Digital/Virtual/Cryptocurrency are an electronic representation of monetary value, an alternative asset. The market is highly volatile, and questions remain as to whether digital is a legitimate currency. This article will help you better understand cryptocurrency, as well as its tax implications.
In its infancy, such items as Bitcoin and certain other digital currencies had a reputation of being utilized for money laundering and illegal drugs. While it is doubtless still being used for such purposes, it has now become a mainstream investment option. Let’s breakdown the subtle but important differences with these various terms:
|Digital currencies are intangible and can be considered a superset of virtual currencies and cryptocurrencies.
Digital currencies may be regulated or unregulated, but are available only in a digital or electronic form. Digital currency (digital money, electronic money or electronic currency) is any currency, money, or money-like asset that is primarily managed, stored or exchanged on digital computer systems, especially over the internet.
All cryptocurrencies are digital currencies, but not all digital currencies are crypto.
Digital currencies are stable and are traded with the markets.
Types of digital currencies include cryptocurrency, virtual currency and central bank digital currency.
Digital currency may be recorded on a distributed database on the internet, a centralized electronic computer database owned by a company or bank, within digital files or even on a stored-value card.
Digital Currency as a broad term can contain anything that represents value in a digital manner.
Digital currency can contain firstly what we would call electronic ‘money’, money that is simply a digital representation of government issued fiat currency. Your debit card is an example of digital currency.
|An unregulated digital currency that is controlled by its developer(s), the founding organization, or the defined network protocol.
Virtual currency is a type of unregulated digital currency that is only available in electronic form. It is stored and transacted only through designated software, mobile or computer applications, or through dedicated digital wallets, and the transactions occur over the internet through secure, dedicated networks.
|A cryptocurrency is another form of digital currency which uses cryptography to secure and verify transactions and to manage and control the creation of new currency units. Bitcoin and Ethereum are the most popular cryptocurrencies.
A cryptocurrency, crypto-currency, or crypto is a digital asset designed to work as a medium of exchange wherein individual coin ownership records are stored in a ledger existing in a form of a computerized database using strong cryptography to:
· Secure transaction record.
· Control the creation of additional coins, and
· Verify the transfer of coin ownership.
While we all deal with digital currency daily if we have a credit card, use an ATM or use our smartphones to perform on-line exchange transactions, understanding cryptocurrency requires serious study.
In the United States, cryptocurrency is growing in popularity. As tax accountants, we need to understand how this world works on a basic level and then expand from there. To begin, we must understand some of the terms associated with the digital currency world.
Think of digital currency as an umbrella of virtual and crypto currency.
Our current U.S. system is “fiat” currency, meaning the dollar. We have the ability to pay for services and products digitally, through a third party. But problems still exist. We need a bank to complete a “debit” transaction, or a card processor to deal with the credit card payment or some other third party such as PayPal, and these third parties charge significant fees. Whether we pay in cash, check or debit card/credit card we continue to have issues with:
- Identity theft
- Dishonored check payments
- Compromised credit cards, and more.
Virtual currency has the ability to solve these issues. A uniform currency created through software engineering that is available to pay someone regardless of their location would be a tremendous boon. Virtual currency has become one of the most talked about investments. In the early days one Bitcoin sold for one cent; in 2021, one Bitcoin sold for over fifty thousand dollars.
The values of such currencies can be tracked on a minute-by-minute basis via We now have blockchain explorers, which track values of cryptocurrency. The use of such blockchain explorers in establishing a fair market value as of a certain date and time is approved by the IRS.
Cryptocurrency Tax Implications and IRS Compliance
Due to the fact that investing in cryptocurrency is currently a potentially profitable endeavor, the IRS is deeply interested. The first regulations were published in 2014, with Notice 2014 – 21. The notice describes how existing general tax principles apply to transactions using virtual currency. The notice provides guidance in the form of answers to frequently asked questions.
The Internal Revenue Service (IRS) is aware that “virtual currency” may be used to pay for goods or services or held for investment. Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments, it operates like “real” currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance — but it does not have legal tender status in any jurisdiction. (Side note: while this was true when these regulations were published, it is no longer accurate: El Salvador now accepts Bitcoin as fiat currency.)
Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency.
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.
In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability. Notice 2014-21 addressed only the U.S. federal tax consequences of transactions in, or transactions that use, convertible virtual currency.
Q-1: How is virtual currency treated for federal tax purposes?
A-1: For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.
Q-2: Is virtual currency treated as currency for purposes of determining whether a transaction results in foreign currency gain or loss under U.S. federal tax laws?
A-2: No. Under current applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.
Q-3: Must a taxpayer who receives virtual currency as payment for goods or services include in computing gross income the fair market value of the virtual currency?
A-3: Yes. A taxpayer who receives virtual currency as payment for goods or services must, in computing 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.
Q-4: What is the basis of virtual currency received as payment for goods or services?
A-4: The basis of virtual currency that an individual receives as payment for goods or services is the fair market value of the virtual currency in U.S. dollars as of the date of receipt.
Q-5: How is the fair market value of virtual currency determined?
A-5: For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Therefore, an individual will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.
Q-6: Does a taxpayer have gain or loss upon an exchange of virtual currency for other property?
A-6: Yes. If the fair market value of property received in exchange for virtual currency exceeds the individual’s adjusted basis of the virtual currency, thy have taxable gain. The individual has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.
Q-7: What type of gain or loss does a taxpayer realize on the sale or exchange of virtual currency?
A-7: The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the individual. An individual generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the individual.
Q-8: Does an individual who “mines” virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) realize gross income upon receipt of the virtual currency resulting from those activities?
A-8: Yes, when an individual successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.
Q-9: Is an individual who “mines” virtual currency as a trade or business subject to self-employment tax on the income derived from those activities?
A-9: If an individual’s “mining” of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by them as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute self – employment income and are subject to the self-employment tax.
Q-10: Does virtual currency received by an independent contractor for performing services constitute self-employment income?
A-10: Yes. Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on by the individual as other than an employee. Consequently, 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 the self-employment tax.
Q-11: Does virtual currency paid by an employer as remuneration for services constitute wages for employment tax purposes?
A-11: Yes. Generally, the medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes. Consequently, the fair market value of virtual currency paid as wages is subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement.
Q-12: Is a payment made using virtual currency subject to information reporting?
A-12: A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
Q-13: Is a person who in the course of a trade or business makes a payment using virtual currency worth $600 or more to an independent contractor for performing services required to file an information return with the IRS?
A-13: Generally, a person who in the course of a trade or business makes a payment 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 – NEC, Non-Employee Compensation. Payments of virtual currency required to be reported on Form 1099-NEC should be reported using the fair market value of the virtual currency in U.S. dollars as of the date of payment. The payment recipient may have income even if the recipient does not receive a Form 1099-NEC.
Q-14: Are payments made using virtual currency subject to backup withholding?
A-14: Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. Therefore, payors making reportable payments using virtual currency must solicit a taxpayer identification number (TIN) from the payee. The payor must backup withhold from the payment if a TIN is not obtained prior to payment or if the payor receives notification from the IRS that backup withholding is required.
Q-15: Are there IRS information reporting requirements for a person who settles payments made in virtual currency on behalf of merchants that accept virtual currency from their customers?
A-15: Yes, if certain requirements are met. In general, a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third-party settlement organization (TPSO). A TPSO is required to report payments made to a merchant on a Form 1099-K, Payment Card and Third-Party Network Transactions, if, for the calendar year, both:
(1) the number of transactions settled for the merchant exceeds 200, and
(2) the gross amount of payments made to the merchant exceeds $20,000.
Until then: When completing Boxes 1, 3, and 5a-1 on the Form 1099-K, transactions where the TPSO settles payments made with virtual currency are aggregated with transactions where the TPSO settles payments made with real currency to determine the total amounts to be reported in those boxes. When determining whether the transactions are reportable, the value of the virtual currency is the fair market value of the virtual currency in U.S. dollars on the date of payment. (It’s worth noting that Revenue Ruling specified only the “date” of payments and receipts, but the FAQs released in 2019 specified “date and time.” This change occurred because the IRS recognized the volatility of virtual currency.)
Q-16: Will taxpayers be subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with this notice prior to March 25, 2014?
A-16: Taxpayers may be subject to penalties for failure to comply with tax laws.
Best Practices for the CPAs and Tax Professionals when Dealing with Virtual Currency
Add the “Crypto” Question to your Standard Engagement Letter. Use the 2021 version: At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?
Questions to address with your client:
- Did the client earn virtual currency through mining or by working with others?
- Did the client, sell, trade, or spend with virtual currency?
- Did the client loan or gift virtual currency?
- Did the client inherit (regardless of method) or receive virtual currency as a gift?
- Did the client lose virtual currency in a manner other than a sale?
- Did the client receive a fork/airdrop?
- Was virtual current held in a foreign exchange?
- Did the client purchase assets in an initial coin offering/initial exchange offering/ initial token offering?
- Did the client hold virtual currency in a foreign account?
- Did the client receive “interest” in the form of virtual currency?
Want to learn more? Join us for a 3-part educational series on Virtual Currency.
Presented by Amy Wall, published author on the taxation of cryptocurrency.
Virtual Currency Part 1: Welcome to the Cryptoverse: The need-to-know guide for tax preparers! Get familiar with the ideas behind cryptocurrency, and the language you need in order to speak intelligently to your clients.
Virtual Currency Part 2: Cryptocurrency Tax Regulations: What the IRS has – and hasn’t – told us about the taxation of virtual currency; an overview of Revenue Ruling 2014-21, Notice 2019-24, IRS FAQs, Chief Counsel Memo.
Virtual Currency Part 3: Applying the Regulations: Here’s where the rubber meets the road! We’ll walk you through case studies showing you how to apply the tax regulations released to date.
Part 1 June 16th 2:00 – 3:00pm EST
Part 2 June 23rd 2:00 – 3:00pm EST
Part 3 July 7th 2:00 – 3:00pm EST
Part 1 October 6th 2:00 – 3:00pm EST
Part 2 October 13th 2:00 – 3:00pm EST
Part 3 October 20th 2:00 – 3:00pm EST