United States

Tax considerations for crypto assets

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Crypto assets such as bitcoin and ethereum exploded in value in 2017. Simultaneously, new startups raised staggering amounts of capital through initial coin offerings (ICOs) and traditional venture capital-backed fundraising. An ICO is similar in nature to an IPO, where crypto assets are issued in exchange for cash or other more popular crypto assets such as bitcoin or ethereum.

Although the market value of all crypto assets declined in 2018, ICOs, blockchain technology development and adoption have only accelerated. Blockchain and crypto asset startups raised over $13 billion through ICOs in the first half of 2018, more than the $5.5 billion raised in all of 2017.1

As of August 2018, the only issued IRS guidance, Notice 2014-21, treats crypto assets as property for tax purposes. Tax principles that apply to transactions of property generally apply to crypto assets as well. However, certain nuances of crypto assets complicate tax matters.

Because crypto assets and blockchain technology industries are not going to be a short-lived fad, it is imperative that tax and accounting professionals understand the intricacies of this burgeoning industry.

Basics of crypto asset income

Individuals or businesses that receive crypto assets are responsible for reporting that income in terms of U.S. dollars. Under the doctrine of constructive receipt, income is considered received when the virtual currency arrives in the crypto asset wallet and becomes available. (The wallet is a digital file, or physical device, that stores the encrypted private key, like an encrypted password, which provides access to send crypto assets from a specific wallet address on a blockchain.) However, under ASC 606, companies must recognize revenue based on actual performance of a contract, which also applies similarly to crypto assets received as payment for a contract.

Crypto asset income: Miners

Miners or validators of public blockchains run complex computer programs on one or more specialized computers.

Individuals “mining” or validating transactions on public blockchains receive crypto assets in return for running an energy-intensive computer software. Individuals who mine crypto assets as a source of primary income are considered self-employed for tax purposes. These individuals should consider the following:

  • File a Schedule C with their 1040 returns
  • Pay both employer and employee Social Security and Medicare taxes
  • Determine whether ordinary and necessary business expenses, such as computer hardware and cost of energy, may be deducted

Crypto assests as compensation

Crypto asset and blockchain companies often compensate their employees and vendors in crypto assets.

  • An employer who compensates any individual over $600 in crypto assets is required to provide and file Form 1099-MISC with the individual and IRS, respectively.
  • An employer who pays interest in crypto assets must provide and file a 1099-INT with lender and the IRS.
  • These are the remittance timing and fines for 1099-MISC and 1099-INT:
    • $50 per information return if correctly filed and remitted within 30 days of Feb. 28
    • $100 per information return if correctly filed and remitted before Aug. 1
    • $270 per information return after Aug. 1
  • W-2 Forms must be sent to each employee by Jan. 31 following the end of the taxable year.
  • Social Security numbers must be used, not TINs.

Crypto assets and blockchain technology work can be performed from anywhere in the world. Unfortunately, the individuals who are most qualified for the position often only provide a wallet address and coder name, making it impossible to file proper 1099 forms. In these situations, the employer should withhold 24 percent of the unidentified employee income and remit it to the IRS.

Companies compensating employees in crypto assets should keep payroll records for a minimum of three years due to the potential of an audit.

Purchases paid with crypto assets

Purchases paid with crypto assets potentially create a transaction with two taxable events. First, the buyer must recognize a capital gain or loss on their crypto asset. Second, the buyer must pay any sales or other transaction related taxes.

Investments in crypto assets

Investments made in crypto assets are considered to be capital gains property. Any sale of digital investments should be reported as either short-term or long-term capital gains or losses. Short-term capital gains are taxed at ordinary income rates. Long-term capital gains are taxed at favorable tax rates. Net capital losses are limited to the standard $3,000 capital loss deduction per year. All exchange fees paid are added to the cost basis of the crypto assets.

The IRS only applies wash sale rules specifically to shares of stocks and securities, and therefore those rules do not directly apply to crypto assets. However, the economic substance doctrine applies. Any transaction executed for the sole purpose of generating a tax benefit is invalid under the doctrine. Economic substance is met when the party exposes itself to market risk. Since crypto assets are extremely volatile, some sources say waiting one to three days is sufficient exposure before purchasing again.

A crypto asset’s fair market value is assessed on both the day it was received or purchased and the day it is sold. Due to lack of pricing information and crypto asset exchange statements, investors have flexibility in how they determine fair market value. However, once a choice is made, it is crucial to stay consistent. 

Fair market value methodologies

Average price

Easiest to determine, but not most tax efficient

Price at moment received

Most difficult to track, but is an accurate depiction of taxes owed

Daily high

Evaluate on a case-by-case basis, sometimes results in the lowest or highest taxable income depending on volatility of the crypto assets

Daily low

Evaluate on a case-by-case basis, sometimes results in the lowest or highest taxable income depending on volatility of the crypto assets


Additionally, since crypto assets are regarded as property, the same cost-basis calculation options available to traditional property may apply here. Investors currently may be able to calculate their gain or loss using one of four methods and stay consistent:

  • Last in, first out
  • First in, last out
  • Specific identification
  • Weighted-average

When one crypto asset is directly traded for another crypto asset, the exchange is treated as the sale of one crypto asset and the purchase of another with the proceeds. The second crypto asset’s cost basis is equal to the fair market value of the first at point of conversion or sale.

Charitable contributions using crypto assets

If a donor is able to directly donate to a charity, the contribution is considered a donation of property. On crypto assets held longer than one year, any capital gain is not taxed. Charitable contributions of crypto assets can be made in two ways:

  • A direct charitable contribution of the crypto asset to the charitable organization allows the donor to take an itemized deduction of the fair market value of the donation, plus fees, of up to 30 percent of the taxpayer’s AGI.
  • If crypto assets are converted into U.S. dollars first, the taxpayer must recognize any gain. The cash from the sale is then contributed to the charity. The taxpayer is allowed to take an itemized deduction for the fair market value of the donation, plus fees, on up to 60 percent of their AGI.

Inheritance

Crypto assets acquired through inheritance have the same tax treatment as other properties. The crypto assets are passed on to beneficiaries at the fair market value at the time of death. The beneficiaries’ basis becomes the crypto assets fair market value at the date of death or the fair market value at the alternate valuation date.

It is important that holders of crypto assets consider updating their wills to include details and instructions for the transfer of private keys.

Losses due to theft or casualty

Crypto assets are considered lost if they are stolen through a hack or physical robbery of a hardware wallet. A hardware wallet is like a miniature offline computer, one that has never been connected to the internet. It is the size of a USB flash drive and stores the private key to a wallet address. They are also considered lost if the owner loses access to his or her crypto assets. Due to recent federal tax reform, losses of crypto assets are not included as an itemized tax deduction. Theft and casualty loss deductions are limited to only federally declared disaster areas. Additionally, abandoned property may not apply because crypto assets do not have a useful life.

Foreign reporting options

While crypto assets held in foreign exchange accounts are generally not required to file an FBAR or FACTA, crypto asset owners may be required to report this information for the 2018 tax year. To err on the side of caution, investors who hold over $10,000 in U.S. dollars or crypto assets on foreign exchanges should consider filing FinCEN Form 114 or IRS Form 8938.

Best practices

Pending additional guidance from the IRS, there are a number of considerations and best practices for crypto asset owners:

  • Calculate the basis of any crypto assets owned and document how the basis was calculated.
  • Use known cryptocurrency exchanges that collaborate with crypto asset tax software.
  • Always maintain records and statements in secure places, including any documentation related to lost private keys. Do not share the private key with anyone.
  • There is no such thing as too much documentation.
  • Once a method is chosen to determine cost basis and reporting options, stay consistent.

1 D. Diemers, H. Arslanian, G. McNamara, G. Dobrauz, L. Wohlgemuth, “Initial Coin Offers – A Strategic Perspective” (June 28, 2018) PWC & Crypto Valley.


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