Category: Cryptocurrency Tax

The Unresolved Tax Consequences Involving Cybercurrency Staking

Posted on by sommers

Introduction:

There is a raging debate on social media about whether the activity of cybercurrency
staking is similar to a baker who creates a cake using raw ingredients and is not taxed until the
cake is sold, or whether staking involves personal services and the taxpayer is receiving assets
(new coins) as compensation, in which case, receipt of the coins is immediately taxable.

The Controversy:

The current controversy involves a Tennessee Federal District Court case, Jarrett v. US in which a taxpayer who paid taxes on “staking rewards” (new coins he received for his activities), sued for a refund claiming his actions were comparable to the baker making a cake. IRS agreed to pay the refund and has moved to have the case dismissed. Many commentators, without the slightest clue as to how IRS operates, have erroneously concluded that staking is akin to making a cake, because IRS decided to issue a refund in the Jarrett case and have the case dismissed

Potential Reasons for the Refund:

First, the amount in controversy involved a refund claim of $3,000 and is would cost the government probably ten times, if not twenty or thirty times the refund claim the litigate the matter. More importantly, IRS is working on the issue of how to tax staking activities and has not reached a conclusion. The issue involves potential hundreds of millions, if not billions in future tax revenue and, logically, IRS did not want a federal judge (who may or may not have substantial federal tax experience) making a potential adverse decision that would cause massive confusion, before it establishes a position on the matter. Thus, the issuance of a $3,000 refund should not be considered definitive win for those participating in staking.

Based on current law, staking income should be realized when there is payment for the services, in the form of an asset, whether a virtual asset or otherwise. In the Jarrett case, the taxpayers received Tezos tokens worth approximately $9,000, so they received property with an ascertainable value for work performed and taxpayers should be taxed upon receipt of the coins.

Taxpayers’ Argument:

Taxpayers’ claim that newly created property is not an accession to wealth that is clearly realized — the making a cake analogy– so they should not be taxed until the coins are sold. Taxing them when the coins are received is analogous to taxing a baker when the cake is finished and for sale, whether or not someone buys it. But were taxpayers actually making the Tezos coins? They reviewed and validated new blocks within an existing block chain, but did not actually create the Tezos coins in the sense that a baker creates a cake or an author writes a book.1 They were paid for their services with coins.

The” Central” Issue:

The core question is the value of the asset when received. In many cases, the asset’s value is zero, in which case the taxpayer does not have income when the asset is received (the taxpayer has a zero basis in the asset). When the asset has an ascertainable fair market value upon receipt, the asset should be immediately taxable; thus, if the asset’s value is $10 when received, taxpayer has $10 in compensation income and a $10 basis in the asset for determining future gains or losses. In Jarett’s case, the coins were worth $9,000 upon receipt, so they should be taxed on that amount as ordinary compensation income.

Conclusion:

It will be interesting to see whether IRS decides that staking is like making a cake or is just another form of payment for personal services.

1 Of course, they had a small role in the creation of the coins, but the same can be said of an auto assembly-line working making a car. If the worker received a car as payment, could the worker claim the car is not taxable under the “making a cake, writing a book” rationale?

Form 3520: Foreign Gift of Cryptocurrency and Other Assets

Posted on by sommers
Global Crytocurrency image

Introduction:

Say you receive a gift or inheritance1 from a foreign individual of cryptocurrency, or other assets, including cash: First, the good news – the gift is not taxable to either the foreign donor (giver) or the done (recipient) – you receive the gift tax free. The bad news, check out these potential filing and disclosure requirements (including Form 3520)!

Example: Assume you are a single U.S. taxpayer (note, your citizenship or visa status is irrelevant– these rules apply to every U.S. taxpayer).2 In calendar year 2020 your foreign parent makes you three gifts on different dates, of: (i) $50,000 in cash; (ii) stock in a foreign company worth $75,000; and (iii) cryptocurrency worth $100,000, for a total of $225,000.3 Assume the cash was deposited into a foreign bank account owned jointly by you and your parent. What were your U.S. tax obligations?

Tax Reporting Obligations:

Form 3520: This form is required whenever you receive one or more gifts from one or more foreign individuals during the calendar year when the aggregate fair market value exceed $100,000. [See my Form 3520 video for more details] In our example, you received foreign gifts worth $225,000 reportable on or before the due date of your 2020 income tax return, either April 15, 2021 or October 15. 2021. Since you did not timely file Form 3520, you could be subject to huge penalties, 5% per each month the return is late, to a maximum of 25%. Form 3520 is a separate and independent filing obligation and must be paper-filed with the IRS in Odgen, Utah. The statute of limitations for IRS to assess this penalty is suspended until three years after the return is filed.

FBAR: Because there was more than $10,000 in your jointly-held foreign bank account in 2020, you were obligated to file an FBAR (Report of Foreign Bank and Financial Account) by the due date of your income tax return, with regard to extensions, similar to the deadline for filing Form 3520. The FBAR is filed on-line and is a separate and independent filing obligation. The FBAR also applies to stock held in a bank or brokerage account (or similar institution). There is a six-year statute of limitations for FBAR penalty assessments.4

Form 8938: Your foreign financial assets exceed the $50,000 threshold for single filers ($100,000 for joint filers residing in the U.S.); therefore, you needed to file Form 8938 with your income tax return. Your foreign bank account and stock holdings are foreign financial assets and your cryptocurrency might be a foreign asset if it is held by a foreign exchange or foreign $100,000, whichever is higher, if IRS concludes you willfully failed to file the FBAR. Penalties may be reduced or eliminated if you can show IRS that the failure was due to “reasonable cause” (a much-litigated concept) and there may be voluntary disclosure programs to mitigate the penalty. financial institution. The penalty for failing to file Form 8938 is $10,000 per year and there is no statute of limitations for assessment of the penalty until three years after the form is filed.5

Form 1040: On the first page of Form 1040, IRS asks, “At any time during 2020, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency? Yes or No.” You must answer this question “Yes” because you received a gift of cryptocurrency. Note receipt of cryptocurrency (other than by purchase), whether from a U.S. or foreign person and whether by exchange, gift or inheritance requires a “Yes” answer. Although there is not a specific penalty for failing to accurately answer this question, it is clearly a badge of fraud if you supply a false or misleading answer and remember, you file tax returns under federal laws of perjury. In short, there are criminal tax fraud implications if you deliberately falsify your answer to this question. Failing to answer the question in circumstances where you were required to answer “Yes” amounts to fraud, so don’t be clever and not answer the question.

Other issues: If your ownership interest in the foreign corporation is 10% or more, you could have a Form 5471 filing obligation. There is a similar, although not identical rule for foreign pass-through entities, such as partnerships or limited liability companies. If the foreign stock was held in a foreign mutual fund or other passive investment, you could have a PFIC (Passive Foreign Investment Corporation) Form 8621 tax issue. The PFIC rules can be extremely complex and only a handful of CPAs are qualified to handle them. Also, PFICs may have potentially punishing tax rates.

Conclusion:

What appeared to be a simple foreign gift/inheritance transaction with no immediate tax consequences may generate a multitude of reporting duties. A foreign gift/inheritance of —

a. Cryptocurrency could trigger Form 3520, Form 8938 and FBAR filing requirements, as well as a Form 1040 virtual currency disclosure.

b. Cash or assets could trigger Form 3520, Form 8938 and FBAR reporting obligations.

c. Foreign stock or securities could spark Form 3520, Form 8938, FBAR (if the stock is held in a foreign financial account). Form 5472 and PFIC filing duties.

  1. Note: The rules apply with equal force to foreign inheritances.
  2. Note: Those who are physically present in the U.S. illegally still must comply with U.S. tax law and these rules apply to illegal assets or substances as well. In general, the tax code makes no distinction between legal or illegal activities or assets.
  3. Note: non-cash gifts are priced at fair market value at the time of the gift.
  4. The penalties range from $10,000 for a non-willful failure to as much as 50% of the amount in the account or $100,000, whichever is higher, if IRS concludes you willfully failed to file the FBAR. Penalties may be reduced or eliminated if you can show IRS that the failure was due to “reasonable cause” (a much-litigated concept) and there may be voluntary disclosure programs to mitigate the penalty.
  5. As with other international form filing penalties, Form 8938 penalties may be reduced or eliminated if you can show IRS that the failure was due to “reasonable cause” (a much-litigated concept) and there may be voluntary disclosure programs to mitigate the penalty.

Taxation of Cybercurrency Exchanges

Posted on by sommers

Internal Revenue Code Section 1031 defers taxation involving exchanges of like-kind property held for investment or business. If a taxpayer traded one parcel of real estate for another, the transaction is, in general, tax-free. Congress changed Section 1031, commencing January 1, 2018, applying it solely to real estate. But what about exchanges of cryptocurrency prior to January 1, 2017; did they qualify for tax-free treatment? Tax experts reasoned that a swap of one cryptocurrency for another probably fell within Section 1031 and was not taxable.

IRS Memorandum

On June 8, 2021, IRS published a Memorandum (Number 2021124008, appended to this article) stating that exchanges involving swaps of Bitcoin, Litecoin, and Ether were not covered by Section 1031 because of differences in overall design, intended use and actual use. This Memo should apply to practically all pre-2018 cybercurrency swaps. Note: although the Memo is not law and the courts are not bound by it, it is followed by IRS so expect audits of pre-2018 cryptocurrency exchanges.

While the like-kind exchange rules are broadly interpreted for real estate, the same is not true for other assets. IRS has ruled that gold is not like-kind to silver and a bull is not like-kind to a cow. Cybercurrencies are intangible assets and the exchange rules for intangibles are much more restrictive than real estate; thus, successfully challenging the Memo could be problematic, if not futile.

Amending Your Return

So, should you amend your pre-2018 tax return to report cybercurrency exchanges? The answer may depend on whether the applicable statute of limitations for tax assessments has expired. The usual rule is three (3) years from the date the return was filed, so assessments for the 2017 tax year (assuming the return was filed on the due date, April 15, 2018), would have expired on April 1, 2021 (or will expire on October 15, 2021 if an extension was filed). There is a special six (6)-year statute of limitations when, in general, taxpayers fail to report more than 25% of their gross income1. Unless the exchanges were properly reported on Form 8824 or IRS was otherwise adequately notified of the transactions, expect the six (6)-year statute to apply.

As a practical matter, taxpayers claiming exchange treatment would have filed Form 8824 so the 3-year statute should apply for pre-2018 exchanges2. Note; If there was tax fraud with the return, there is no statute of limitations for assessment.

Conclusion

Taxpayers who timely and accurately reported their cryptocurrency exchanges for tax years prior to 2018, the statute of limitations for assessment will have expired (or will expire on October 15, 2021 if the return was on extension). If they failed to report their exchanges and the omitted gross income amount exceeding 25% of the income reported, the special six (6)-year assessment period applies, which means IRS could assess back taxes, penalties and interest for tax years 2015, 2016 and 2017.

1 Example: If a taxpayer files a return reporting $100,000 of gross income the omitted income must be at least $25,000 for the six(6)-year statute of limitations to apply.

2 The 6-year statute does not apply when IRS has been adequately apprised of the potential omitted gross income and filing Form 8824 puts IRS on notice of the exchange transactions.

Announcing a New Tax Brief: Tax Planning for Cryptocurrencies

Posted on by sommers

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.