By Anthony Diosdi
Cryptocurrency and blockchain technology have grown in popularity and ubiquity in the past few years. Bitcoin and other forms of cryptocurrency have experienced unprecedented growth in recent years, leaving many investors with unexpected large gains. The growth in the cryptocurrency has also caught the attention of the Internal Revenue Service (“IRS”). As a result, the number of IRS audits of cryptocurrency transactions has been on the increase. This article focuses on how cryptocurrency holders can survive an IRS.
Introduction Cryptocurrency Technology and the Taxation of Cryptocurrency
Cryptocurrency relies on blockchain technology for record keeping. A blockchain organizes information added to ledgers known as blocks or groups of data. Each block can hold only a certain amount of information. As a result, new blocks are continuously added to the ledger to form a chain. When a block is filled, itr is finalized, and each block in the chain has a precise timestamp that serves as a digital signature.
Cryptocurrency is treated as property and currency for the purposes of U.S. federal tax law. This is a departure from the rest of the world which treats cryptocurrency the same as fiat currency or currency issued by the government that is not backed by a physical commodity. As a result, gain or losses in cryptocurrency is recognizable and taxable every time cryptocurrency is sold or used to purchase goods or services. The sale or exchange of property is taxed at long or short term capital gain rates. To determine the amount of capital gain or loss on the sale or exchange of cryptocurrency, a holder of cryptocurrency must know the basis of his or her cryptocurrency and the fair market value of his or her cryptocurrency when it is sold or transferred. In order to determine the proper capital gain rate, the cryptocurrency trader must determine how long the virtual currency was held before its liquidation.
Short-term capital gain is gain occurring from the sale or exchange of virtual currency when it is held less than one year. Long-term capital gain is gain that occurs from the sale or exchange of virtual currency when it is held for more than one year. Under the current tax rates, long-term capital gains are taxed up to 20 percent, plus 3.8 percent Net Investment Tax (“NIT”) in certain cases. Short-term capital gains rates are taxed at rates up to 37 percent, plus 3.8 percent NIT in certain cases.
The Importance of Properly Determining Basis in Cryptocurrency
Anyone trading cryptocurrency must determine his or her basis in the virtual currency. Determining basis in cryptocurrency is not only important to determine one’s tax liability when trading virtual currency, it is equally important to surviving an IRS tax audit. Cost basis is the amount an investor spent to acquire an asset such as cryptocurrency. At first glance, calculating the cost basis in cryptocurrency seems simple. The cost basis is the amount an investor spent to acquire the cryptocurrency. This includes the purchase price, any transaction fees, commissions paid, and any other relevant costs. However, determining the basis in cryptocurrency quickly becomes more difficult after this initial stage. The main reason it can be difficult to determine the basis of cryptocurrency is the method used to acquire the virtual currency. Cryptocurrencies are often acquired through a cryptocurrency trading platform or exchange. In these cases, the cost basis of the cryptocurrency is the amount that is recorded by the cryptocurrency exchange for that transaction. However, if the acquisition of the cryptocurrency happens “off-chain,” which means the transaction is not recorded on the distribution ledger, then the basis is the amount the virtual currency was trading for on the exchange at the date and time the transaction would have been recorded on the ledger if it were on “on-chain” transaction. If cryptocurrency is acquired in a peer-to-peer transaction or some other transaction that does not involve a platform or exchange, the basis of the cryptocurrency is determined as of the date and time the transaction is recorded on the distribution ledger or would have been recorded on the ledger if it is an “off-chain” translation.
The method of acquiring cryptocurrency is not the only factor that determines the cost basis of cryptocurrency. The cost basis of an investor’s cryptocurrency depends on his or her method of tax accounting. There are three methods of tax accounting for purposes of cost basis calculation:
1) Determine cryptocurrency taxation under first-in, first-out (“FIFO”). FIFO is an assumption that the first goods acquired or produced should be assigned to the first goods sold.
2) Determine cryptocurrency taxation under last in, first-out (“LIFO”). LIFO is an assumption that the cost of the goods most recently acquired or produced should be assigned to the first goods sold.
3) Determine cryptocurrency taxation under the highest-in, first-out (“HIFO”) method. HIFO is used when inventory with the highest cost of purchase is the first to be used or taken out of stock.
A simple example how a cryptocurrency trader would calculate his or her basis would be as follows; suppose an investor uses FIFO to determine his or her tax basis and the investor acquired one Dogecoin in 2018 and two Dogecoin coins in 2019. If the investor sells two Dogecoins in 2021, the trader would use the cost basis for the one Dogecoin purposed 2018 and the cost basis for the Dogecoin purposed in 2019 to his or her tax basis.
Determining cost basis becomes more complicated if there are multiple coin transactions. For example, assume that a cryptocurrency investor has 10 coins of virtual currency at a cost of $1 per coin acquires additional virtual coins at the following times and costs:
Assuming that 12 coins remain on hand at the end of the year, it is necessary to determine what portion of the $51.50 aggregate cost should be allocated to these 12 virtual coins. Under LIFO, the ending inventory of virtual coins would be deemed to cost $12.04 (consisting of a layer of 10 virtual coins at $1.00 per coin and a layer of 2 coins at $1.02 per coin). The balance of $39.46 would be allocated to the cost basis. Under FIFO, the ending virtual coin inventory would be deemed to cost $12.68 ((10 x $1.06) + (2 x $1.04)), and the balance of $38.82 would be allocated to the cost basis.
Another challenge in basis calculation is when an investor exchanges one cryptocurrency for another cryptocurrency. In these cases, investors often cannot directly purchase new virtual currency using fiat currency. Instead, the cryptocurrency can only be acquired through major cryptocurrencies such as bitcoin or ethereum. only by exchanging major cryptocurrencies. From a cost basis calculation point of view, the exchange of cryptocurrency is crucial because one capital asset is being liquidated to purchase another capital asset. This type of transaction not only triggers a taxable event from the disposition, but it also requires the basis to be calculated on the newly acquired cryptocurrency.
Prior to the IRS releasing its FAQs on virtual currency, it was thought that since virtual currency is usually held for investment purposes, like stock, it should be subject to the same basis and accounting rules as stock and as such, unless other specific exceptions are made. The FIFO method should be used in identifying which ‘coin’ is sold or transferred, which determines the gain or loss of the transaction. One of the exceptions to FIFO as it relates to stock as if there can be “adequate identification.” The obvious issue with adequate identification is whether that could ever be applied to virtual currency. With bitcoin, for example, there is no actual “coin;” it is just an entry on a distributed ledger. The IRS provided guidance in its FAQs that permit investors to choose which units of virtual currency are sold if those units can be “specifically identified.” If the units of virtual currency are not specifically identified then the first in, first out method is to be used. An investor can use specific identification by documenting the specific unit’s unique digital identifier, such as a private key, and address, or by records showing the transaction information for all units of a specific virtual currency held in a single account, wallet, or address.
The Taxation of Mining Cryptocurrency
We often hear of mining cryptocurrency. Cryptocurrency mining is the process in which transactions between users are verified and added to the blockchain public ledger. The process of mining is also responsible for introducing new coins into the existing circulating supply. The IRS has not provided a large amount of guidance regarding the taxation of mining virtual currency. The primary source of discussion is found in Notice 2014-21, which states the following:
Q-8: Does a taxpayer who “mines” virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) realize gross income upon receipt of the virtual currency resulting from those activities?
A-8: Yes, when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. See Publication 525, Taxable and Nontaxable Income.
Pursuant to IRS Notice 2014-21, the mined virtual currency has a fair market value, and is included as gross income, as of the date of receipt. The fair market value of the cryptocurrency is determined as of the date and time the transaction is recorded on the distributed ledger.
The Tax Controversy of Hard Forks
In 2018, the IRS launched a virtual currency taxation awareness campaign that evolved into a targeted compliance effort in 2019 aimed at taxpayers with virtual currency transactions who failed to report the resulting income and pay the associated taxes. In 2019, the IRS also issued Revenue Ruling 2019-24 which provides guidance regarding the taxation of “hard forks” and “air drops.” For the most part, a hard fork is a blockchain software update used to correct security flaws that adds new functions or reverses transactions. Hard forks do not undo a network’s transaction history, hard forks do create a permanent divergence from the previous blockchain that may require the forced exchange of the old network’s virtual currency for the virtual currency of a new network. A hard fork also results when there is a split in a cryptocurrency’s blockchain.
In brief, a hard fork represents a permanent change to the coding of a virtual currency’s underlying blockchain that necessitates the creation of a separate and distinct cryptocurrency. A hard fork will impact the basis and taxation of cryptocurrency. However, the IRS and the Department of Treasury have yet to issue comprehensive guidance in this area.
There are currently three theories as to how a hard fork will impact the basis and taxation of cryptocurrency. Some view a hard fork as the receipt of a new asset. Under this view, the investor would recognize ordinary income on the opening market value of the new cryptocurrency against the cost basis of the ordinary acquired cryptocurrency. A second view is to treat a hard fork as a spinoff or stock split in which the existing cryptocurrency splits into two. Under this theory, the virtual currency trader would immediately recognize income on the new cryptocurrency received and would split with the cost basis tacked on the original cryptocurrency between the two using the respective market values following the split using the best available data. Anyone considering taking this position should understand that the IRS would likely challenge it. This is because this theory does not fit well into the existing provisions allowing for nonrecognition treatment. A third approach and final approach is to apply a zero basis to the new cryptocurrency. The rationale behind this approach is that although the new cryptocurrency may be a new asset, the validity of the cryptocurrency market makes assigning a market value immediate to it difficult. Anyone virtual currency transfer involved in a “hard fork” transaction, should seek professional advice as to how to report the transaction.
Finally, another transaction unique to cryptocurrency is the airdrop. IRS Rev. Rul. 2019-24 explains that investors who receive an “airdrop” of units of new virtual currency to their digital wallet after a hard fork realize ordinary gross income on the date the new currency is received regardless of whether that currency is converted into U.S. dollars.
The challenge with this treatment is taxpayers may not be aware that an airdrop has occurred.
Surviving an IRS Audit by Being Able to Substantiate Basis in Cryptocurrency
Probably the most important planning consideration to surviving an IRS audit is to properly determine the basis in cryptocurrency and to substantiate the basis. If a trader had a gain or loss in cryptocurrency, the trader will need to be able to substantiate his or her basis in the virtual currency in an IRS audit. Sometimes cryptocurrency traders can utilize informational forms to determine taxable basis in cryptocurrency. For example, a trader of cryptocurrency may receive a Form 1099-K to determine the total value of cryptocurrency assets received during a year. A trader may receive a Form 1099-B which provides a list of transactions with the cost basis in crypto assets. A cryptocurrency trader may utilize these forms to determine a cost basis and taxable gains for cryptocurrency transactions. However, utilizing this method may result in the overpayment of taxes. This is because these tax forms do not always not take into consideration a number of deductible costs that can reduce the taxable gain associated with the disposition of cryptocurrency.
In most cases, a better way to determine cost basis in cryptocurrency is to utilize a number of reputable crypto tax software. Software programs typically automatically aggregate transactions across cryptocurrency traders wallets and exchanges. As a result, in many cases, software programs can calculate the cost basis, net gain or net loss, and populate the required IRS forms. However, software programs are not always the answer. Problems occur determining taxable basis when a trader transacts in wallets off exchange or with peers.
In the event of an IRS audit, traders of cryptocurrency keep detailed records as to how their basis is computed. Traders of cryptocurrency should be prepared to answer a number of questions that will come up in an audit. The most common questions that will likely be asked in an IRS cryptocurrency audit as as follows:
1) The IRS will likely ask all wallet identification information and blockchain addresses held by the cryptocurrency trader;
2) The IRS will typically want to know all digital currency exchanges and peer-to-peer facilitators used by the cryptocurrency trader;
3) The IRS will typically ask for the date and time of all cryptocurrency acquisitions;
4) The IRS will ask the cryptocurrency trader to provide the cost basis and fair market value of the cryptocurrency at the time of acquisition;
5) The IRS will ask the cryptocurrency trader to provide fair market value of the cryptocurrency at the time of sale, exchange, and the amount of money paid to acquire cryptocurrency;
6) Finally, the IRS will ask for an explanation of the method used to compute the cost basis in cryptocurrency.
If a cryptocurrency trader cannot properly answer any of the aforementioned questions or the IRS finds any irregularities, the audit may escalate. This will increase the probability for an unfavorable income tax adjustment or the assessment of penalties.
Don’t Assume that the IRS Will Not Seek Outside Assistance to Find Unreported Cryptocurrency
There are still cryptocurrency traders who assume that they can keep their cryptocurrency transactions hidden from the IRS. This is a very dangerous assumption. The IRS has been utilizing summons and other information to detect unreported cryptocurrency transactions. The IRS has partnered with high powered law firms to assist in the past. The IRS may do the same exact thing in the future to go after individuals with unreported cryptocurrency in the future. By way of background, in 2014, the IRS retained the California law firm of Quinn Emanuel Urquhart & Sullivan LLP to assist it in a transfer pricing case with Microsoft Corporation. The retention of Quinn Emanuel was authorized by the regulation under Internal Revenue Code Section 7602. Under these regulations, third-party contractors (such as lawyers) can even attend witness summons interviews and provide assistance to the IRS in the questioning of witnesses. We are at the early stage of the IRS investigation of unreported cryptocurrency. The IRS will likely partner with a number of third-party contractors to assist IRS agents in finding unreported cryptocurrency. The best way to survive an IRS cryptocurrency audit is to make sure all cryptocurrency and cryptocurrency transactions have been properly disclosed for income tax and reporting purposes.
IRS Cryptocurrency tax audits are on the rise. If you have cryptocurrency, you should prepare for an IRS audit proactively. Make sure that you maintain records of your cryptocurrency transactions and have these translated into U.S. dollars. You should also maintain records as to how you determined the basis of your cryptocurrency. These records should be maintained indefinitely. The IRS may have been slow to audit returns over the past couple of years, but the IRS has stepped up its enforcement of cryptocurrency transactions. By keeping your risk of an IRS audit in mind and accurately recording your transactions, you can minimize your exposure to costly tax adjustments, penalties, and interest. In the event you are audited by the IRS, you should seek the assistance of a qualified tax attorney. We have consulted and represented hundreds of clients audited by the IRS.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.