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Tax implications

Tax implications

Information regarding tax treatment of crypto remains limited. What are the key tax implications for a crypto business?

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Tax implications

Although the crypto market is rapidly growing, guidance regarding the tax treatment of crypto remains minimal.

The only clear guidance from the IRS came in the form of Notice 2014-21, released almost four years ago, stating the IRS position that a virtual currency is a digital representation of the value that functions as a medium of exchange but does not have all the attributes of real currency, such as legal tender status in any jurisdiction. Accordingly, the IRS treats crypto as property, not as another currency.

Tax treatment of crypto: The basics

  • When crypto is sold or exchanged for cash for other property, the taxpayer recognizes a gain on the difference between the amount of the cash or the fair market value of the property received and the taxpayer's adjusted basis in the crypto sold or exchanged (typically the amount paid for the crypto).
  • When the crypto is held as a capital asset, such as investment property, any gain or loss from the sale of the asset is taxed as capital gain or loss. For individuals, capital gains are subject to a favorable tax rate, depending on the taxpayer s holding period.
  • When taxpayers receive crypto due to airdrops or mining activity, they include the fair market value of the crypto in gross income on the date received.
  • When the crypto is held as inventory or otherwise held for sale to customers in a  trade or business, the gain or loss  is ordinary.

Tax accounting

In addition to potentially sizable tax liabilities incurred on the sale or exchange of crypto, taxpayers may also bear significant tax accounting burdens with respect to their holdings, depending on the number and frequency of crypto transactions in which they engage. As noted above, users of crypto must calculate gain or loss every time they transact. Taxpayers that are transacting at a high frequency using a trading bot, or mundane transactions such as buying cups of coffee with a crypto debit card, can rack up significant amounts of taxable transactions that they will have to individually account for.

Taxpayers will need to identify those transactions that represent a sale or an exchange of crypto for a good or service (and are thereby taxable) and those that are merely transfers into an account that the taxpayer controls, such as another wallet or a payment channel (and are potentially not taxable). They will then need to determine the value in dollars of each transaction.

Determining this dollar value is relatively straightforward for sales of cryptoassets for fiat currency, but exchanges of crypto for other property may present a challenge. Taxpayers will need to determine the dollar value of the good or service received from the counterparty less the dollar value taxpayer paid for the crypto used to buy that good or service, which presents two potential issues:

1. What if a taxpayer is using a crypto to purchase another crypto? 

Provided that transactions are with respect to more commonly used cryptoassets, there are some reputable sources of pricing data. However, altcoins that are not sold for dollars may need to be priced based on a readily convertible crypto such as Bitcoin. 

2. If the taxpayer has purchased multiple units of crypto at different prices, which price should they use to determine the cost of crypto used in a particular transaction? 

General tax principles may point to specific identification— the crypto exchange must be traced to a particular tranche of purchases to determine what was paid for a specific block of Bitcoin, for example. Alternative methods such as last in, first out (LIFO) or first in, first out (FIFO) may also be available. These alternative methods do not require a taxpayer to distinguish specific blocks of crypto. Rather, in the case of LIFO, the taxpayer is assumed to be using the most recent crypto the taxpayer purchased and uses that price for which it was purchased. Or, in the case of FIFO, the taxpayer is assumed to be using the first crypto the taxpayer purchased and uses that price for which it was purchased. 

The availability and relative merits of each method of tax accounting should be assessed by taxpayers at the outset of their participation in the crypto marketplace.

Intermediaries and tax compliance obligations  

Custodial business models will trigger compliance obligations with respect to cryptoassets. Generally, if a company holds crypto on behalf of others and facilitates transactions, the company should consider whether certain tax information reporting (usually on IRS Form 1099) is required with respect to the person for whom the crypto is held. If a company pays service providers with crypto, other tax reporting rules may apply depending on whether the service provider is an employee. 

Further, companies should be aware that they may be subject to withholding tax obligations on payments to service providers even if the payment is made in crypto. As a general matter, these reporting and withholding requirements require companies to request, at a minimum, the tax identification or social security number of customers, service providers, and other payees. However, the pseudonymous nature of crypto presents a challenge. A primary role of tax advisers should be to assist companies in simplifying and automating tax reporting and withholding compliance procedures in order to prevent these requirements from disrupting the market. This will reduce the burden on individuals and organizations such that taxpayers may freely transact with cryptoassets.

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