Announcing a New Tax Brief: Tax Planning for Cryptocurrencies

Introduction

I’ve written a Tax Brief discussing long-term U.S. tax planning for cryptocurrency investors. Every such investor must be fully aware of the potential tax traps and planning opportunities involving cryptocurrencies.  My Tax Brief runs the gambit from absolute disaster and financial ruin to extremely favorable taxation, including in some cases, cryptocurrency gains without federal or state taxation. Here are excerpts from my Tax Brief – you decide whether spending $9.95 for this information is worth it:

Beware – Major Tax Trap!:  Trading in cryptocurrencies carries a huge tax risk!  Losses from one calendar year cannot be carried back to offset gains from prior years.  This drawback often occurs with day traders of securities and others who do not understand how the capital gain and loss rules work.  Consequently, taxpayers can generate a huge tax without retaining sufficient assets to pay it.

Cryptocurrency As Payment For Goods or Services:  Receiving cryptocurrency as payment creates ordinary business income, but the asset is subject to capital gains and losses, so the cryptocurrency recipient has ordinary income as to the fair market value of the product being sold or service performed, whether or not the cryptocurrency thereafter increases or decreases in value.

The Lesson: Be cognizant of your gain or loss position and make sure you sell loss positions by the end of the calendar year to offset gains during the year.  Selling the loss positions in the subsequent year can lead to disaster because you cannot carry them back.  For merchants and service providers, make sure your cryptocurrency transactions comprise a fraction of your business transactions or sell them immediately to protect yourself against a devaluation; remember, your income is based on the price of the product or service sold and not the subsequent value of the cryptocurrency.

Tax-Planning Concept:  A C corporation is a separate taxpaying entity.  Prior to 2017, C corporations were taxed at a maximum federal rate of 35%; the 2017 tax act lowered the corporate tax to 21%.  This compares favorably to the highest federal individual tax rate of 38.8%.  However, if a C corporation makes dividend distributions to individual taxpayers, the dividends are taxed at capital gains rates, so there is a potential double tax on corporate income, once at the C corporation level and again at the shareholder level.  If the goal is to invest and reinvest in cryptocurrencies (or any other investment asset, such as stock or securities) for the long term, the initial savings in taxes by using a C corporation should outstrip the potential for a shareholder-level tax down the road.  The earnings of the corporation may be used to fund family real estate ventures or other investments, without triggering a tax on dividends.  Note: with careful planning, state income taxes can be avoided as well.  A C corporation can protect you against individual liability if disaster strikes in the form of gains in one year and losses in a subsequent year.

Conclusion:  Savvy taxpayers should consider investing through a C corporation to reduce taxation and for personal asset protection.  At a minimum, investors need to thoroughly understand how capital gains and losses work, since IRS considers cryptocurrency property, an asset, and not the equivalent to actual currency.  Thus, every transaction with cryptocurrency is taxable.

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U.S. Tax Laws Involving Foreign Income, Assets and Financial Accounts

1. U.S. Taxpayers (generally individuals physically present in the U.S. 121 days or more during a calendar year, long-term residents and citizens) must report their world-wide income, credits and deductions on U.S. tax returns (Form 1040) and, in general, are entitled to foreign tax credits for income taxed by a foreign country. Non-residents are subject to U.S.: (i) income tax on their U.S. source income; and (ii) estate tax on their U.S. property, including real estate and securities (stocks, bonds and debt instruments) of U.S. companies and individuals. See IRS Publication 54 (also available as a .pdf) for details. 

2. U.S. Taxpayers with an ownership interest or signature authority over foreign financial accounts (bank and brokerage accounts, corporate, trust and other entity accounts, certain retirement plans and life insurance with a cash value) are required to electronically file an annual Foreign Bank and Financial Account Reports (FBARS) on or before the due date of their income tax return for the following year. The maximum fine for non-willful failure to timely file an FBAR is $10,000 and there is a six-year statute of limitations for assessing the penalty. The penalty may be reduced or eliminated upon showing “reasonable cause.” 

3. In addition to the FBAR requirement, starting in 2011 U.S. taxpayers with foreign financial account and certain other financial assets (generally, stock or securities, including certain employee stock benefit plans) must report those assets on Form 8938, which is filed with the Form 1040. The threshold filing requirements start at $50,000 for single taxpayers ($100,000 11 The amount increases to $400,000 if you and your spouse are living outside the U.S. and file a joint return. for married couples filing joint returns) living in the U.S. 

4. U.S. Taxpayers who have a 10% or greater interest in a foreign corporation must file Form 5471 with the Form 1040. There are equivalent filing requirements for 10% or more ownership in a foreign partnership. 

5. U.S. Taxpayers who receive a foreign gift or inheritance from an individual of more than $100,000 during the calendar year must file Form 3520 to report the gift or inheritance. The due date of Form 3520 is the same as the Form 1040, and is extended if a valid extension is filed for the Form 1040. The threshold reporting requirement for a gift from an entity or trust is much lower. 

6. U.S. Taxpayers who earn wages or self-employment income while residing outside the U.S. may be entitled to a foreign earned income exclusion if they are considered residents of a foreign country or remain outside the U.S. for a period of 330 days during any 12-month period. The maximum income exclusion is $104,100 for 2018. The exclusion must be claimed on a timely filed U.S. tax return, it is not automatic. There is also a partial exclusion for housing costs, if they exceed a certain minimum. 

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