Bitcoin and other cryptocurrencies, referred to as convertible virtual currencies or CVCs, have been held and traded for a number of years by U.S. taxpayers. In 2014, the Internal Revenue Service issued a notice that it considered CVCs to be property and not fiat currency.
As a result, any sale or exchange of CVCs or the use of CVCs to purchase property or to pay for services would be a taxable transaction, with the taxpayer having either a gain or loss depending on the difference between the fair market value of the property or services and the taxpayer's basis in the CVCs that were used in the transaction. A gain or loss would also arise under the IRS notice if one type of CVC was exchanged for another type of CVC (with the exception of certain Section 1031 exchanges prior to 2018).
Reporting and Filing Requirements:
Taxpayers would thus be required to track each transaction involving CVCs, determining the tax basis of the CVCs involved, and the value of the property or services received, and report each transaction on their U.S. income tax return. In the case of a taxpayer who merely invested in Bitcoin and then held the investment with an occasional sale, the tax issues and reporting requirements would be relatively straightforward. However, many taxpayers bought CVCs on a regular basis, frequently exchanged them for other types of CVCs, lent them to friends, used them on Overstock to buy furniture and other items, invested in Initial Coin Offerings, received CVCs in “airdrops,” and held CVCs long enough to receive additional CVCs in a “hard fork.” For those taxpayers, keeping track of the basis of all of their CVCs, and the gains and losses from each transaction, proved to be very complicated, if not overwhelming. In addition, many investors in CVCs did not think a CVC was property and thus didn’t require the accounting and reporting expected by the IRS. As a result, many taxpayers may not be fully compliant with their reporting and filing obligations as viewed by the IRS.
IRS Enforcement Actions:
Concerned that taxpayers may not be complying with their reporting and filing requirements, the IRS subpoenaed records on clients of Coinbase, a U.S.-based CVC exchange, and eventually a court enforced the subpoena. More recently, the IRS announced that it has sent or will be sending letters to some 10,000 taxpayers. The first two letters, Letters 6174 and 6174-A, merely informed the recipient that the IRS has information suggesting that the taxpayer either may have entered into CVC transactions that could give rise to a gain or loss and reporting requirements or have entered into CVC transactions. In both cases, the letters ask the recipient to review their CVC transactions to determine if they have fully complied with their reporting and filing requirements.
The third letter, Letter 6173, states that the IRS knows the recipient has entered into CVC transactions and requires the recipient to either file original tax returns (if not previously filed) or amended tax returns, as the case may be, by the date set out in the letter. If recipients believe they are compliant with their reporting and filing obligations, they are required to respond to the letter, setting out a description of the transactions they entered into, how they were reported on the previously filed tax returns, and the reasons why the recipient believes their treatment of the transactions is appropriate and in compliance with U.S. tax laws. The response must be signed under penalty of perjury.
Another example of just how seriously the IRS is taking tax evasion and avoidance with respect to CVCs was the international coalition launched by the IRS with four other countries to investigate CVC crimes, including fraud and money laundering. The coalition, known as the J5, launched in response to the Organization for Economic Cooperation and Development's request for countries to take action to reduce tax crime. The agencies among the J5 countries will share information and best practices and will also conduct joint investigations. With the cooperation of other countries, the possible information the IRS could have on a taxpayer with respect to their CVC transactions has expanded significantly.
Access to Third-Party Records:
Taxpayers who received the third type of letter should be careful in preparing their responses since they won’t necessarily know what information the IRS already has in its possession. In certain cases, the IRS can subpoena banks, financial institutions and other third parties, as it did with Coinbase, to obtain records relating to one or more taxpayers. The IRS may already have information on the CVC transactions that it believes a taxpayer has entered into, and omitting one or more such transactions in the taxpayer’s response to the IRS could give rise to serious penalties, and in some cases civil or criminal fraud charges. In addition, financial institutions and other third parties may have issued the taxpayer a Form 1099-B, a copy of which would have been sent to the IRS.
Issues to Consider:
CVC transactions give rise to a number of tax issues, many of which are complicated and not clearly addressed under existing tax law.
The first issue is one of recordkeeping, where a list of all CVC transactions is maintained with the tax basis of the CVCs involved, the fair market value of the CVCs at various transaction dates, other property or services involved, the CVCs lent to third parties, and the value of the CVCs received in repayment of the loans, etc.
A second issue is whether the exchange of one type of CVC for another type of CVC in years prior to the 2018 tax year qualified for “like-kind” exchange treatment under Section 1031.
A third issue is whether the additional CVCs received when a “hard fork” in the applicable blockchain occured should be included in income, or whether instead a portion of the tax basis of the existing CVCs should be reallocated to the new CVCs.
A fourth issue is whether the taxpayer should be treated as an investor or a dealer. The answer to this question will determine whether a taxpayer will be able to fully offset losses against gains.
A fifth issue is whether a miner of CVCs should recognize income upon the receipt of the CVC or should instead treat the receipt as a nontaxable transaction.
Another issue is how to treat CVCs received by a taxpayer in connection with an “airdrop,” the distribution of a crypto token or coin to a wide amount of wallet addresses.
Lastly, taxpayers who invested in CVCs through investments in ICOs, and discovered later that the ICO was a scam and the CVCs are now worthless, need to consider how and when to claim a loss on the investment.
Given all of the above issues and many others not raised here, complying with the IRS’s request to justify the taxpayer’s treatment of the CVC transactions within the response time provided in the letter (which will typically be 30 days with one 30-day extension) could prove challenging. The response should address in detail all of the CVC transactions entered into by the taxpayer, starting with the first investment or mining transaction, which could be quite some time ago. Many taxpayers may not have retained the records for all of their CVC transactions, so substantiation of earlier transactions may be challenging.
“If bitcoins are bought as an investment and sold at a profit, the treatment of such income depends on the holding period. If held for less than a year, the net receipts are treated as ordinary income which may be subject to additional state income tax. If the holding period is for more than a year, it is treated as capital gains and may attract an additional 3.8 percent tax on net investment income.”
- Shobhit Seth, Investopedia.com
“The New York Times reports that similar to the tax rules for the stock market, cryptocurrency “ losses can be used to offset capital gains, subject to certain rules, and losses that are not used to offset gains can be deducted — up to $3,000 — from other kinds of income.”
- Shobhit Seth, Investopedia.com
In all three cases, consider urging yourself to take the letters seriously and to seek to comply with their reporting and filing obligations. If you receive an IRS notice, ignoring the problem will end very badly and likely be expensive. Particularly in the case of taxpayers who have received the third letter that the IRS is taking compliance with tax laws in this area very seriously, and time is of the essence. All transactions should be reviewed and the tax treatment on the tax return, if any, should be compared to the IRS’s view of how such transactions should have been treated.
Certain taxpayers may have reported some, but not all, of their CVC transactions; in other cases, upon detailed review you may determine that the initial treatment may not have been appropriate. In both such cases, the taxpayer may need to both prepare amended tax returns to correct reported transactions, and report previously unreported transactions. At the same time, the taxpayer may need to respond to the IRS addressing the treatment of those CVC transactions that the taxpayer believes are correct. All this within not more than 60 days (a challenge at any time, but a particular challenge now that the September 15 and October 15 filing deadlines are rapidly approaching).
Depending upon the scope of the issues and the frequency of CVC transactions, tax professionals may want to consider working with a knowledgeable tax attorney under a Kovel Letter arrangement, particularly where the client may have significant unreported CVC transactions, or where aggressive reporting positions may have been taken. The use of a Kovel Letter, which may provide confidentiality and attorney-client privilege to communications between the client and tax preparer, may allow taxpayers to be more candid when discussing their transactions. If the taxpayer has entered into transactions with non-U.S. parties or has CVCs on non-U.S. exchanges, the taxpayer may feel the IRS cannot get access to information about such transactions and thus may be less inclined to disclose them.
Tax preparers are now strongly considering getting a signed letter from taxpayers stating that the taxpayer has fully and completely disclosed all of the CVC transactions and relevant information to you. Taxpayers would not want to find out after the fact from the IRS that they failed to disclose CVC transactions to the tax preparer and that the IRS was considering taking action against the taxpayer for filing incorrect amended or late tax returns.
Lastly, consider reviewing any amended tax returns prior to filing them to determine if there are any issues with the treatment of other non-CVC transactions or items reported or omitted on the original tax return, since the IRS in reviewing the CVC transactions may decide to review the entire tax return for accuracy. Better to find out and correct aggressive positions before the amended returns are filed than during the course of a tax audit.
“As cryptocurrency adoption grows, it is important for an investor to create a strategic tax plan that will maximize their profits as well as take advantage of any losses. As an investor in this space, I understand the complexity of keeping track of every single transaction and ultimately calculate how much is owed. However, that burden is mitigated when consulting with a tax professional that is an expert in this space.”
- Alejandro Salgado, Executive Assistant, TaxBridge Advisors, Corp.