UNCERTAINTY IN VIRTUAL CURRENCY TAXATION.

• Author: Goel, Neha

1. INTRODUCTION

   The popularity of virtual currency and crypto assets has increased tremendously in the recent years. In fact, "[t]he U.S. is among the countries that host the highest concentration of cryptocurrency and Bitcoin trading volume in the world." (1) The Internal Revenue Service ("IRS") issued its first guidance on virtual currency in 2014 in the form of a sub-regulatory Notice. (2)

   The guidance came in the form of a Revenue Ruling and Frequently Asked Questions ("FAQs") that apply to taxpayers holding virtual currency as a capital asset (together referred to as the "IRS guidance"). (3)

   For the purposes of this Note, the terms virtual currency and cryptocurrency are used interchangeably.

   The IRS defines virtual currency as:

   [A]ny digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary. .... Digital assets are not real currency (also known as "fiat") because they are not the coin and paper money of the United States or a foreign country and are not digitally issued by a government's central bank. (4) With new virtual currencies (5) bombarding the blockchain. the guidance related to virtual currency needs to evolve as well. (6) Currently, the IRS has some FAQs and Notices addressing the basic definitions and clarifying the treatment of various types of virtual currency transactions. (7)

   The IRS Notice 2014-21 acknowledges that there are still unanswered questions pertaining to the taxation of virtual currency. (8) Taxpayers dealing in virtual currency need to be extra vigilant while filing their federal and state tax returns to properly document their transactions as the reporting requirements can be complicated. (9)

   This Note will discuss the inadequate guidance on virtual currency and the tax law treatment of most popular virtual currency transactions such as staking and Non-Fungible Tokens ("NFTs"). This Note will also discuss the current foreign reporting requirements (FBAR and FATCA) for virtual currency held abroad and the challenges posed by the inadequate guidance. Finally, this Note will propose solutions to address some of the current challenges and uncertainties the taxpayers face.

2. CURRENT GUIDANCE ON VIRTUAL CURRENCY

   The threshold issue is the lack of proper guidance issued by the IRS on virtual currency or the related transactions. The IRS first clarified its stance on virtual currency in 2014 in the form of a sub-regulatory Notice. (10) The IRS has also published forty-six FAQs regarding virtual currency on its website. (11) Additionally, the IRS expanded its guidance from 2014 by including Revenue Ruling 2019-24 and adding more FAQs. (12) In the past, the FAQs have been used to provide information about "run-of-the-mill topics, such as filing timelines, filing statuses," how to check the status of a refund or an amended return, and so on. (13) Recently, the IRS has relied heavily on FAQs as they are an immediate source of information for the taxpayers to provide guidance on more technical and complicated issues. (14)

   However, the taxpayers should be critical when relying on the FAQs. "FAQs are not published in the Internal Revenue Bulletin, are not treated as precedential or binding on the IRS and may be removed or changed by the IRS at any time (without any repository available to find prior versions of FAQs)." (15) National Taxpayer Advocate Erin M. Collins has described the "FAQ problem" as a "violation of the Taxpayer Bill of Rights, namely, the rights to be informed and to a fair and just tax system." (16)

   In the Government Accountability Office's ("GAO") Report, the IRS took the stance that "FAQs are illustrative of how longstanding tax principles apply to property transactions." (17) The agency also clarified that it "does not take positions contrary to public FAQs." (18) The statement is contrary to the agency's previous stance that FAQs are not legal authority. (19) On October 15, 2021, the IRS initially published a news release to further clarify its position on the legal authority of the FAQs. (20)

   The news release does two important things. First, it gives the FAQs some standing in the realm of the sub-regulatory guidance. (21) The IRS has enhanced the information reporting process by issuing the FAQs via "Fact Sheets." (22) IRS's FAQs are not binding authority but "[a]ccording to the press release, Fact Sheets are considered authority for purposes of the exception to accuracy-related penalties that applies when there is substantial authority for the treatment of an item on a return." (23)

   Second, the news release addresses the "archival storage" of the previously published and deleted FAQs. (24) Specifically, the news release focuses on a taxpayer's "good-faith" and "reasonable reliance" as a defense against negligence or accuracy related penalty. (25) IR 2021-202 was accompanied by a new policy, "General Overview of Taxpayer Reliance on Guidance Published in the Internal Revenue Bulletin and FAQs." that is published on the IRS website. (26) The language in the news release and the new policy on the IRS website are quite similar. The policy recognizes the non-precedential nature of the FAQs but, like the news release, gives weightage to "a taxpayer's reasonable reliance on an FAQ" in determining certain accuracy related penalties. (27)

   Reasonable reliance, according to the IRS, refers to reliance that was reasonable and based on all the relevant facts and circumstances. (28) Such reliance is considered "a valid reasonable cause defense" against "a negligence penalty or other accuracy related penalty." (29)

   The news release and the policy provide important benefits to taxpayers, especially when they rely on FAQs to take a position contrary to the IRS. Taxpayers can now have a reduced penalty exposure if they can show "reasonable cause" and "good-faith" reliance. (30) The policy and news release mention that the relief does not apply to all the penalties. (31) Furthermore, taxpayers must exercise caution in case the FAQ turns out to be an inaccurate statement of law. (32) In such a scenario, the existing law will govern and the taxpayer may end up with additional penalties. (33)

   The news release states that "[i]n addition to significant FAQs on new legislation, the IRS may apply this updated [Fact Sheet] process in other contexts, such as when FAQs address emerging issues." (34) The IRS has already published forty-six FAQs related to virtual currency transactions. (35) It is unclear whether the guidance in the news release and the policy will apply to the already published FAQs. In addition, it is unclear if the outdated versions of the FAQs will be archived.

   Confusion surrounding the complexities of the virtual currency technology has contributed to the underreporting of income in many instances. (36) This leaves the unsophisticated taxpayers confused and ina state of disarray. The volatility of the cryptocurrency market--especially during the last two years--has posed challenges to ensure that the agency is able to keep up with proper guidance and regulations. (37) Failure to accurately report or to underreport carries steep civil penalties along with criminal charges in some cases. (38)

   For tax year 2020 the IRS moved the cryptocurrency question from Schedule 1 of the Form 1040, where it was in 2019, to the much more prominent position of Page 1 of the Form 1040 itself.... The question reads as follows: "At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?" .... On March 2, 2021 the IRS issued new guidance... that states "If your transactions involving virtual currency during 2020 were purchases of virtual currency with real currency, you are not required to answer yes to the Form 1040 question." (39) While this disclosure makes reporting easier, it also shows "the disconnect between the instructions and the FAQs--with a lack of formal guidance." (40)

   The new infrastructure bill (41) signed on November 15, 2021, contained legislation pertaining to new reporting requirements for virtual currency. (42) "The new law will require the brokers... to issue a 1099-B" and "notify the IRS directly of crypto transactions." (43) The law extends traditional reporting requirements for certain transactions involving over $10,000 in physical cash transactions involving a newly defined category of "digital assets," including cryptocurrencies. (44)

   Section 60501 requires businesses that "receive" over $10,000 in cash (or other untraceable instruments like cashiers' checks and money orders) to file a Form 8300 with the IRS, which includes the name, address, and taxpayer identification number, among other information, of both the payer and the beneficiary (usually the recipient) of the transaction. Because the "receipt" of physical cash generally involves an in-person transaction, Section 60501 historically has been applied mainly to transactions involving the in-person purchase of goods or services, such as when a person pays cash for jewelry, a car, or legal representation. (45) Violation of this law is considered "a felony punishable for up to five years in prison." (46) Those who oppose the law fear that the law will expand the government's reach and "warrantless surveillance[;]" proponents of the law argue that it is a much-needed step in regulating the digital transactions. (47)

   Taxpayers have to be cautious while reporting their virtual currency transactions due to the lack of comprehensive guidance. The 2014 and 2019 Revenue Rulings do not "address the administrative challenge associated with the taxation of cryptocurrencies." (48) They do not address the different kinds of virtual currency transactions--including staking rewards and NFTs--and foreign reporting requirements. (49)

   Even though the IRS is trying to keep up with the volatility and changes in virtual currency transactions, it is...