The use of cryptocurrencies has been growing in recent years. The most well-known cryptocurrency is bitcoin, with more than 100 large and medium-sized companies now accepting it for purchases. In the accounting and finance world, EY became the first of the Big 4 accounting firms to accept bitcoin as payment for auditing and advisory services in 2017. PwC also began accepting bitcoin as payment for its advisory services in 2017 and announced that it is advising clients about cryptocurrency funds, exchanges, and investments.
USE OF BITCOIN
Sales transacted in bitcoin saw a 55% increase in 2017 but still comprise a very low share of transaction volume for the companies that accept it. Nevertheless, today you can buy everything from satellite service, airline tickets, prescription drugs, and even a Tesla automobile with bitcoins. Additionally, as of December 2017, there were 1,884 bitcoin ATMs operating worldwide. More than 74% are located in North America, and an additional four machines are added daily worldwide.
Not only is bitcoin a payment system to rival fiat currency or PayPal, but it’s also a popular investment. Bitcoin appreciated 100% in 2016, topping $19,783 in mid-December 2017, growing 1,824% since January 1, 2017. With bitcoin prices hovering between $8,000 and $9,000 during the first quarter of 2018, it might appear that bitcoin is a poor choice for purchasing a six-inch sandwich at Subway, one of the many businesses now accepting bitcoin. Yet one bitcoin can be divided down into as many as eight decimal places. Consequently, 0.00000001 bitcoin is the smallest amount that the peer-to-peer network can currently handle in a transaction—adequate for any transaction denominated in dollars. The price of a bitcoin would have to surge to $1 million before the smallest denomination of bitcoin would be worth even one penny.
TAX IMPLICATIONS
Every single trade or transaction in cryptocurrency is a potentially taxable event. Cryptocurrencies like bitcoin are considered property for tax purposes. Therefore, the same tax principles that apply to property transactions are generally applied to cryptocurrency transactions. This means that cryptocurrencies are capital assets in the hands of most taxpayers and subject to capital gain and loss treatment. Furthermore, the Tax Cut and Jobs Act of 2017 ensured that trading one cryptocurrency for another wouldn’t qualify for like-kind exchange treatment.
Individuals and businesses that accept cryptocurrency as payment for goods and services have ordinary gross income equal to the fair market value of the cryptocurrency received. Individuals who “mine” cryptocurrency by processing digital transactions have income from self-employment, which is subject to both income and self-employment taxes. Payments made with cryptocurrency are also subject to the same information reporting rules as cash payments, so W-2s or 1099s may be required. Furthermore, according to IRS Notice 2014-21, rules for backup withholding likewise apply to cryptocurrency payments.
On August 1, 2017, bitcoin went through a “hard fork,” which means the cryptocurrency split into two currencies. This came about as a result of a change to the software underlying the currency’s network. A taxpayer who owned bitcoin immediately prior to the hard fork suddenly owned an equal quantity of the new cryptocurrency, bitcoin cash.
There have been numerous hard forks among the various cryptocurrencies. Each new cryptocurrency created by a hard fork becomes viable only if it manages to survive. Sometimes a new currency chain won’t be accepted by miners who process cryptocurrency transactions. Other times, digital currency exchanges such as Coinbase, one of the largest exchanges, won’t support the new cryptocurrency. But what are the consequences to a taxpayer who now owns an equal quantity of the new and the old cryptocurrency?
The new digital coins produced by a hard fork are property that the taxpayer has neither solicited nor paid for. Nevertheless, free property such as lottery winnings, found property, and new digital coins from a hard fork are an economic windfall that can be taxed as ordinary income if and when the taxpayer claims the windfall by exercising “dominion and control” over the property. This can involve, for example, making a transfer of the unsolicited property or in some other way demonstrating the intent to exercise dominion and control over the property. A taxpayer isn’t obligated to claim the property and could consequently never realize income from a hard fork.
Equally important as when the taxpayer realizes income is the amount of that income. The amount of income from a hard fork requires the establishment of fair market value at the time that the taxpayer realizes income by exercising control over the new cryptocurrency. Taxpayers must use a method that’s reasonable to determine fair market value and report that amount as income. Fair market value is the agreed-upon price a willing buyer will pay to a willing seller, yet sometimes the new cryptocurrency hasn’t begun trading on the digital exchanges yet. In that case, establishing the fair market value may be pure speculation. For bitcoin cash, however, that issue shouldn’t be a challenge. When it emerged from the hard fork of bitcoin, bitcoin cash had already been trading on futures markets for two full weeks, making the establishment of a fair market value straightforward.
Bitcoin futures began selling on the Chicago Board Options Exchange and the Chicago Mercantile Exchange in late December 2017. This trading allows investors to take a position in bitcoin without entering the unregulated market of bitcoin exchange. Trading bitcoin futures should give more favorable tax treatment than trading in actual bitcoins. As a regulated futures contract, gains and losses under IRC §1256 are treated as 60% long-term gain and 40% short-term gain. These gains and losses are reported on Form 6781, Gains and Losses from Section 1256 Contracts and Straddles.
A declaration filed by the IRS in San Francisco federal court indicated that an investigation found fewer than 1,000 taxpayers filed IRS Form 8949 to report gains and losses in bitcoin transactions on their 2013-2015 returns. This likely represents only a small proportion of those who should have recognized bitcoin income. In November 2017, in federal district court, the IRS was granted enforcement of a summons to examine larger accounts on Coinbase. Users of cryptocurrency undoubtedly need to consider the tax implications of their digital currency transactions carefully.
© 2018 A.P. Curatola
June 2018
