency as a dealer-one who holds it as inventory-any increase in the value of the virtual currency will be treated as ordinary income. In contrast, a non-dealer individual investor will hold the virtual currency as a capital asset. The taxpayer will realize capital gains upon sale of the property.
Using Cryptocurrency to Fund a Charitable GiftBecause holders of virtual currency face the same capital gains tax ramifications as owners of other appreciated assets, many will find similar charitable solutions to be attractive. Outright gifts, charitable gift annuities and charitable remainder trusts are all potential solutions to the capital gains tax problem. As with other gifts of appreciated property, it is important to keep in mind that the donor will need a qualified appraisal in order to substantiate the value of a donation of virtual currency in excess of $5,000 in value.
Advisors and donors should be mindful that the relative novelty of cryptocurrency could be an obstacle in circumstances where owners wish to transfer ownership of these digital assets to charitable organizations. While there are many organizations that have begun accepting cryptocurrency donations, there are many others that have not yet tested the waters. For these organizations, charitable gifts that require a transfer of legal ownership directly to the charity may not be an option.
One alternative solution is for the owner to establish a charitable remainder trust, naming the charity as the beneficiary of the trust. The owner then transfers units of cryptocurrency to the trust, which may then sell the cryptocurrency and reinvest. This generates both a payout stream and a charitable deduction for the donor and a residual benefit for the charity, without the charity having to take ownership and possession of the cryptocurrency.
Example 2Determining the capital gains allocated to a cryptocurrency can be relatively straightforward. For cryptocurrency acquired by purchase, the owner's cost basis is equal to the amount paid for the property. The cost basis of a cryptocurrency received as a payment for goods and services is the fair market value of the cryptocurrency on the date of receipt. However, there are other ways a taxpayer may acquire cryptocurrency, which can make the valuation process more difficult.
Cryptocurrency ForksWhen a software coding change is proposed to a cryptocurrency, the change will bring about what is called a fork. The fork creates an alternate path in the blockchain. A fork may either be a soft fork or a hard fork. A soft fork will result in a change to the makeup of all future blocks in the blockchain. This might occur if there is agreement as to how the blockchain should be modified. While there is a change to all future blocks in the chain, no new asset is created in the hands of the owner of the virtual currency.
A hard fork, on the other hand, creates two divergent paths for the blockchain, resulting in completely separate cryptocurrencies. Anyone who owns units of a particular cryptocurrency prior to a hard fork will continue to own the same number of units of that cryptocurrency, along with an identical number of units of the new cryptocurrency.
Bitcoin, for example, has experienced multiple hard forks. On August 1, 2017, Bitcoin owners received the newly created Bitcoin Cash in an amount equal to the number of Bitcoins that the owner originally held. Similar hard forks occurred on October 24, 2017 and February 28, 2018, creating Bitcoin Gold and Bitcoin Private. Anyone who held units of Bitcoin prior to August 1, 2017 and did not dispose of them prior to March of 2018, subsequently held an equal number of units of Bitcoin, Bitcoin Cash, Bitcoin Gold and Bitcoin Private. Hard forks have the potential to generate extra value for the owner of cryptocurrency, since the holder of one unit of a particular cryptocurrency can eventually become the holder of units of multiple distinct and separate cryptocurrencies following a series of hard forks. However, this increase in value to the owner depends on the ability of the new cryptocurrency to gain traction in the market. If the new cryptocurrency is not well-received, the owner may end up with little or no increased value.
The pressing question for the owner of cryptocurrency acquired through a hard fork is whether the new property is treated as taxable income. Under IRC Sec. 61, gross income is defined as "all income from whatever source derived." Absent specific guidance from the IRS to the contrary, the most conservative approach is to treat the new cryptocurrency as ordinary income on the date it is created. Under this theory, the cryptocurrency owner will realize ordinary income for the year in which the hard fork occurred, equal to the new cryptocurrency's fair market value on the date of the fork.
Example 3In a letter dated March 19, 2018, the American Bar Association (ABA) Section of Taxation submitted comments to IRS Acting Commissioner David Kautter, seeking updated IRS guidance on cryptocurrencies and offering recommendations, specifically related to the tax treatment of cryptocurrency hard forks. Among its suggestions, the ABA recommended that the IRS create a temporary safe harbor for cryptocurrency holders who experienced a hard fork in 2017. The ABA Section of Taxation cited "difficult timing and valuation issues" as the impetus for the suggested safe harbor rule. The date on which an owner takes possession of a unit of cryptocurrency has been the subject of debate and may depend on whether the owner holds the unit directly or through an intermediary. A similar difficulty arises as to the valuation of the new cryptocurrency, as there are various online exchanges, each of which may provide a different estimated value on the starting date.
The ABA's proposed temporary rule would treat a hard fork as a taxable event whereby the owner of the original unit of cryptocurrency would realize taxable income with a zero basis in the newly created unit of cryptocurrency. The taxpayer would then have a capital asset that will have capital gain treatment after the owner has held it for more than one year.
Example 4The ABA's request for updated IRS guidance is just one of many attempts to clarify the tax treatment of cryptocurrency. The IRS has not responded to the ABA's request, or other similar requests for guidance, choosing instead to remain silent in the years following the release of Notice 2014-21. Professional advisors, therefore, are left to determine the proper treatment of their clients' cryptocurrencies by applying general principles of law, despite the fact that those general principles may not be directly on point for this relatively new type of asset.
ConclusionCryptocurrency is a new and constantly developing facet of the 21 st century economy. While the IRS has provided certain guidelines as to its tax treatment, and general principles of law can be used to fill in certain gaps, the ever-evolving nature of this new type of property means that additional guidance will be required in the years to come. Nevertheless, appreciated cryptocurrency may be a good asset to use to fund a charitable gift, as the owner may receive a tax deduction and be able to bypass capital gains on the cryptocurrency.
The current limited nature of the IRS's guidance regarding the tax treatment of cryptocurrencies affects owners, tax professionals and charitable gift planners, causing uncertainty over the value of potential donors' cost basis and capital gains in their cryptocurrency holdings. Cryptocurrency owners should seek guidance from their professional advisors prior to acquiring, selling or donating units of cryptocurrency. Owners should also beware that they may be deemed to have acquired new cryptocurrency during a given year, thus increasing their adjusted gross incomes, due to a hard fork.
Published July 1, 2018