by Richard P. Breed, IV
Virtual currencies, such as Bitcoin or Ethereum, have moved beyond curiosities, and have, for several years, become legitimate and accepted methods of payment and exchange. Federal and state regulators, including the United States Internal Revenue Service (“IRS”), however, have been slow to keep up – until now.
IRS Notice 2014-21
Since publishing its initial general guidance in IRS Notice 2014-21 (“Notice 2014-21”) concerning the tax treatment of certain transactions involving virtual currency, the IRS has taken few steps to enforce compliance. In fact, despite billions of dollars being exchanged through virtual currency, the IRS estimates that a substantial amount of taxable virtual currency transactions have not been reported by taxpayers. GAO-28-188 Taxation of Virtual Currencies at page 11. Recently, however, with the publication of additional guidance in October 2019 pursuant to IRS Revenue Ruling 2019-24 (“Rev. Rul. 2019-24”) and other actions, the IRS is working to increase taxpayers’ understanding of and voluntary compliance with reporting obligations for virtual currency. Tax counsel should be mindful of this policy shift and be prepared to advise clients about the inevitable increase in taxpayer audits and, in egregious cases, criminal charges.
Notice 2014-21 clarified that the IRS will apply existing tax principles applicable to property transactions to virtual currency. Therefore, payments for goods and services using virtual currency, or exchanges from one virtual currency to another, will be treated as sales or exchanges of property that trigger gain or loss for income tax purposes. Such gain or loss will be taxed as ordinary income/loss or capital gain/loss depending on the taxpayer’s circumstances. Taxpayers who receive virtual currency in exchange for goods or services recognize income in the amount of the fair market value of the virtual currency as of the date of the exchange. Taxpayers need to track their tax basis in the virtual currency in order to properly calculate the gain or loss upon its later disposition.
IRS Revenue Ruling 2019-24
Rev. Rul. 2019-24 provided additional guidance limited to the tax consequences of a “hard fork” and an “airdrop,” which are transactions unique to cryptocurrency and its blockchain technology. As explained in Rev. Rul. 2019-24 “cryptocurrency is a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Distributed ledger technology uses independent digital systems to record, share and synchronize transactions, the details of which can be recorded in multiple places at the same time with no central data store or administration functionality.” Id. at 2. A hard fork “occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger” and “may result in the creation of a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger.” Id. A hard fork followed by an airdrop results in the “distribution of units of the new currency to addresses containing the legacy cryptocurrency. However, a hard fork is not always followed by an airdrop.” Id.
Rev. Rul. 2019-24 clarified when a taxpayer has receipt, for income tax purposes, of cryptocurrency distributed to the taxpayer from an airdrop. The IRS concluded that such receipt occurs on the date the taxpayer exercises “dominion and control over the cryptocurrency,” such as the ability to “transfer, sell, exchange, or otherwise dispose of the cryptocurrency”, id. at 3, which can occur before or after the date on which the transaction is recorded on the distributed ledger for the cryptocurrency. Id. at 2-3.
Simultaneous with the publication of Rev. Rul. 2019-24, the IRS published (and further revised on December 31, 2019) forty-five “Frequently Asked Questions” (“FAQs”) designed to promote voluntary compliance with tax reporting of virtual currency transactions. The FAQs came on the heels of the IRS Virtual Currency Compliance Campaign, which had been launched in July 2018 and is designed to reduce noncompliance in tax reporting through additional education, outreach, and, if necessary, examinations.
Don’t expect the IRS, however, to rely solely on taxpayer voluntary compliance. For example, in 2018, the U.S. District Court for the Northern District of California granted the IRS’s motion to enforce its summons against Coinbase, Inc. (“Coinbase”), a virtual currency exchange platform, to turn over identification data, including tax ID numbers, on any user who engaged in a virtual currency transaction in excess of $20,000 from 2013-2015. United States v. Coinbase, Inc., 2017 U.S. Dist. LEXIS 196306, *21, Case No. 17-cv-01431-JSC, November 28, 2017. Coinbase ultimately transferred personal data and account information on over 13,000 users to the IRS. Id. Not surprisingly, using this information, the IRS sent 10,000 warning letters in early 2019 to taxpayers whom it thought failed to properly report at least one transaction involving virtual currency. The letters advised taxpayers to amend prior tax returns to report any virtual currency transactions. IR-2019-132, July 26, 2019. See also Shehan Chandrasekera, “How the IRS Knows You Owe Crypto Taxes,” Forbes (January 21, 2020).
IRS Amended Schedule 1 to Form 1040
To assist taxpayers for future years, beginning with calendar year 2019, the IRS also amended personal income tax form, Schedule 1 to Form 1040 to add a question concerning whether or not the taxpayer engaged in any transaction involving virtual currency during the year. If so, the form directs the taxpayer to disclose such transaction, if taxable. Taxpayers may wish to seek assistance of tax counsel to decipher which transactions must be reported and to calculate any gain or loss.
IRS Solicitation of Virtual Currency Professionals to Assist in Audit of Tax Returns
Most recently, in May of 2020, the IRS began to privately solicit experienced virtual currency professionals to assist the IRS with taxpayer examinations dealing with virtual currency. A copy of that solicitation has been posted online by various sources and is available here.
It should be noted that the IRS has not indicated a plan to offer an amnesty-type program similar to the Offshore Voluntary Disclosure Program, which dealt with taxpayers who previously failed to report income or assets held in accounts the custodian for which is located outside the United States. In addition, it is unclear whether taxpayers who voluntarily amend their tax returns to report taxable income from virtual currency transactions will be entitled to relief from interest and penalties due for failing to report the income.
It is abundantly clear, however, that the IRS is focused on increasing compliance in reporting taxable transactions involving virtual currency, and that taxpayers need to be aware of this. For their part, tax counsel should be mindful of these developments when advising their clients and remain vigilant for additional notices and rulings in the ever-evolving field of virtual currency.
Richard P. Breed, IV is an associate with the firm Tarlow, Breed, Hart & Rodgers, P.C., whose practice concentrates on business and tax planning for individuals and privately-held businesses.