7721 / How is bitcoin and other forms of “virtual currency” taxed?

Until late 2019, the IRS had released very little guidance on the tax treatment of what it refers to as “virtual currency” except Notice 20141, which defined virtual currency as “property,” like collectible coins and antiques, which can appreciate in value. Therefore, virtual currency can be included in taxable income and taxed based the sale or exchange of the virtual property. “Convertible virtual currency” is virtual currency that is convertible into real currencies (e.g., U.S. dollars), or as a substitute for a real currency. Notice 20141 provides the basic tax rules that currently apply to bitcoin, Ethereum and other cryptocurrency transactions.

Under Notice 20141, the IRS generally treats bitcoin and other forms of virtual currency as property (and not currency that is legal tender in the United States or elsewhere). In the IRS’ own words, “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency.” This means that it is typically subject to capital gains treatment upon sale, exchange or other disposition under the general rules applicable to property dispositions, including intangible property (e.g., stocks, bonds, and collectibles).

A taxpayer who receives bitcoin in exchange for goods or services must include the fair market value (measured in U.S. dollars) of the bitcoin received in gross income. Therefore, if the fair market value of property or currency received in exchange for the bitcoin exceeds the taxpayer’s adjusted basis in the bitcoin, the taxpayer will recognize capital gain (or loss if the fair market value of property received is less than that of the bitcoin).¹ The generally applicable holding period rules can be used in determining whether the gain or loss is long-term or short-term ( Q 699). Similarly, the $3,000 capital loss limitation that can be applied against ordinary income also applies.

If the bitcoin is held by the taxpayer as inventory or property held for sale to customers in the ordinary course of trade or business (i.e., so that the property is not treated as a capital asset in the hands of the taxpayer), the gain or loss will be treated as ordinary gain or loss in accordance with generally applicable rules. In keeping with this position, the IRS Counsel indicated in a late 2020 internal Tax Advice Memorandum that cryptocurrency paid for providing micro-services, like completing an online survey, processing data or reviewing images, is taxable ordinary income to the recipient, and may even be subject to self-employment taxes, depending on the circumstances.² Every taxable event involving a taxpayer’s cryptocurrency holdings must be reported on IRS Form 8949, Cryptocurrency Tax Form.

While these rules seemed clear-cut, a recent letter from members of Congress to the IRS indicated that there was much uncertainty still remaining in the rules and procedures for taxing bitcoin transactions.³ Perhaps in part as a consequence, on October 9, 2019, the IRS released Revenue Ruling 20194 and a set of new FAQs.

Rev. Rul. 20194 and FAQ

Revenue Ruling 20194 defines and addresses the income recognition of certain crypto-currency transactions/events. In doing so, it introduces two new terms into our tax vocabulary; (1) “hard fork,” and (2) “airdropped.” The ruling outlines the taxability resulting from a hard fork when a new crypto-currency is airdropped to the holders of existing crypto-currency. A “hard fork” for tax purposes occurs when cryptocurrency on a ledger undergoes a protocol change that results in a permanent diversion from the legacy or existing distributed ledger. An “airdrop” is a vehicle of distributing crypto-currency to the distributed ledger addresses of multiple taxpayers.

The IRS outlines two scenarios of hard fork ledger protocol change situations:

(1) A hard fork ledger protocol occurs, but there is no airdrop of new cryptocurrency to current holders as part of the transaction. Hence, the IRS indicated there is no tax event generated because no new property is received increasing a holder’s wealth (see FAQ 21).

(2) A hard fork occurs but there is an airdrop of new cryptocurrency to the holders in connection with the hard fork. As a consequence, there is reportable ordinary income generated for a holder because of the receipt of new cryptocurrency (property) at the time of the airdrop.

Taxability in these situations appears to be based upon the recipient-holder’s “dominion and control” over the property- the receipt of and ability to transfer, sell, exchange, or otherwise dispose of the new cryptocurrency created by the hard fork.⁴ The ruling indicates that “[a} taxpayer does not have receipt of cryptocurrency when the airdrop is recorded on the distributed ledger if the taxpayer is not able to exercise dominion and control over the cryptocurrency.” Moreover, the ruling indicates that a hard fork is not considered a sale or exchange of a capital asset; therefore, it generates ordinary income and not capital gain.

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Planning Point: A hard fork, coupled with an airdrop, followed by a drop in value of the holder’s existing cryptocurrency has the potential to create a wealth decrease in the aggregate for the holder with ordinary income generated at the front end and capital loss at the back of the transaction. Holders with substantial holdings might find themselves stuck with significant taxable ordinary income but an unusable capital loss. Given the likelihood of more hard forks for cryptocurrency holders, anticipatory planning is in order to prevent or ameliorate this potential outcome for the taxpayer.

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The set of IRS FAQs⁵ that accompanied Revenue Ruling 20194 offered some useful information as well on the taxation of cryptocurrency transactions. In general they appear to reinforce the application of the basic income tax principles applicable to cryptocurrency. Although they cover various types of convertible virtual currency that are currently used as a medium of exchange, they do not address the treatment of contracts for the receipt of virtual currency.

Cost Basis Methods: As to some specifics, the FAQs allow only two cost basis assignment methods when selling or exchanging cryptocurrency of the same type that was acquired at different times and for different prices

(1) They require a taxpayer to use “first-in first-out” (FIFO) cost basis assignment methods; unless,

(2) The taxpayer can specifically identify the cryptocurrency being sold or exchanged.⁶

Prior to this guidance, taxpayers were potentially using five different methods of cost basis assignment (see [taxfacts_faq_link id="7723_"]).

Fair Market Value: The FAQs clarify that a taxpayer is required to look at the specific exchange for pricing data if the cryptocurrency was purchased on an exchange. As evidence, the IRS will accept the fair market value as determined by a cryptocurrency or blockchain “explorer” that analyzes worldwide indices of cryptocurrency and calculates the value at an exact date and time, if the transaction was not facilitated by a cryptocurrency exchange, or the taxpayer engages in a peer-to-peer transaction not involving an exchange. The FAQ does not specify which index or data source should be used. The FAQ allows the taxpayer to establish the fair market value under general valuation principles in lieu of using an explorer value. Finally, per the guidance, the fair market value of the cryptocurrency is the fair market value of the property or services exchanged for the cryptocurrency in the case of a cryptocurrency not traded on any exchange and that does not have a published value.⁷

It is important to note that in 2019 the IRS announced⁸ that it would begin sending letters to holders of various forms of cryptocurrency, including bitcoin, informing those taxpayers of potential misreporting (or failure to report) on virtual currency transactions. The IRS sent out another set of letters in August 2020.⁹ The IRS advised taxpayers who receive such a letter to review past tax filings to uncover any errors or underreporting, and amend those returns in order to pay back taxes, interest and penalties as soon as possible.

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Planning Point: The IRS has recently been sending out CP2501 letters to individuals with cryptocurrency holdings. If a client receives one of these letters, it's important to act quickly to avoid potential penalties. The CP2501 letter provides a taxpayer with notice that the IRS has noticed a discrepancy between reported information and other information that the IRS has received. Any client with a discrepancy could receive a CP2501 letter. Employers, cryptocurrency exchanges, and other entities report information to the IRS. When that information varies from what the client reports on a tax return, the IRS may issue a CP2501 letter. These letters do not always include an amount that the taxpayer owes to the IRS. In some cases, the taxpayer may not owe additional tax. However, it's important to respond by the letter's due date to avoid a penalty. Clients receiving CP2501 letters should review information, such as Forms 1099-B, 1099-K, 1099-MISC, and any Ws to determine whether their reporting was correct.

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These letters are part of a larger campaign designed by the IRS to crack down on misreporting or underreporting of virtual currency transactions. The IRS also announced a new Schedule 1 (to Form 1040) with a controversial, prominent Yes/No question about cryptocurrency holdings and transactions for tax year 2019 returns, and doubled down by moving the question to nearly the top of page 1 of Form 1040 for the 2020 tax year and thereafter.¹⁰

This IRS campaign to impose inclusion and taxation on virtual currency transactions has already developed a significant litigation challenge.¹¹ All this activity suggests the high IRS focus on income tax compliance of cryptocurrency transactions, and the need to carefully comply with IRS reporting and tax calculation guidance. Finally, it seems likely that a “yes” answer to cryptocurrency question on Form 1040 will increase a taxpayer’s chances of incurring an audit.