Several years back, a client who had just sold their business inquired about investing some of their proceeds from the sale in a “cryptocurrency mining” venture based in Upstate N.Y. I thought they had lost their mind. “A what?” I asked. The client replied that the project involved the use of many powerful computers, but was otherwise unable to describe the business, let alone explain it to me in simple-to-understand terms.[i] Still, they pressed me, “What would you do?”
I hate that question. After reminding them that I could not provide any investment advice, I suggested they do more homework, and seek out a qualified investment adviser. Finally, I answered their question, saying that I would consider a more conventional place to park my hard-earned money.
Fast forward. Not only is cryptocurrency still with us – I think “virtual currency” may be more accurate[ii] – its acceptance seems to have grown among both closely-held and public companies; in fact, Facebook announced only last month that it was launching its own form of cryptocurrency.
These developments have caused some concern at the IRS, which believes that the increasing use of virtual currencies may jeopardize tax revenues.
Before describing the IRS’s position, including its recently announced plans, with respect to cryptocurrency, it may be helpful to review – albeit in an overly simplistic and somewhat fictional[iii] way – the evolution of currency, generally.[iv]Think of what follows as the development of my understanding of the concept.
Legal Tender
Thousands of years ago, our ancestors bartered – exchanged things of value – with one another in order to acquire the goods and services they needed. One would swap, or trade, a haunch of deer in exchange for two loaves of bread. A second would clear a field in exchange for an axe. A third would chop wood in exchange for a set of new clothes. A fourth would, to the delight of many, demonstrate their ability to successfully throw a ball through a hoop once out of every 4 attempts, for twenty minutes at a time, in exchange for a lifetime’s worth of food, clothing, shelter, protection, adulation, influence, and so much more – no wait, specialization was a later development (I’m getting ahead of myself).[v]
Specialization and Barter
The growth of societies was accompanied by two developments: (1) individuals began to realize that they could not dabble successfully in all skills;[vi] rather, they began to specialize in the production of certain goods and services – things they were good at – which they would trade with “specialists” in other goods and services; and (2) some people (the “government”) offered to protect the individuals who lived within an area (the “governed”) from the marauders that roamed the countryside, to patrol the roads that allowed them to travel to other places where they could trade their goods and services with people who lived elsewhere, and to settle disputes among the governed; in exchange for these services – another barter transaction – the governed were required to pay “taxes” and “tolls” in the form of goods and services.[vii] As the roles and responsibilities of the government grew and expanded, so did the need for more taxes by which the governed periodically paid for the additional services provided to them by the government.[viii]
Eventually, both the government and the governed realized that the transfer of value in-kind was unwieldy and inefficient. After all, what would a farmer do if the only thing of value that they owned was some seed, and they wanted to trade it with the blacksmith for some nails, but the blacksmith had no need for seed?[ix]Would you have to find someone who could use the seed who also had something of value that the blacksmith may want?[x]
Currency
In response to this quandary, the government eventually came up with the idea of “currency”: something that people can exchange for goods and services – also known as a “medium of exchange” – that is issued by the government and that is accepted at its face amount within the territory controlled by the government.
Originally, currency was issued in the form of coins made out of a precious metal (like gold), so that the coin itself was inherently valuable.[xi]
Later, currency was made out of paper that, in itself, was worthless but which was easier to handle. This paper, or banknote, was, and continues to be, a bearer note – meaning that its “value” is not “payable” to a specified person, but rather to whomever holds it – that is issued only by the government’s central bank.[xii] The paper’s status as a bearer note – “cash,” in the colloquial – affords the persons who transact business using such notes a degree of anonymity.[xiii]
It used to be, however, that the paper was backed by gold – meaning that the banknote could be presented to the government’s central bank and exchanged for gold[xiv] – but that is no longer the case.
Today, as in the case of any debt issued by the U.S. government, a banknote – your ordinary dollar bill and its siblings, all of which represent “legal tender” that a vendor of property or services is legally obligated to accept in satisfaction of the debt created in connection with such sale – is backed “only” by the “full faith and credit” of the U.S.,[xv] and that seems to be enough for most of the world.
Virtual Currency – As Understood by a Layperson [xvi]
Like “real” currency,[xvii] virtual currency acts as a medium of exchange for purchasing goods and services; as such, it can circulate from person to person, much as real currency does. Also like real currency, it can exist in different units of value.[xviii]
Unlike real currency, it is not issued by a national government or its central bank; it is not legal tender that must be accepted by someone selling goods or services within a particular jurisdiction. What’s more, it does not exist in any tangible form (like paper money), but only electronically.
Its proponents claim that, because virtual currency is not controlled by a central bank, it is free from interference by any such institution. They also claim that it may be transferred between parties to a transaction[xix] without incurring the high fees often charged by traditional financial institutions. In addition, the software that is used to effectuate these transfers functions without the need for the “identifying information” of the parties, thus providing a degree of anonymity.
I can’t comment on whether these advantages do, in fact, exist.
I will observe, however, from a theoretical perspective, that both the real and virtual systems depend upon the maintenance of a data base for each user, one that records the user’s transactions in which the real or virtual currency is acquired or transferred. In the case of real currency, a central bank handles this function; in the case of virtual currency, the function is performed by many private persons through a process called “mining,” which seeks to maintain the integrity of the “system” by validating transactions between parties.[xx]
The IRS’s Position
Although the term “cryptocurrency” seems to have entered the public lexicon around 2008,[xxi] the IRS did not issue any guidance until 2014.[xxii]
At that time, the IRS limited its guidance to virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency (so-called “convertible” virtual currency).[xxiii]
According to the IRS, virtual currency is treated as “property” for federal tax purposes; consequently, general tax principles applicable to property transactions apply to transactions using virtual currency.
Income
For example, a taxpayer who receives virtual currency as payment for goods or services must, in computing their gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. This amount also represents the initial basis of such virtual currency in the hands of the taxpayer.[xxiv]
The fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to self-employment tax.
Gain
If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency,[xxv] the taxpayer has taxable gain.[xxvi] This should be compared to legal tender – like the dollar – which is always worth its face value, and the basis of which is also equal to its face amount.[xxvii]
The character of the gain generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. A taxpayer generally realizes ordinary gain on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer.
Information Reporting
A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. For example, a person who in the course of a trade or business makes a payment of fixed and determinable income[xxviii] using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee.
Similarly, a person who in the course of a trade or business makes a payment in virtual currency of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment to the IRS and to the payee on Form 1099-MISC, Miscellaneous Income.
More Recent Developments
The foregoing guidance was all well and good.
However, in 2016, the AICPA[xxix] asked that the IRS provide additional guidance on the tax treatment of cryptocurrency. It repeated the request in 2018. The IRS has thus far failed to issue more guidance.
That being said, in early 2018, the IRS reminded taxpayers that income from virtual currency transactions was reportable on their income tax returns, and that virtual currency transactions were taxable just like transactions in any other property.[xxx] Taxpayers who did not properly report the income tax consequences of virtual currency transactions, it stated, could be audited for those transactions and, when appropriate, could be liable for penalties and interest. In more extreme situations, the IRS continued, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions.[xxxi]
As if to impress upon the public the magnitude of the challenge, the IRS noted that, as of the date of the release of this reminder to taxpayers, there were more than 1,500 known virtual currencies.[xxxii] The IRS stated that, because transactions in virtual currencies could be difficult to trace,[xxxiii] and have “an inherently pseudo-anonymous aspect,” some taxpayers may be tempted to hide taxable income from the government.
Compliance Campaign
Then, in July of 2018, the IRS announced a Virtual Currency Compliance Campaign to address tax noncompliance related to the use of virtual currency through outreach and through examinations of taxpayers.[xxxiv]
According to the announcement, the Compliance Campaign is aimed at addressing noncompliance related to the use of virtual currency. It stated that the compliance activities will follow the general tax principles applicable to all transactions in property, as outlined in the IRS’s 2014 guidance. It also urged taxpayers with unreported virtual currency transactions to correct their returns as soon as practical.
Significantly, the IRS indicated that it was not contemplating a voluntary disclosure program specifically to address tax non-compliance involving virtual currency.[xxxv]
Evidently not pleased with the pace of the IRS’s efforts to issue additional guidance, a group of lawmakers requested, in April of 2019, that the IRS update its 2014 guidance on the taxation of cryptocurrency transactions.
July 26, 2019
Last week, however, the IRS announced that it has begun sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from such transactions, or that did not report their transactions properly.[xxxvi]
By the end of August, the IRS stated, more than 10,000 taxpayers will receive these letters. It indicated that the names of these taxpayers were obtained through “various ongoing IRS compliance efforts.”[xxxvii]
The IRS further stated that it will remain actively engaged in addressing non-compliance related to virtual currency transactions through a variety of efforts, ranging from taxpayer education to audits to criminal investigations. As if to emphasize this last point, the IRS stated that virtual currency is an ongoing focus area for IRS Criminal Investigation.
The announcement ended with a statement that the IRS anticipates issuing additional legal guidance in this area “in the near future,” and with a reminder that taxpayers who do not properly report the income tax consequences of virtual currency transactions will be liable for tax, penalties and interest, and criminal prosecution when appropriate.[xxxviii]
What’s Next?
With the announcement that it is going to start auditing taxpayers with cryptocurrency assets, the IRS is ramping up its focus on cryptocurrency transactions.
As in the case of unreported foreign accounts years ago, I would expect the IRS to engage in some high profile exams and prosecutions of both larger and smaller transactions so as to demonstrate that it is serious about across-the-board compliance in this area, and to thereby discourage noncompliance.
The fact that it is not considering, as a first step, a voluntary disclosure program, of the kind once made available to holders of unreported foreign accounts, may be an indication of the IRS’s perception of the potential magnitude of the threat to tax revenues that is presented by cryptocurrency transactions.
It is also likely that these exams will generate a great deal of data from which the IRS will derive the principles for additional guidance on the tax treatment of cryptocurrency transactions. The exams may even highlight any shortcomings in the IRS’s technical capability, as well as in its legal ability, to investigate such transactions, which in turn could form the basis for legislation to remedy any such shortcomings.
In the meantime, the IRS will rely on its not insignificant administrative, interpretive and enforcement powers to monitor cryptocurrency transactions.
Of course, there are bad actors who believe their transactions cannot be traced – like those folks who still transact business only in cash, or like those who used to hide their wealth in overseas accounts that were once protected by “privacy” laws, these taxpayers believe they are somehow acting “anonymously.”
What these folks forget is that the taxpayer bears the burden of establishing their proper tax liability. The taxpayer is charged with keeping records that support the amount of income received and expenses incurred, as well as their basis for property sold or exchanged. When they are found out, well, they may find that they are up a certain creek.
Speaking of which, it’s only a matter of time before they are found out. The same technology that they believe affords them the ability to go about their business undetected will one day enable the IRS to piece together the extent of their activities.
In light of the foregoing, any closely held business that determines, for bona fide business reasons, that it has to transact, or would benefit from transacting, with vendors or customers (“peers”) using a virtual currency must not lose sight of its tax reporting, record maintenance, and payment obligations.
[i] Call it a version of the “smell test.” If you can’t understand it well enough to explain it to someone else, stay away from it.
[ii] “Crypto” has a negative connotation in my mind. It is derived from the Greek word for “secret” or “hidden.” Query whether that selection was intended to convey something nefarious.
[iii] And hopefully humorous.
[iv] Lots of disclaimers, here. I am not a professional economic historian, though I am a student of government and of the “social contract” theory from which are derived the government’s responsibilities to the governed and the responsibilities of the governed to each other.
[v] Is it a sign of a mature or successful society that entertainers – be they athletes, singers, or actors – are treated as demigods? What about former public “servants” who become wealthy writing and talking about their years “in service”? I know, it’s what “the market” values.
[vi] I couldn’t be both a farmer and a fisherman, a teacher and a carpenter.
[vii] “In-kind.”
[viii] Think of these “exchanges” as forms of credit, debt and repayment.
[ix] We’re not going to discuss commercial credit here. In fact, commercial credit did not come into its own until after the introduction of currency.
[x] Think about the deferred like kind exchange. Rarely do you see two parties swapping properties between them. Rather, the seller who is seeking to acquire replacement property has to search elsewhere for the desirable property. Thus, at least four parties are required to effect the transaction: the seller of the relinquished property, the buyer of such property, the qualified intermediary who accepts payment for the relinquished property, and the seller of the replacement property, from whom the qualified intermediary acquires such property on behalf of the original seller. Phew!
[xi] “Valuable” in that someone was willing to give up something they had in exchange for the coin.
[xii] The Federal Reserve Bank, in the U.S.
[xiii] I.e., the ability to avoid their lawful tax obligations. After all, it is relatively difficult to trace and relatively easy to hide.
[xiv] Before 1971, paper money included the following statement: “This note is legal tender for all debts, public and private, and is redeemable in lawful money at the United States Treasury or at any Federal Reserve Bank.”
“Lawful money?” Gold.
[xv] Take a look at the paper money in your pocket or wallet, assuming you still carry any. It includes the following statement: “This Note Is Legal Tender for All Debts, Public and Private.” It is no longer redeemable for money.
In 1971, President Nixon eliminated the convertibility of the dollar into gold. One of the reasons for doing so was to prevent foreign governments from exchanging the dollars held by their central banks for the U.S.’s gold reserves.
[xvi] Me.
[xvii] For example, U.S. dollars.
[xviii] As I understand, these “units” or “tokens” are created by a complex computer code.
For a good discussion of cryptocurrencies, generally, I found the one on ASIC’s website especially helpful: https://www.moneysmart.gov.au/investing/investment-warnings/virtual-currencies .
[xix] The transfer is described as being “peer to peer.”
[xx] For example, by ensuring that the same unit of currency is not used twice in short order by the same person.
I can’t speak for others, but give me a central bank over private miners any time. Again, if I can’t understand it, . . .
[xxi] Though it appeared in the “computer world” well before that.
[xxii] Notice 2014-21.
[xxiii] Bitcoin is one example of a convertible virtual currency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.
The IRS stated that no inference should be drawn with respect to virtual currencies not described in the notice.
[xxiv] Query how such fair market value is to be determined. By reference to the value of the service rendered or of the property sold?
[xxv] To-date, the IRS has not treated virtual currency in the same way as foreign currency for purposes of IRC Sec. 988, which addresses foreign currency transactions.
[xxvi] Viewed differently, has the virtual currency appreciated in value? I’ve wrapped my head around this by thinking of the virtual currency as a metal or other commodity. Supply and demand at work?
[xxvii] Though its value relative to other items may be different at different periods of time; for example, because of inflation. I remember when a regular slice of pizza was 25 cents. Today, that regular slice is $3.00.
[xxviii] For example, as rent, premiums or compensation.
[xxix] American Institute of Certified Public Accountants.
[xxx] Virtual currency, the IRS explained, is generally defined as “a digital representation of value” that functions in the same manner as a country’s traditional currency. Hmm. A glimpse of things to come?
[xxxi] IR-2018-71.
[xxxii] The figure is probably closer to 2,000 now.
[xxxiii] Presumably because of the “peer to peer” feature. Like barter?
[xxxiv] https://www.irs.gov/businesses/irs-announces-the-identification-and-selection-of-five-large-business-and-international-compliance-campaigns
[xxxv] Compare the IRS’s approach (the OVDP) toward undisclosed foreign bank and other financial accounts.
[xxxvi] IR-2019-132.
[xxxvii] The IRS’s own data mining.
[xxxviii] Talk about beating a dead horse.
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