Compliance with the internal revenue laws relating to cryptocurrency is sorely deficient. As of Dec. 31, 2015, the market capitalization of cryptocurrencies was roughly $7 billion spread among 5.8 million active digital wallets, 34 percent of which (or 1.97 million wallets) were attributable to U.S.-based users. Despite the prevalence of U.S.-based cryptocurrency users, of the 128 million tax returns electronically filed during 2015, a mere 802 returns reported cryptocurrency gains.
In light of these statistics, the Internal Revenue Service (IRS) and the U.S. Department of Justice (DOJ) have threatened civil penalties and criminal prosecution for taxpayers who violate tax laws while using cryptocurrency. For taxpayers who engaged in cryptocurrency transactions but did not report the transactions for federal, state or local income tax purposes, a qualified amended return or voluntary disclosure may create a path to compliance that limits the likelihood of civil or criminal penalties. Section references are to the Internal Revenue Code of 1986, as amended.
Background on Digital Currencies
Digital currencies, which are a type of currency available only in digital form and which function as a medium of exchange, are of relatively recent vintage. Digital currencies include:
- Cryptocurrency, consisting of digital currencies convertible into traditional physical currencies, like the U.S. dollar, Euro or British Pound. Examples of cryptocurrencies include Bitcoin, Etherium, Litecoin, Dash and numerous other digital currencies that, at the time of this writing, have a market capitalization of around $329 billion; and
- Virtual currency, consisting of digital currencies used primarily for online entertainment in virtual worlds and not typically to pay for goods and services. Examples of virtual currency include, depending upon their use, coupons, credit card rewards or customer loyalty and incentive programs.
U.S. tax authorities have focused on cryptocurrencies, and this tax-centric article speaks to the taxation and tax reporting of only cryptocurrencies. The tax authorities’ interest in cryptocurrencies is unsurprising—the large number of U.S.-based cryptocurrency users compared to the relatively few returns reporting cryptocurrency transactions suggests income is being underreported, and tax is being underpaid.
Much has been written on the underlying technology and nontax regulation of cryptocurrencies. Tax practitioners and advisors should know that users who trade in cryptocurrency generally have a digital wallet used to store one or more private digital keys. Using key cryptography technology, two pieces of information authenticate the trade: a public key, which identifies the sender or recipient (and can be distributed to others); and a private key, which is used with the public key to create a theoretically unforgeable signature (and is not typically distributed to others). The public and private keys are different, but mathematically linked through a signature algorithm used to authenticate trades.
The sale or exchange of cryptocurrency, or using cryptocurrency to pay for goods or services, has tax consequences that often results in a tax liability and/or tax reporting obligations for income tax purposes. The sole authority on the taxation of digital currencies is Notice 2014-21, where the IRS described how existing tax principles apply to digital currency transactions. The IRS concluded, for tax purposes, that digital currencies are property, not a functional currency. Below is a brief discussion of the substantive tax and reporting issues likely to arise concerning cryptocurrencies.
A. Substantive Tax
Generally. Taxpayers who invest (or have invested) in cryptocurrency must apply to cryptocurrency transactions the same tax rules that apply to other property transactions. Thus, like dispositions of most other property, gain or loss from the sale or other disposition of cryptocurrency (including the use of cryptocurrency to pay for other property) is computed as the difference between the amount realized and the taxpayer’s adjusted basis in the cryptocurrency. The amount realized is the fair market value of the cryptocurrency on the date the cryptocurrency was sold or otherwise disposed of, less disposition costs. The adjusted basis is the fair market value of the cryptocurrency on the date it was originally acquired, increased by related acquisition costs. Additional basis adjustments may be appropriate depending upon the facts of the acquisition and sale.
Character of Gains and Losses. The character of gain or loss (i.e., ordinary or capital) generally depends upon whether the cryptocurrency is a capital asset in the taxpayer’s hands. A taxpayer recognizes capital gain on the sale or exchange of cryptocurrency that is a capital asset to him or her. Stocks, bonds and other investment property are typically treated as capital assets. A taxpayer recognizes ordinary income or loss on the sale or exchange of cryptocurrency that is not a capital asset in the taxpayer’s hands. Examples of non-capital assets include inventory and other property held for sale to customers in a trade or business. This article does not address the tax treatment of taxpayers who hold cryptocurrency as other than a capital asset.
Loss Limitations. Taxpayers may have losses from cryptocurrency investments. Where cryptocurrencies are a capital asset, the ability to use losses may be limited. First, losses are generally not deductible unless the loss was incurred in a trade or business or in a transaction entered into for profit. Second, a taxpayer generally may use capital losses from the sale or exchange of cryptocurrency against capital gains from the sale or exchange of other capital assets. Third, if a taxpayer has an overall net capital loss for the year, the taxpayer can deduct only up to $3,000 of that loss against ordinary income.
Valuation. Cryptocurrency gains, losses and income must be reported on tax returns in U.S. dollars. The fair market value of the cryptocurrency in U.S. dollars at the time of payment or receipt must be determined. For exchange-traded cryptocurrency, the fair market value is typically determined daily based on market supply and demand. For non-exchange-traded cryptocurrency, determining fair market value typically requires a valuation similar to valuing the stock of a pink sheets company (though the methodologies are different because the value of a cryptocurrency depends largely on community participation, as opposed to cash flows).
Postponement of Gain Under Section 1031. Cryptocurrency-for-cryptocurrency exchanges completed on or before Dec. 31, 2017, arguably qualified for nonrecognition treatment under section 1031, assuming the relinquishment and replacement cryptocurrencies were both held for business or investment purposes. However, as a result of the recently-enacted tax reform legislation, section 1031 has been limited to exchanges of business or investment real estate, effective for exchanges completed after Dec. 31, 2017 (subject to a limited transition rule).
B. Tax Reporting
Reporting Gains and Losses. Individuals, corporations and other pass-through entities engaging in cryptocurrency transactions and who hold the property as capital assets generally must report gains and losses from the transactions on Form 8949, Sales and Other Dispositions of Capital Assets. Individuals also report such gains and losses on Schedule D, Capital Gains and Losses. Partnerships, limited liabilities companies classified as partnerships, S corporations, estates and trusts report gains and losses on the entity’s tax return, which pass through to the entity’s owners or beneficiaries.
Cryptocurrencies Potentially Reportable on FBAR. Taxpayers with a financial interest in, or signature authority over (i.e., possession of a private key), certain digital wallets may have to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), if: (1) the wallet is held outside the U.S.; and (2) the fair market value of all foreign financial accounts (cryptocurrency or otherwise) exceeded $10,000 during the calendar year reported. The FBAR reporting requirement applies even if the taxpayer holds an account that produces zero taxable income. Steep civil penalties apply for failing to file a required FBAR, including: (1) with non-willful violations, $10,000 per violation; and (2) with willful violations, the greater of $100,000 or 50 percent of the value of the account (i.e., wallet) at the time of the violation.
Cryptocurrencies Potentially Reportable on IRS Forms. Taxpayers may also be required to file certain IRS forms depending upon the structure of their cryptocurrency holding. For example, Form 8938, Statement of Specified Foreign Financial Assets, is generally required to be filed if: (1) the holder’s digital wallet is held outside the U.S.; and (2) the fair market value of the cryptocurrency in the wallet is: (A) with unmarried taxpayers, above $50,000 on the last day of the taxable year or $75,000 at any other time during the taxable year, or (B) with married taxpayers filing a joint return, above $100,000 on the last day of the taxable year or $150,000 at any other time during the taxable year. The Form 8938 reporting requirement applies even if the taxpayer holds an account that does not produce taxable income. The IRS may impose a $10,000 base penalty for failing to file Form 8938, with an additional $10,000 continuation penalty authorized for each month the taxpayer, after receiving from the IRS notice of the filing requirement, fails to cure the delinquent filing, up to a maximum $50,000 continuation penalty. Additional reporting requirements may apply if cryptocurrency transactions are conducted through certain foreign entities.
Correcting Historical Noncompliance
Noncompliance with the tax laws regarding cryptocurrency is a key enforcement priority of the IRS and the DOJ. The IRS has assembled a team of criminal investigators to examine persons using cryptocurrency to evade U.S. taxes. The IRS previously addressed this magnitude of tax noncompliance in the foreign bank account arena, and there it adopted various amnesty programs, including the Offshore Voluntary Disclosure Program (OVDP). The IRS recently announced it will end the OVDP on Sept. 28, 2018.
The IRS has not yet announced a tax amnesty program for taxpayers who failed to report gains or income from cryptocurrency transactions, though there is widespread speculation that such a program is forthcoming. Until the IRS adopts a cryptocurrency voluntary disclosure program, taxpayers have various other mechanisms to comply voluntarily with the tax laws without the threat of criminal prosecution or accuracy-related penalties.
A. Qualified Amended Returns
One avenue for taxpayers to voluntarily come into tax compliance regarding previously unreported cryptocurrency transactions is the qualified amended return. The benefit of filing a qualified amended return is that a taxpayer can avoid accuracy-related penalties that might otherwise apply. Absent a fraudulent position on the original return, the qualified amended return rules allow a taxpayer to treat the tax reported on the amended return as the tax reported on the original return so the accuracy-related penalty under section 6662(a) will not apply. Stated differently, to compute the base underpayment of tax to which an accuracy-related penalty applies, the qualified amended return reduces the base by the additional amount of tax paid with the amended return.
The definition of a qualified amended return is important when evaluating compliance alternatives. As relevant here, Treasury Regulations generally define a “qualified amended return” as an amended return filed after the properly extended due date of the original return, but before the earliest to occur of: (1) the date the taxpayer is first contacted by the IRS for any civil examination or criminal investigation with respect to the return; (2) the date the IRS issues a John Doe administrative summons relating to the tax liability of a person, group or class that includes the taxpayer with respect to a tax benefit claimed on the return; (3) the date the IRS announces a settlement initiative to compromise or waive penalties regarding a listed transaction; or (4) concerning a pass-through item, the date the pass-through entity is first contacted by the IRS for any examination regarding the entity’s return to which the pass-through item relates.
In late 2016, on behalf of the IRS, the DOJ requested judicial permission to serve a John Doe summons on Coinbase, Inc. Coinbase is an exchange dealing in cryptocurrency that operates a bitcoin wallet and exchange business headquartered in San Francisco. During 2013 through 2015, Coinbase maintained more than 4.9 million wallets in 190 countries with 3.2 million customers served and $2.5 billion exchanged.
The Coinbase summons initially sought “information regarding United States persons who, at any time during the period January 1, 2013, through December 31, 2015, conducted transactions in a convertible currency as defined in IRS Notice 2014-21.” That request was later narrowed to Coinbase users who “bought, sold, sent or received at least $20,000” of cryptocurrency in a year. The court granted the request. Following Coinbase’s initial refusal to comply, the United States petitioned the court to enforce the summons. On Nov. 28, 2017, the court granted the petition to enforce. Coinbase has since announced it will comply with the summons.
Absent some exemption from the IRS, which has not yet occurred, the Coinbase summons makes individuals who “bought, sold, sent or received at least $20,000” worth of cryptocurrency through Coinbase between 2013 and 2015 ineligible for the qualified amended return procedures. Even if the qualified amended return is available to users, its attractiveness as an option must still be evaluated in light of its drawbacks. If the IRS determines the underpayment of tax regarding the original return is fraudulent, the taxpayer is potentially liable for criminal prosecution and a civil fraud penalty equal to 75 percent of the underpayment of tax. Moreover, qualified amended returns do not protect taxpayers from other civil penalties, such as those attributable to failing to file international information returns (including the FBAR or Form 8938).
Qualified amended returns are an option for taxpayers who:
- Have unreported cryptocurrency transactions;
- Did not engage in cryptocurrency transactions through Coinbase during 2013 through 2015;
- Do not have international reporting requirements, including but not limited to the FBAR or Form 8938, or are amenable to paying a penalty of up to $10,000 for failing to file each form; and
- Did not willfully underreport gain from cryptocurrency transactions (i.e., did not voluntarily and intentionally violate a known legal duty).
B. Voluntary Disclosures
Taxpayers, including those ensnared by the Coinbase summons, also have other options. First, individuals with an international component to cryptocurrency transactions can currently use the OVDP to come into tax compliance because the program does not end until Sept. 28, 2018.
Second, regardless of whether the IRS adopts a formal cryptocurrency amnesty program, taxpayers can come into compliance using a traditional voluntary disclosure. The IRS has long allowed taxpayers with unreported income from legal sources to make a voluntary disclosure. The voluntary disclosure process is now a part of the IRS’s Internal Revenue Manual, a compilation of the agency’s policies and procedures. Depending upon the facts, a voluntary disclosure may be initiated through the Special Agent in Charge for the territory in which the taxpayer resides or through the IRS Criminal Investigation Division. Voluntary disclosures do not guarantee immunity from prosecution, but often result in prosecution not being recommended.
The law surrounding the taxation and tax reporting of cryptocurrency is mutable. As offshore bank account enforcement confirms, promises from the government to impose civil penalties and pursue criminal sanctions are not veiled threats. Practitioners should advise noncompliant taxpayers to use a qualified amended return, the OVDP, or a traditional voluntary disclosure to come into compliance with the tax laws to mitigate civil penalties and/or criminal investigations and prosecutions.
Guariglia is a partner of, and Lawrence A. Sannicandro is an associate at, McCarter & English in Newark. Both advise clients regarding unreported cryptocurrency and foreign bank account issues.