You Might Owe Cryptocurrency-Related Taxes

Got your attention? We thought so.

In a recently published Notice, the Internal Revenue Service seems to be offering some cautionary advice about the legal risks associated with using cryptocurrencies to avoid capital gains taxes.

Likely displeased by the volume of folks who have utilized cryptocurrencies to avoid reporting capital gains, the IRS may be signaling its intent to crack down on cryptocurrency trading activity.

At this point, there can be no doubt that the IRS is well aware of how cryptocurrencies are used, and how to tax virtual currencies.

The short of it is this: The IRS views cryptocurrency no differently than the U.S. dollar. Crypto-traders no longer can keep their heads in the sand, pretending the IRS does not know how to trace virtual funds back to their owners. Aliases and murky foreign jurisdictions no longer provide plausible deniability on the issue.

What Are Cryptocurrencies?

Considering that they are seemingly so new on the scene, you may be surprised to learn that cryptocurrencies actually are based on technology dating back to the 1970s. Two key patents containing the fundamental technology utilized in cryptocurrencies were issued in 1979. Those patents were used to create what we now refer to as “blockchain.”

Blockchain is a distributed public database with immutable connected records. After the patents expired in 2002, the essential components of the technology were used by Satoshi Nakamoto (maybe not a real person) to create the first blockchain in 2008. That led to the first cryptocurrency, bitcoin, which appeared the next year.

Since 2009, blockchain technology and the cryptocurrencies it supports have evolved dramatically into the global virtual currencies we think of today. The resulting proliferation of cryptocurrency products has caused a global marketplace explosion. As of this writing, there are approximately 2,300-plus different cryptocurrencies in existence.

Unlike the U.S. dollar and foreign legal tenders, cryptocurrencies are not regulated by a particular government or subject to any one country’s jurisdiction. Indeed, the very nature of cryptocurrencies is that of an anonymous tender of payment. Initially, governments around the world struggled with how to collect tax revenue on an anonymously owned asset.

Without delving into the complexities of the ownership issue, suffice it to say that cryptocurrencies pose a host of logistical and regulatory challenges — not only in locating these virtual assets, but in identifying when there is an appreciation in their value. These are uniquely challenging aspects of cryptocurrency assets.

IRS Cryptocurrency Notice – 2014

In 2014, the IRS issued Notice 2014-21 — a regulatory guidance piece — to educate taxpayers about their obligations in connection with cryptocurrency activities.

The 2014 Notice begins with the fundamental question: “How is virtual currency treated for federal tax purposes?” The IRS answer: “For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.” The 2014 Notice’s fifth question: “How is the fair market value of virtual currency determined?” The IRS answer: “For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.”Back in 2014, cryptocurrency was a relatively new mode of payment. Since then, the proliferation of its use in the U.S. and worldwide has grown exponentially.

2019 IRS Update on Hard Forks and Airdrop Deliveries

In October 2019, the IRS issued Revenue Ruling 2019-24 and frequently asked questions, or FAQs, to update taxpayers.

It set forth its reasons for issuing the guidance in a news release, “Virtual currency: IRS issues additional guidance on tax treatment and reminds taxpayers of reporting obligations.””The IRS is aware that some taxpayers with virtual currency transactions may have failed to report income and pay the resulting tax or did not report their transactions properly. The IRS is actively addressing potential non-compliance in this area through a variety of efforts, ranging from taxpayer education to audits to criminal investigations.”In today’s world of cryptocurrency, a permanent diversion of the distributed ledger is referred to as a “hard fork.” “A hard fork may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger and transactions involving the legacy cryptocurrency continue to be recorded on the legacy distributed ledger.”Another event that may take place is an “air drop” which is a means of “distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.” The IRS makes the following observation:”A hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency to addresses containing the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop.”So it seems pretty clear the IRS is working on ways to require taxpayers to report income tied to ownership of cryptocurrencies. If you have invested in cryptocurrencies, you should check the other IRS FAQs as well.