Catching up with cryptocurrency

Mainstream interest in receiving and trading cryptocurrencies (crypto) has increased among individuals and corporations. This article reviews what we know regarding the tax treatment of crypto so far, examines current proposals, and offers expert insight on common questions.

This new digital space can be intimidating for the uninitiated and just as confusing for those who hold or plan to trade cryptocurrency. There is a demand for crypto assistance that can “help explain to folks what is this and what’s happening” so they can make informed decisions, Julio Jimenez, a principal at Marks Paneth, told Checkpoint in an interview.

What taxpayers should be aware of when dealing with digital assets

“What events result in a taxpayer receiving ordinary taxable income as opposed to an asset subject to capital gains tax?” is the most frequently asked-about tax matter regarding the nature of digital assets such as cryptocurrency, digital tokens, or non-fungible tokens (NFTs), Julio Jimenez explained.

If someone receives cryptocurrency due to a transaction, the fair market value is treated as ordinary income. Also, if someone uses computer resources to validate transactions on the blockchain in a process known as “mining” and receives a cryptocurrency reward, the miner includes the value of the reward at the time it’s received in their gross income.

Rev Rul 2019-24 clarified two situations where a taxpayer may have gross income. A “hard fork” occurs when a cryptocurrency’s code changes and results in a split, with one branch following the old protocol and the other following the new one. Users upgrade their software as a new currency is created.

The bottom line for tax purposes is that if a hard fork occurs on a taxpayer's cryptocurrency, they only have gross income if they receive units of a new cryptocurrency. The same applies to “airdrops” of new cryptocurrencies following a hard fork. An airdrop, the IRS explained, “is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.”

• Owners of multiple crypto “wallets” — where a taxpayer’s cryptocurrencies are digitally stored — should note that transfers between wallets aren’t taxable events, as no assets are transacted with another party.
• The $15,000 gift tax annual limit also applies to gifts of crypto, meaning total gift amounts in a year under that threshold aren’t subject to the gift tax.

Timeline of guidance and rules

The IRS first established its position nine years ago in Notice 2014-21, defining 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.” Expanded FAQs were eventually released in 2019, clarifying that a cryptocurrency is a type of virtual currency that “uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.”

So-called stablecoins, or “convertible virtual currencies” like Bitcoin, have an equivalent value in fiat currency. For instance, one Bitcoin is worth over $29,000 at the time of writing. However, despite the implication of the word “currency,” the key takeaway from the IRS notice is that for federal tax purposes, virtual currencies are considered to be property, to which general tax principles for property transactions apply.

This means that a taxpayer may realize a gain subject to capital gains tax in various transactions, such as selling cryptocurrency for cash, paying for goods and services, or exchanging a form of cryptocurrency for another — like-kind exchange rules don’t apply. Like other capital assets, the tax rate depends on how long the cryptocurrency is held.

Short-term capital gains apply to transactions involving assets held less than a year and are taxed at the same rate as ordinary income. Long-term capital gains are subject to rates of either 0%, 15%, or 20%, depending on income and filing status. Cryptocurrency holding periods begin the day after the asset is received. The fair market value of cryptocurrency is determined at the time of receipt.

For example, assume a taxpayer buys one Bitcoin worth roughly $30,000. The initial transaction is not a taxable event. The taxpayer has an annual income of $100,000. Six months after acquiring that Bitcoin, they exchange it for U.S. dollars when it’s valued at $40,000. In this scenario, the taxpayer recognizes a $10,000 gain subject to short-term capital gains tax at their income tax rate. Based on current tax brackets, the $10,000 would be taxed at 24%. Conversely, if the Bitcoin is exchanged 18 months later and is valued at $40,000, the $10,000 gain would be taxed at 15%.

For compliance purposes, tracking the original cost basis for denominations of cryptocurrency is vital. The IRS recommends having records of each “unit” as described in the FAQs — including the date and time acquired — and the fair market value at the time.

What about non-fungible tokens?

Non-fungible tokens are unique digital assets derived from blockchain technology that can take various forms, such as artwork, music, or in-game items. Although their purpose and function are distinct from a “currency,” tax treatment rules for purchasing an NFT are similar.

“The act of buying an NFT, just like buying any asset, does not by itself create a taxable event. Whether buying an NFT is a taxable event depends on the medium of exchange used to purchase,” Trudie Kanter, a partner in the tax services group at Crowe, told Checkpoint.

“If using cash … there is no taxable event,” she said. “If using a digital asset to purchase the NFT, there could be a taxable event because the purchase using the digital asset is treated as a disposition of such asset, which could generate taxable gain or loss.”

For more NFT tax coverage, see “IRS Issues guidance, seeks comments on NFTs.”

Security or commodity?

In recent years, there has been ongoing discussion and a desire to clarify whether cryptocurrencies should be categorized as commodities or securities — or neither — for federal income tax purposes. Ultimately, this would affect which government agency has regulatory authority. If cryptocurrencies are treated as securities like stocks or bonds, the Securities and Exchange Commission would apply laws under the Securities Act of 1933.

Alternatively, the Commodity Futures Trading Commission could treat cryptocurrencies as a form of goods, more akin to oil or metals, pursuant to the Commodity Exchange Act of 1936. Reuters recently reported that the SEC uses the so-called Howey Test to determine whether an asset is an “investment contract” and thus a security.

On April 18, 2022, the New York State Bar Association Tax Section submitted a report to top officials at the Treasury Department requesting guidance on the security/commodity issue concerning cryptocurrencies and other fungible digital assets.

“The desire for guidance on the tax treatment of digital assets is significant and extends to a multitude of tax provisions,” the report said. “However, the diversity of digital assets, and the rapid pace at which new digital assets are being developed, makes providing a comprehensive set of recommendations to address all or even most of the significant issues affecting digital assets unrealistic.”

Among the NYSBA’s recommendations were to apply Code Sec. 864(b)(2)(B) commodities trading safe harbor rules to cryptocurrency and to allow Code Sec. 475 market-to-market elections for cryptocurrencies only if they qualify as actively traded property as described by Code Sec. 1092(d)(1), assuming the CFTC has jurisdiction.

Who is a broker?

At the time of writing, there have been no proposed regs following the enactment of the infrastructure bill to clarify the definition of a broker as it pertains to those who deal in cryptocurrency. Depending on interpretation, the expanded definition under this new statute that will take effect next year could apply to considerably more parties than perhaps initially intended by lawmakers. The IRS could ease the minds of many taxpayers with guidance just on this point alone.

In December of 2021, a bipartisan group of senators wrote a letter addressed to Treasury Secretary Janet Yellen asking for clarification on to whom the provision applies. As enacted, it could technically “capture certain individuals who are solely involved with validating distributed ledger transactions through mining, staking, or other methods, and entities solely providing software or hardware solutions enabling users to maintain custody of their own digital asset wallets,” the letter read.

Given the slim party margin in the Senate, new laws governing crypto — especially those wrapped up in larger packages — face an uphill battle to reach the president’s desk. Jimenez said, “everyone was shocked to the core” when the digital asset reporting requirements survived in the infrastructure bill’s final version. It seemed a sure thing that if there were something that would be carved out, it would be that, according to Jimenez.

The private crypto lobby was “pushing last minute talking to the Senate. Everyone thought this was going to get yanked out. It didn’t,” Jimenez said. In light of that unexpected development, regulations on who is a broker is necessary “so that we know how [Form] 1099 and U.S. payment reporting works.”

New reporting rules for brokers

The most recent major crypto development was the Infrastructure Investment and Jobs Act (IIJA; PL 117-58), signed into law on November 15, 2021, which featured two provisions affecting the crypto marketplace. First, Code Sec. 6045 was modified to require brokers, or anyone “responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person,” to report digital asset transactions on Form 1099-B in a way similar to some securities. Reported details include sale proceeds, basis, and dates. The Act defines a “digital asset” as any digital representation of value recorded on a cryptographically secured distributed ledger or any similar technology.

Further, crypto transactions in excess of $10,000 must be reported on Form 8300, and digital assets are treated like cash. These reporting changes take effect for applicable transactions occurring after January 1, 2023, and for reports due after December 31, 2023. To learn more, see the “Executive Summary: Infrastructure Investment and Jobs Act” and “Client Letter: IIJA New Digital Asset Info Reporting,” a sample client letter breaking down these provisions.

Also, the IRS has announced that brokers will not be required to report or furnish additional information concerning dispositions of digital assets under Code Sec. 6045, issue additional statements under Code Sec. 6045A, or file any returns with the IRS on transfers of digital assets under Code Sec. 6045A(d) until it issues final regs (Ann. 2023-2; IR 2022-227).

The reporting rules for digital assets were originally scheduled to come into effect for returns or statements required to be filed or furnished after December 31, 2023, that is, for post-2022 transactions.

Until the IRS issues final regs pursuant to section 80603 of the Infrastructure Investment and Jobs Act (PL 117-58, IIJA) under Code Sec. 6045, a broker may report gross proceeds and basis as required under existing law and regs as of December 23, 2022. In addition, until the IRS issues final regs pursuant to IIJA section 80603 under Code Sec. 6045A, a broker may furnish statements on transfers of covered securities as required under existing law and regs as of December 23, 2022.

For more information on the broker requirement to report digital assets, see “Checkpoint's Federal Tax Coordinator ¶S-3707.”

The need for guidance

It would be a gross understatement to say that there is an appetite among practitioners and their clients for more guidance. The IRS has been slow in keeping up with cryptocurrencies and how the technology is used. While the agency often directs most questions to their existing guidance — particularly the FAQs — there has been a deluge of speculation on how specific crypto situations could be treated on the tax end.

New questions arise daily as individuals and corporations find roadblocks where there is no reliable answer from the federal government. “The blockchain world is evolving at a breakneck pace, and there are many areas in which the IRS has yet to provide specific guidance,” Raghuvanshi and the Greenberg Traurig team said.

Although it would be an impossible task to identify everything we don’t know, some questions are squarely in the minds of lawmakers and industry experts. The following are some examples of pressing hot-button crypto issues.

A note on terminology

It can be easy to use terms from the crypto glossary interchangeably, but the distinction between specific words is becoming increasingly relevant despite their overlap in meaning. With the timeline of developments from the initial 2014 notice through the infrastructure bill now reviewed, let’s recap the nomenclature before moving on to future considerations.

As noted above, President Joe Biden’s administration has been using the definition of digital asset to encapsulate both fungible and non-fungible digital assets, such as cryptocurrency, which is a type of virtual currency, and NFT, a specific piece of content that isn’t “spent” like money.

Some common cryptocurrency terms include:

• Bitcoin is a type of digital currency that uses cryptography to secure and verify transactions and operates on a decentralized peer-to-peer network.
• Stablecoins like Bitcoin are convertible to fiat currency.
• Utility tokens are tokens issued that offer their holders access to a product or service.
• Security tokens are considered ownership of a stock or security.
• In this context, the difference between a coin and a token is that tokens don’t have their own native blockchain.

“To date, the IRS has painted a very broad brush by characterizing all cryptocurrencies as property for tax purposes, without making any distinction between different types of cryptocurrencies,” a team of tax professionals at Greenberg Traurig told Checkpoint in comments curated by shareholder Pallav Raghuvanshi.

For more on the nuances between these terms, see “ABA tax meeting: Why words matter when taxing crypto.”

Current administration’s policies

Following the passage of the infrastructure bill, the Biden administration has taken steps indicating that compliance enforcement, new regulatory authority, and risk assessment will be key focus areas moving forward.

On March 9, 2022, the president signed an executive order laying out his digital asset plan, calling for more oversight over cybersecurity and bad actors by effectively centralizing the digital asset world. This begins with a review of a potential Central Bank Digital Currency (CBDC). Biden instructed a concert of top agency officials to submit a report on “the future of money and payment systems” within 180 days.

Such a sweeping review will examine digital payment technologies, the interplay of related market forces, and the effect of modernization on the U.S. economy. For more information, see “President Biden signs executive order on digital assets.” The executive order can be seen as the beginning of a campaign to crack down on digital asset-related schemes and other white-collar crimes, or at the very least, an acknowledgment that crypto is likely not going anywhere anytime soon. The value of Bitcoin rose after this move, though the volatile cryptocurrency is prone to massive fluctuation.

Later in March, the administration released the fiscal  2023 “Green Book,” which serves as a platform for outlining budget proposals for the next fiscal year. Biden’s fiscal 2023 agenda includes a trio of modernization-themed rule changes to accommodate digital assets. The first has to do with crypto lending and would provide that securities loan nonrecognition rules apply to loans of actively traded digital assets recorded on cryptographically secured distributed ledgers if the loan terms are similar enough to securities loans.

The Green Book argued that the recent growth in digital asset trading justifies this expansion and that “taxpayers should be required to take income accruing on the asset into account as they would do absent the loan.” The proposal, which would take effect for returns filed starting in 2024, would give the secretary of the Treasury the authority to determine when a digital asset is actively traded and potentially later apply the rules to non-actively traded digital assets.

The next two proposals would take Biden’s digital asset compliance efforts to the international stage via the Foreign Account Tax Compliance Act (FATCA). One proposal would create a new reporting requirement category under Code Sec. 6038D(b). Taxpayers in the U.S. holding an aggregate value of over $50,000 in cryptocurrency and related digital assets in a “foreign digital asset account” would report this information to the IRS. Doing so would crack down on tax avoidance behavior by crypto investors and apply to returns filed after December 31, 2022.

“The global nature of the digital asset market offers opportunities for U.S. taxpayers to conceal assets and taxable income by using offshore digital asset exchanges and wallet providers,” according to the Green Book. For more on the proposed rules, see Treasury Eyes New Reporting Rules for Foreign Digital Assets.

Finally, the Green Book suggests that the U.S. would bolster its automatic information sharing with other countries. Specifically, U.S. digital asset exchanges would have to disclose information on substantial foreign owners of some passive entities. Certain financial institutions would also need to report the account balance “for all financial accounts maintained at a U.S. office and held by foreign persons,” which includes digital asset brokers, likely under the definition provided by the infrastructure bill. The proposal would be integrated with existing law and be effective for returns filed beginning in 2024.

The “Wild West” of the current state of digital asset trading has attracted investors with a promise of decentralization, unburdened by regulation or red tape. Depending on whom you ask, the Biden team’s position could either be seen as a vehicle for bringing legitimacy to this adolescent space or a big government sticking its nose where it doesn’t belong and crashing the party. The IRS, naturally, is motivated by capturing revenue from unreported transactions and closing the so-called tax gap. Many investors simply want to know what is expected of them to avoid audits, according to Jimenez.

Income sourcing and staking

Determining the source of income and which jurisdiction has the authority to impose tax is tricky, especially for transactions involving multiple countries.

A team of Skadden Arps lawyers wrote in January in a post on the firm’s site that this “is particularly difficult in a world of the distributed ledger,” which makes finding a solution “critical to establishing the existence of branches or permanent establishments under tax treaties.” The global tax community will need to address this as more countries hitch their wagon to the Organization for Economic Cooperation and Development’s two-pillar model. Differences in income-sourcing laws between nations are complicated enough without factoring in the tax treatment of digital assets. Meanwhile, El Salvador adopted Bitcoin as legal tender in September 2021; the Central African Republic followed suit in April this year.

Another unanswered and consequential matter is the treatment of income from what is known as “proof of stake,” a cryptocurrency consensus mechanism for validating blocks on the blockchain. The goal of proof-of-stake is to reduce the negative impacts on the environment from the traditional mining process, whereby an individual with multiple dedicated computers can consume enormous amounts of energy by trying to gain as many token rewards as possible. This is done by using an algorithm for determining an individual’s ability to mine after they “stake” their own cryptocurrency.

This is the core issue at Jarett v. U.S., ongoing litigation that could shed light on whether staking rewards are taxed the same as new cryptocurrency received from typical mining. Taxpayers Joshua and Jessica Jarrett reported stake rewards as “other income” on their 2019 return but later filed an amended return to reflect that the rewards weren’t taxable income. The IRS offered a refund check to resolve the overpayments, but the Jarretts contend that a single refund doesn’t set a sufficient precedent for other blockchain validators.

The Greenberg Traurig team said, “While the IRS specifically treats cryptocurrency mining as a taxable transaction, it isn’t entirely clear how staking income would be taxed,” absent a definitive close to Jarrett. The IRS filed a motion to dismiss for lack of jurisdiction, arguing that their refund settlement offer should suffice. The case is before the U.S. District Court for the Middle District of Tennessee.

Wage payments in crypto

There has been increasing interest, especially among younger employees, in receiving wages in cryptocurrencies because of its potential for future profit. Last November, Nasdaq analyzed the findings of a poll conducted by deVere Group. Of those born after 1996, 51% reported that they “would be happy to receive 50% of their salary” in cryptocurrency, according to the survey.

This situation prompts the question of whether such arrangements are even possible under current law; the answer may depend on which government agency you ask. The Labor Department’s response to a Checkpoint query on whether cryptocurrencies are viable employee compensation pointed to a regulation under the Fair Labor Standards Act providing that wage payments may be “made in cash or negotiable instrument payable at par.” The department declined to comment further when asked if this included cryptocurrencies.

The IRS supplied a more direct answer, telling Checkpoint that “employers may choose to pay employees in cryptocurrencies.” This is backed up by the answer given to Q11 in the 2019 FAQs mentioned above. For employment tax purposes, “the medium in which remuneration for services is paid is immaterial.” For more on crypto wage payments and agency responses, see “Can Employers Pay Wages in Cryptocurrency?”

Advice for tax and accounting professionals

Taxpayers should “generally start with the presumption that any transaction involving cryptocurrency would be a taxable event unless certain specific exceptions apply,” according to Greenberg Traurig. Bear in mind that while guidance is sparse, it behooves taxpayers to pick up on signals sent by lawmakers and federal agencies on which way the wind is blowing. At the same time, investors needn’t panic in response to every proposal.

Online trading platforms that operate as crypto exchanges have become more commonplace. “To the extent you use software to keep track of your digital asset transactions, it is imperative to review the reports and transactional-level details to verify the proceeds, cost basis, and holding period,” Crowe’s Kanter said. “In addition, we urge clients to remain consistent with the cost basis methods (FIFO vs. Specific Identification), and to the extent they do switch software, make sure the variances in gains and losses in prior years are reviewed.”

Taxpayers should be mindful of their cryptocurrency transactions and use software — like Checkpoint Edge — to track their digital asset transactions to ensure they accurately report the proceeds, cost basis, and holding period. Doing so will help ensure they remain consistent with the cost-basis methods and minimize their risk of being in a regrettable position come tax season.

Checkpoint Edge, a tax research and compliance software, can be an invaluable tool for taxpayers who want to ensure compliance with tax laws related to cryptocurrency. It provides access to comprehensive tax research and analysis and real-time tax news and updates. Additionally, Checkpoint Edge can help taxpayers keep track of their digital asset transactions, including the cost basis, holding period, and proceeds. This information is crucial in calculating gains and losses and determining tax liabilities.

Cryptocurrency exchanges, which operate as online trading platforms, have become more prevalent, and investors who use these platforms should diligently track their digital asset transactions. Reviewing reports and transactional-level details are critical to verify the accuracy of cost basis and holding period information. Using Checkpoint Edge can help ensure taxpayers have access to accurate and up-to-date tax information essential for compliance with tax laws. In summary, while the IRS's guidance on the taxation of cryptocurrency may be sparse, taxpayers should try to stay informed and use tools like Checkpoint Edge to ensure compliance with tax laws.

The rise of cryptocurrency has undoubtedly disrupted the traditional financial system, challenging existing regulations and raising new legal and ethical questions. As governments and financial institutions continue to grapple with this emerging technology, it is clear that a flexible and adaptable approach is needed to ensure a balance between innovation and protection for consumers and investors.

While uncertainties and risks are still associated with cryptocurrency, its potential for transforming how we exchange value and conduct transactions cannot be ignored. As the crypto landscape continues to evolve and mature, it will be necessary for all stakeholders to remain vigilant and informed to make the most of the opportunities and navigate the challenges that lie ahead.

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