White paper
Accounting for cryptocurrency: A challenge and opportunity for CPA firms and professionals
Since its introduction in 2008, cryptocurrency has been gaining increased acceptance and use. That trend will continue as more people seek decentralized, private, and portable currency in a global economy.
This is good news for CPA professionals. The sheer number of cryptocurrency options is overwhelming, and there are aspects of fraud to consider, so people are likely to need advice from tax and accounting professionals.
CPAs who become cryptocurrency experts can take advantage of this opportunity. By offering cryptocurrency advice and auditing services to clients, firms can realize a new revenue source to offset the loss of other income from services such as traditional compliance work.
In this white paper, we examine the three different paths CPA firms can take to help cryptocurrency clients and the importance of continuing education for tax and accounting professionals to take advantage of these new opportunities.
How people use cryptocurrency
As cryptocurrency becomes mainstream, tax and accounting clients will likely be looking at cryptocurrency in three ways:
- As an investment vehicle. Cryptocurrency has created a huge alternative investment market for people looking to grow their money. The upside is obvious, but a lightly regulated market means the protections typically available for traditional investments may not apply to cryptocurrency.
- To transact business as either a payor or payee. While it’s difficult to make straight-to-vendor crypto transactions, a growing number of platforms are enabling businesses to take cryptocurrency.
- To raise capital, although this is less frequently the case. The ability to raise money via an initial coin offering (ICO) is attractive to businesses looking to generate capital for a product or service. The relative newness of the vehicle and the complexity of the process have constrained adoption so far.
- Blockchain: A digital, public ledger that records online transactions. Blockchain is the core technology for cryptocurrencies.
- Cryptocurrencies: Decentralized digital assets that use computer-generated cryptography as an encryption mechanism for security. Cryptocurrencies are autogenerated, which means they’re created by computing processes inside a blockchain. (“Understanding cryptocurrency: A guide for accountants,” Thomson Reuters.)
- Cryptography: The mathematical and computational practice of encoding and decoding data.
- Initial coin offering: The cryptocurrency industry’s equivalent to an initial public offering. A company looking to raise money to create a new coin, app, or service launches an ICO to raise funds. Interested investors can buy into the offering and receive a new cryptocurrency token issued by the company.
How CPAs can help: Compliance
Compliance is probably the most immediate, and most accessible, line of cryptocurrency business for firms.
To help clients file properly, firms must get educated on IRS rulings about cryptocurrency. The IRS first weighed in on cryptocurrency in 2014 with Notice 2014-21. In this, the IRS applied general tax law principles to determine that virtual currency is property for federal tax purposes.
In October 2019, the IRS issued Revenue Ruling 2019-24. This newer guidance covers “autogenerated” cryptocurrency. While the guidance is pretty straightforward for firms, clients may find it complex. Where most taxpayers deal with known and expected revenue events, cryptocurrency can present events where income is generated in ways that don’t have traditional currency parallels.
Tax and accounting professionals need to have a firm understanding of these two pieces of guidance. Since IRS guidance is constantly evolving, firms must constantly be on the lookout for changes, for what happens next, and for where the guidance goes.
Below are some common compliance questions and answers to help firms better serve clients:
How is cryptocurrency taxed?
- Virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.
- Any taxpayer who mines cryptocurrency, sells or exchanges cryptocurrency holdings, and/or receives cryptocurrency as payments for goods or services must pay taxes on it.
How is cryptocurrency fair market value (FMV) determined?
- FMV is determined by converting the cryptocurrency into US dollars based on the valuation established by whatever exchange lists it. If an exchange is not used, FMV is determined by a cryptocurrency or blockchain explorer.
Are clients responsible for gains and losses?
- Yes. If the FMV of property received in exchange for virtual currency exceeds the cryptocurrency’s adjusted basis, that is a taxable gain. If the FMV of the property received is less than the adjusted basis of the virtual currency, that constitutes a loss.
What kind of gain or loss is realized?
- In most situations, gain or loss will be capital in nature because clients typically hold cryptocurrency for investment purposes. A client will generally realize ordinary gain or loss on the sale or exchange of cryptocurrency that is not held as a capital asset.
What about cryptocurrency received by clients working as independent contractors?
- This would be included in gross taxable income and subject to self-employment tax. Also, a person who, during a trade or business, makes a payment using virtual currency with an FMV of $600 or more is required to report the payment to the IRS and the independent contractor.
What about cryptocurrency received by a client working as an employee for a business?
- The medium of compensation is irrelevant – this income is taxable alongside all other currencies.
Are payments made via cryptocurrency subject to backup withholding?
- Yes, just like other payments made on property.
Does a taxpayer realize gross income as a result of a cryptocurrency hard fork if the taxpayer does not receive units of a new cryptocurrency? A hard fork happens when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the old or existing distributed ledger. A hard fork may also result in the creation of a new cryptocurrency on a new distributed ledger.
- Following a hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger; transactions involving the legacy cryptocurrency continue to be recorded on the legacy distributed ledger.
- Revenue Ruling 2019-24 concludes that a taxpayer does not have gross income under section 61 as a result of a hard fork if the taxpayer does not receive units of the new cryptocurrency.
Does a taxpayer realize gross income as a result of a cryptocurrency airdrop if the taxpayer receives units of new cryptocurrency? Airdrops are means of distributing units of a cryptocurrency to multiple taxpayers.
- A taxpayer has ordinary gross income under section 61 as a result of an airdrop of a new cryptocurrency following a hard fork if the taxpayer receives units of the new cryptocurrency.
In some cases, firms might be preparing taxes for somebody who works as a cryptocurrency miner or converter. According to IRS guidance:
- Any taxpayer who receives cryptocurrency for their efforts realizes gross income upon receipt of that currency. These efforts can include actual mining or maintaining the blockchain ledger.
- The FMV of the currency on that day is includible in income.
- The same rules regarding self-employment tax and expenses apply to anyone compensated for their auto-generation work where they are not an employee of another business.
- The rules also affect third parties that settle payments between merchants and their customers (known as third-party settlement organizations [TPSOs]). If the number of transactions settled exceeds 200, and the gross amount exceeds $20,000, these organizations must report payments made to merchants on a Form 1099-K, Payment Card and Third-Party Network Transactions.
- Airdrop: A marketing stunt that involves sending coins or tokens to wallet addresses to promote awareness of a new virtual currency.
- Block explorer: A tool people use to view all cryptocurrency transactions online.
- Hard fork: A radical change to a network’s protocol that makes previously invalid blocks and transactions valid, or vice-versa. A hard fork requires all nodes or users to upgrade to the latest version of the protocol software.
- Zero Knowledge Proof: A digital protocol that allows for data to be shared between two parties without using a password or any other information associated with the transaction.
How CPAs can help: Advisory
Firms can move beyond tax implications to advise clients on the business opportunities and risks associated with cryptocurrency. The complexity of blockchain and cryptocurrency essentially combines all the hard work of investment advice with an evolving market and regulatory landscape.
In this advisory role, firms can offer a solid action plan that:
- Helps clients evaluate options
- Guides clients through adoption or implementation
- Identifies critical controls and metrics that can illuminate success and ensure compliance
Firms looking to offer advisory services must become experts in the market. This means understanding the currencies themselves, but more importantly, understanding the business ecosystem built around them. How are large businesses and other adopters settling their cryptocurrency transactions? What platforms are emerging, and how do they specialize? What does a typical implementation roadmap involve, from choosing a provider to integrating into backend tax and accounting systems?
Since payment platforms will drive the growth in cryptocurrency adoption, advisers should become familiar with that space and be able to help clients evaluate their options. Understanding adoption trends can also help firm clients evaluate what peers are doing in similar markets and what lessons can be learned.
When working with businesses looking to invest in cryptocurrency, tax and accounting professionals need to understand the basics of the market and be up to date on available investment vehicles. They need to be able to steer their clients into reputable currency and exchanges. Firms can also help these clients understand the tax ramifications when making investment decisions.
Businesses looking to accept cryptocurrency need advisory help considering their options. Companies can build their own mechanisms for receiving currency or leverage an off-the-shelf platform or provider. CPA firms should acquire the knowledge required – a mixture of technical, tax, and finance expertise –to help businesses evaluate these two options and proceed with confidence.
Furthermore, firms need to be able to advise clients about two primary challenges to accepting cryptocurrency:
- How is the payment actually made for companies looking to receive cryptocurrency?
- Once received, are funds stored in cryptocurrency or immediately settled and converted into regular cash? What are the implications of both approaches?
- Cold storage: An offline wallet used for storing cryptocurrency. The digital (or cryptocurrency) wallet is stored on a platform that is not connected to the internet, thereby protecting the wallet from unauthorized access, cyber hacks, and other vulnerabilities.
- Cryptocurrency exchange: An exchange where users can buy or sell cryptocurrencies using electronic monetary units, fiat currencies, or other digital assets.
- Cryptocurrency wallet: An app that allows cryptocurrency users to store and retrieve their digital assets.
- Decentralized exchange: A peer-to-peer (p2p) online service that allows direct cryptocurrency transactions between two interested parties.
How CPAs can help: Audit
This is the most difficult service to provide. The private nature of cryptocurrency makes auditing assets and establishing controls difficult. How do you inject trust into an ecosystem built and sustained on being trustless? How can a firm gain visibility? How can auditors build controls into a blockchain that is controlled by a collective?
Then, there is a lack of external regulations. Without guidance from the IRS and other authorities, customers have had little to no external pressure to demonstrate real visibility and transparency into cryptocurrency holdings. The pressure has mainly come from internal stakeholders and business partners.
Plus, there is a lack of tools. To gain access to cryptocurrency holdings, auditors need specialized tools that can offer visibility into assets without sacrificing the blockchain’s core privacy principles. Auditors need to be able to:
- Certify proof of control
- Determine true valuation
- Verify private transactions vs. public blockchain
Overcoming these obstacles, though, will be beneficial for firms because we see a need in this path: 70% of big firm customers expect help with blockchain audits. (“How blockchain can drive finance and audit performance,” Forbes, February 18, 2019)
Auditing for cryptocurrency requires a deep understanding of the underlying blockchain. It also requires firm staff to understand how controls – mechanisms of trust – can be built into the blockchain. This must be the starting point for the education needed to start reskilling.
- Proof of stake: A concept that states a person can mine or validate block transactions according to how many coins they hold. The more Bitcoin or altcoin owned by a miner, the more mining power they have.
- Wallet address: Similar to a bank account number, a wallet address is a unique 26–35 digit combination of letters and numbers.
- Vanity address: A cryptocurrency address with certain starting letters that spell out words such as a person’s name or company’s brand.
Conclusion: On becoming a cryptocurrency compliance, advisory, or audit expert
Firms looking to build out their cryptocurrency capabilities need to start by getting educated in the space. This is the critical first step to equip their firms or practices with the knowledge and skills they’ll need to help their clients embrace the opportunity while always keeping an eye on risk.
Luckily, more resources are coming online explicitly designed for accounting firms. From industry webinars to CPE materials, the volume of information available continues to increase over time. Firms would be smart to consider which cryptocurrency path – compliance, advisory, or audit – is best suited to their skills and client needs. Then, as competency increases, so can the services and expertise firms can offer.
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