Update from the Cryptocurrency Front
By Anthony Wimperis, Manager, Tax & Business Services
The IRS Takes Action
On July 26, 2019, the Internal Revenue Service issued a statement that it would be sending letters during the month of August to more than 10,000 taxpayers that the Service has deemed to own or have owned cryptocurrency accounts.
This action is the Service’s latest attempt in the ongoing battle to capture untaxed cryptocurrency transactions. The intent of these letters is to educate taxpayers about the tax filing requirements for reporting virtual currency transactions (such as Bitcoin) and to provide information about correcting errors made on previous tax returns.
Although the IRS does not specify how this list of taxpayers was obtained, some commentators believe that at least part of list was the result of the Service’s Summons of Coinbase, Inc. (one of the largest virtual currency exchanges for Bitcoin and other virtual currencies) in 2017, from which it collected the names of approximately 14,355 cryptocurrency account owners who initiated transactions of $20,000 or more between 2013 and 2015.
Three versions of the letters were issued:
Letter #6713 – Issued to taxpayers who the IRS believes have or had a virtual currency account but may not have met the U.S. tax filing requirements for cryptocurrency transactions made between 2013 and 2017. The letter requires a response from the taxpayer, either by filing a late or amended tax return or via correspondence explaining why no further reporting is necessary, including the taxpayer’s signature indicating, under penalties of perjury, that they have complied with their filing obligation. The correspondence approach may create a higher risk of audit.
Letter #6714 – Issued to taxpayers who the IRS believes have or had a virtual currency account but may not be aware of the reporting requirements. The letter is for awareness purposes only and does not anticipate that the taxpayer has done something wrong. It urges the taxpayer to check his or her records to determine if a transaction needs to be reported and take corrective action if necessary.
Letter #6714A – Issued to taxpayers who the IRS believes have or had a cryptocurrency account and met their tax filing requirements, but may not have reported a transaction correctly on their tax returns. It urges the taxpayer to check his or her records to see whether or not there is indeed an error and to take corrective action if necessary.
If it is ultimately determined that there has been an underpayment of tax as a result of transactions not reported or misreported, penalties and interest on the unpaid balance of tax will apply. Criminal penalties may also apply, depending on the severity of individual cases.
Why is the IRS Taking this Approach?
IRS Commissioner Chuck Rettig indicated in May 2019 that additional guidance will be issued by the Service to facilitate proper reporting of virtual currency transactions, but it appears that the IRS is taking action to hold taxpayers accountable for their transactions before issuing this guidance. If people are receiving notices without proper tax rules in place, why is the IRS taking this approach?
Many taxpayers are unlikely to fulfill their reporting obligations for their cryptocurrencies for a few reasons, but mainly because the administrative task of tracking virtual currency transactions for proper tax reporting is a nightmare. There is no central bank or “data hub” for all transactions. Virtual currency is not considered to be legal tender by any country. The exchanges (where the virtual currencies are traded) often do not share information with each other, although units of currency can be transferred between exchanges very easily. Many of the exchanges do not require that participants identify themselves, and in fact, anonymity is sometimes a big draw for traders with criminal intent to escape taxation or even the law in general.
Given this extraordinary complexity involved with regulating and tracking virtual currency transactions, there is currently no requirement for the exchanges to furnish 1099-Bs to participants, properly reporting sales proceeds and cost basis (similar to stocks or other investments).
To provide some perspective on the potential magnitude of this issue, it is cited on Bitcoin.com that in 2018 there were over 500 cryptocurrency exchanges in existence globally. In the same timeframe, there were more than 1,600 different types of cryptocurrencies available for purchase, according to The Motley Fool. At the time of this writing, according to CoinMarketCap.com, the total market capitalization of all cryptocurrencies was approximated $271 billion U.S. dollars. When the IRS was granted its summons to collect data on the 14,355 Coinbase, Inc. accounts in 2017, it was documented in the court order (U.S. District Court in Northern District of California) that the IRS estimated that only 800-900 taxpayers of the 14,355 holding these accounts during 2013 – 2015 tax years had filed tax returns for transactions that had a description related to Bitcoin. Given that Coinbase, Inc. operates one of the largest exchanges for Bitcoin worldwide, this has caused serious concern for the Internal Revenue Service.
How is Cryptocurrency Taxed?
Since the inception of cryptocurrencies in 2009 (with the debut of Bitcoin), there has been much confusion over how these transactions should be taxed in the United States. In fact, for the first five years, there were no tax laws or formal guidance issued by the IRS at all.
To help clear the confusion and lay the groundwork for taxing these transactions, in 2014 the IRS issued Notice 2014-21, which is a concise FAQ providing guidance on how virtual currency transactions will be taxed in the United States. In the notice, the Service takes the position that cryptocurrency is to be treated as property and NOT currency, because no country has deemed it to be legal tender. The IRS takes the position that Bitcoin and other virtual currencies hold value in the hands of the taxpayer upon receipt because they are easily convertible into U.S. dollars.
There is obviously no taxable event when U.S. dollars are converted to a virtual currency; thus, the real objective of the notice is to provide guidance on the transactions that follow the conversion once the U.S. dollars have become virtual currency – because at that point the funds would be considered “property,” and the rules concerning the exchange of property would apply.
For example, if a taxpayer (not in the trade or business of professional trading) were to convert U.S. dollars to Bitcoin and then convert the virtual currency back to U.S. dollars for a small profit, the Bitcoin would be treated as a capital asset in the hands of the taxpayer, and the sale would be taxed as a capital gain at either short-term or long-term rates. Alternatively, if the taxpayer is a professional trader, the gain would be taxed at ordinary income rates as business income.
But what if the taxpayer, instead of converting the Bitcoin back to cash, decides to do some online shopping and spends the appreciated Bitcoin on a new television set? In this case, the transaction is treated as if the Bitcoin had been converted back to cash as a deemed sale, and it will be taxed the same as in one of the first two examples above. The average taxpayer is most likely unaware of this, which adds to the virtual currency gains and losses that are underreported each year. Again, the focus of the IRS guidance is on what happens after the funds are converted into virtual currencies, because at that point the funds would no longer be considered “currency” and would be subject to the tax rules governing sales and exchanges of property.
Despite this general framework put forth by Notice 2014-21, there are several unresolved tax issues concerning virtual currencies as of this writing: the proper accounting of basis in cryptocurrency investments, given that the currency can be transferred between different virtual wallets and exchanges; whether or not the wash sale rules apply to loss transactions; whether or not retirement accounts are permitted to hold virtual currencies; and whether or not virtual currency accounts are required to be reported as foreign accounts on either Form 8938 or FBAR filings (FINCEN Form 114).
In 2018, the American Institute of Certified Public Accountants petitioned the IRS for immediate guidance on the unresolved issues within the virtual currency realm. As mentioned above, in May of 2019 IRS Commissioner Chuck Rettig indicated that further guidance will be issued on the subject, but nothing further has been released as of this writing.
Despite the unresolved tax issues and the headaches involved with tracking cryptocurrency transactions, this new round of IRS notices has indicates that the Service is going straight to the source and holding taxpayers accountable for their virtual currency transactions (rather than the exchanges). If you ultimately receive one of the IRS’s new tax notices or simply have a question about the taxability of a cryptocurrency transaction, please do not hesitate to reach out to your Marcum tax advisor for further assistance.