Between a Rock and a Hard Fork: the Tax Implications of Cryptocurrency

• Publication year: 2019
• Author: By Ryan Schuh & Kali McGuire

Between a Rock and a Hard Fork: The Tax Implications of Cryptocurrency

By Ryan Schuh & Kali McGuire¹

I. INTRODUCTION

The cryptocurrency bubble that appeared to peak in December 2017 will have considerable aftershocks in the coming years, and understanding the tax impact of the massive value gyrations of the various forms of cryptocurrencies on practitioners' individual and institutional clients will be paramount. The additional estimated $25 billion in potential tax revenue² is of great interest and may lead to heightened enforcement efforts of the Internal Revenue Service ("IRS") and other regulatory bodies. This article explores some of the US federal tax implications of cryptocurrency to both individual and institutional investors in a variety of circumstances as well as the currently uncertain regulatory environment.

Three US federal regulators have introduced certain guidance on cryptocurrency in the absence of a comprehensive regulatory environment. The IRS has characterized cryptocurrency as property for tax purposes,³the Financial Crimes Enforcement Network ("FinCEN") monitors cryptocurrency as part of its anti-money laundering procedures,⁴ and the Securities and Exchange Commission ("SEC") has made some strong statements on initial coin offerings ("ICOs") and the trading of cryptocurrency, warning taxpayers about "rampant fraud" in the ICO market. While not inconsistent with each other, this multi-agency approach has confused tax and financial reporting, and has likely contributed to some level of non-disclosure or reporting as taxable income.⁵

II. IRS GUIDANCE

To date, the IRS has solely addressed cryptocurrency in Notice 2014-21 ("the Notice"), which to date is the entire insight into the IRS's position on cryptocurrency.⁶ The Notice states that although certain cryptocurrency (referred to in the Notice as "convertible virtual currency") has attributes of "real" currency in some circumstances, such as coins and paper money of the US, it does not have legal tender status as a fiat currency in any jurisdiction.⁷ The Notice also details various tax attributes of virtual currency that will be discussed in this article.

Notably, the Notice states that cryptocurrency is treated as property for federal income tax purposes.⁸ For investors, the tax attributes of cryptocurrency can be compared to shares of corporate stock, which is also taxed as property and is characterized as a capital asset subject to capital gains tax. However, virtual currency is not definitively characterized as a capital asset—the Notice points out that the character of the gain or loss depends on whether the virtual currency is a capital asset in the hands of the investor.⁹ A capital asset is defined as property held by the taxpayer, usually for investment purposes.¹⁰ If the taxpayer is not holding the virtual currency for investment, the character of the gains and losses are treated as ordinary. In either case, the basis and fair market value for virtual currencies are computed the same way. Basis is generally the amount paid to acquire the virtual currency, while the fair market value is the value on the day it is sold. The difference between the two being the taxpayer's gain or loss, which may be capital or ordinary depending upon the circumstances.¹¹

In addition, the Notice addresses specific transactions related to cryptocurrency that are taxable.¹² It provides that payments denominated in cryptocurrency made to employees or other individuals are subject to the same informational reporting as traditional payments.¹³ Additionally, such payments are also subject to federal tax withholding and the various employment taxes (FICA, FUTA, etc.) must be reported on Form W-2 issued to the taxpayer by his or her employer.¹⁴ Additionally, individuals who "mine" cryptocurrency (discussed in more detail later) are also subject to tax and reporting.¹⁵

III. TAX IMPLICATIONS OF CRYPTOCURRENCY

Taxpayers receive cryptocurrency in a variety of circumstances, including acquiring cryptocurrency for investment purposes and receiving compensation paid in cryptocurrency for services performed. In each instance, there may be differences between the character of the relevant cryptocurrency and, consequently, the type of tax imposed on the related gain or loss (in the "investment" scenario). The Notice addresses a few specifics related to investment,

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wages, and if cryptocurrency is subject to self-employment tax—and in what context.

A. Trading and Investors

Trading cryptocurrency is a taxable event. In concept, cryptocurrency is similar to commodity trading because trading one cryptocurrency for another causes a taxable event in the same way that trading gold for copper does.¹⁶Computing gain or loss on cryptocurrency transactions is theoretically simple—the taxable gain or loss is the difference in the investor's basis in the cryptocurrency and the fair market value on the date of sale.

If the cryptocurrency in question is treated as property held for investment, gain on the transaction is subject to taxation as capital gain. The current long-term capital gains rates are zero percent, 15 percent, and 20 percent depending on the taxpayer's taxable income bracket,¹⁷ while short-term (i.e., held less than one year) capital gains are taxed at ordinary rates. Capital gain treatment allows a taxpayer to net his or her gains and losses, which is of course favorable to the taxpayer, but the ability to deduct net capital losses is capped at $3,000 per year.¹⁸ Additionally, investors in the top tax brackets may be subject to the 3.8 percent net investment income tax ("NIIT") imposed on investment income. Gains and losses realized as a result of investment and sale in cryptocurrency should be reported on Schedule D of the Form 1040 as a capital gain or loss.

Due to the volatility of cryptocurrency prices and the frequency in which some investors execute trades, the most important and potentially contentious aspect of trading is documenting basis and sales price at the moment the cryptocurrency is bought and sold. Cryptocurrency exchanges are not currently considered "brokers" within the scope of section 6045(c). Therefore, investors are generally not issued a Form 1099 for their activity on the exchange and are in charge of their own documentation.¹⁹ Accordingly, it is the individual investor's responsibility to record and keep track of the basis and fair market value of all cryptocurrencies held, so as to properly report gain and loss for US tax purposes upon ultimate disposition.

B. Mining Income

Individuals that mine cryptocurrency—that is, those that create or are granted units of a cryptocurrency on the blockchain through the use of their personal computer for executing smart contracts or other computing assets—may report the cryptocurrency thus created as "other ordinary income," or, in some instances, wages. In a practical sense, mined income should be treated as wages or self-employment income if it is the taxpayer's primary source of income or part of a trade or business.²⁰ If mining is a secondary source of income, it may be treated as other income. Any cryptocurrency mined should accordingly be considered gross ordinary income in the amount of the fair market value of the cryptocurrency at the moment of mining. If the individual mines cryptocurrency as his or her primary employment, then self-employment taxes should be considered as it could be construed as a trade or business transaction.²¹ Individual or entrepreneurial miners may also be able to deduct the reasonable expenses incurred in generating cryptocurrency.²²

C. Hard Forks

On July 31, 2017, perhaps the most well-known "fork" in the blockchain took place—the hard fork that derived Bitcoin Cash from Bitcoin. On November 15, 2018, Bitcoin Cash subsequently hard forked into Bitcoin SV.²³ A "fork" typically occurs on the blockchain when developers want to add new features to an existing coin/token or mitigate the effects of hacking.²⁴ A "hard fork" creates a change in the blockchain that is substantially different from the original blockchain such that it creates a distinct and separate cryptocurrency. Although a new cryptocurrency is created, it may not be recognized until exchanges, wallets, and developers support it.²⁵ The value of the assets created from the hard fork is therefore speculative until a relatively stable market is established for the new currency.

A hard fork, specifically, is relevant for tax purposes because frequently the investor on the main blockchain receives one coin of the new chain for each original coin that they own. For example, if an investor owned ten Bitcoin immediately prior to the Bitcoin Cash fork, they may have received, or were at least entitled to receive, ten "free" Bitcoin Cash after the hard fork occurred.

1. Basis Uncertainty

Because the investor receives "free" coins, there is some question about what the investor's basis is in the new coin. One might surmise that his or her basis in such a coin is represented by the fair market value of the coin at the date of receipt, but, setting aside the question...