Transactions involving cryptocurrencies (also known as virtual currencies) are becoming more and more common. The Internal Revenue Service (IRS) defines 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. To provide safety for the owner, some form of cryptography is used with these currencies to secure the transactions. Interestingly, these systems tend to be maintained on a distributed ledger that’s often public.
This type of system has some cost advantages: It avoids the need to have a third-party facilitator such as a bank and provides a great deal of anonymity to the holder of the currency. Of course, the second advantage also makes it attractive for those involved in illegal activities or those who seek to avoid taxes. As with most new things, particularly investments or currencies, questions arise regarding their proper regulation and taxation.
The tax gap created by taxpayers failing to report income and gains related to cryptocurrency transactions has been of growing concern to the IRS. In fact, Form 1040 now asks, “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” on page 1 just below the taxpayer’s name and address information. This makes the issue readily apparent to anyone dealing with the form.
In April 2021, former IRS Commissioner Charles Rossotti testified that the tax gap could exceed $1 trillion. Yet this number is likely higher than the actual amount and wasn’t an official analysis. The IRS website contains a report based on a 2019 analysis of the years 2011 to 2013 and estimates this tax gap at $441 billion. In addition, it cites research that estimates the gap could grow in the next decade to $750 billion annually. Regardless of the absolute size of the tax gap, it’s growing as the volume and types of virtual currencies and related transactions increase.
The area of cryptocurrency presents unique reporting challenges as authorities try to maintain fairness in the tax system while not stifling innovation and growth within the industry. If the regulatory burden becomes too great, particularly if the United States isn’t moving in a manner similar to other jurisdictions, it would be expected that innovators in the area would avoid the U.S. as much as possible.
At the same time, allowing cryptocurrencies to be used without the reporting requirements applicable to other mediums of exchange can contribute to the tax gap. This also creates a fairness issue in comparison to other mediums of exchange and investments that are reported for tax purposes.
INFRASTRUCTURE INVESTMENT AND JOBS ACT
In an attempt to address this growing tax gap, the Infrastructure Investment and Jobs (Infrastructure) Act (P.L. 117-58), which became law on November 15, 2021, created new reporting requirements for cryptocurrency transactions. The new reporting requirements come into effect with statements required to be filed after December 31, 2023. Thus, cryptocurrency transactions occurring in 2023 or later will be subject to these new reporting requirements.
The IRS began issuing guidance with respect to virtual currencies in 2014 in Notice 2014-21. This early guidance treats virtual currencies as property. The result is that its exchange may create gains and losses. Those taxpayers who receive virtual currencies as a form of compensation or earnings will have ordinary income.
Even this early guidance noted that a business making payments of more than $600 in the form of virtual currency would be subject to the usual 1099 reporting requirements. The Notice also states that those being paid in virtual currency for work, including those mining virtual currency, are recognizing income and that if the individual is self-employed, then the person is subject to the self-employment tax.
The IRS has had success in court in using a “John Doe” summons to obtain information from virtual currency exchanges. With this approach, the IRS is basically requesting information on a person or class of persons that it feels may not have complied with the tax law.
Based on the information it was able to obtain, the IRS announced in IR-2019-132 that it was sending letters to taxpayers who might have engaged in virtual currency transactions but didn’t report them for tax purposes. Since these letters were issued, there have been lawsuits filed by taxpayers arguing that the use of this type of summons isn’t appropriate. The changes in the Infrastructure Act should enable the IRS to obtain much of this information without the need for this type of summons.
Formally, the Infrastructure Act added Internal Revenue Code (IRC) §6045(c)(1)(D), which adds to the definition of broker language that includes any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person. Brokers report these transactions on a Form 1099-B, Proceeds from Broker and Barter Exchange Transactions. A digital asset is defined by §6045(g)(3)(D) as any digital representation of value that’s recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary of the Treasury.
IRC §6050I(d)(3) was also added and treats digital assets as cash for business reporting purposes, also after 2023. This means that businesses that receive digital assets of more than $10,000 will be required to file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business. Those required to make these reports but fail to do so will be subject to penalties.
The tax treatment of virtual currencies is clearly going to be of even more concern moving forward, both in terms of minimizing the tax gap and monitoring for illegal activities.
Balancing the need to maintain equity with other forms of monetary exchanges and investments while not stifling growth will also continue to be an issue for the tax authorities.
For those seeking more information regarding the taxation of virtual currency transactions, visit the “Virtual Currencies” page on the IRS website.
© 2022 A.P. Curatola