What investors and employers need to know about digital assets and taxation

Digital assets, such as Bitcoin that debuted in 2009, have gone mainstream and total about $2.75 trillion worldwide. Despite the prevalence of digital assets as investments as well as their use in commerce, the IRS has only issued limited guidance. Nonetheless, taxpayers must determine whether their virtual currency transactions are taxable and reportable.

Overview

Virtual currency is defined by the IRS as a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.

Virtual currency goes by a number of names, including digital assets and cryptocurrency. The IRS ruled that cryptocurrencies are property, not currency (Rev. Rul. 2014-21). As such, the general rules applicable to property transactions apply to transactions using virtual currency.

Investors

When individuals holding virtual currency sell some or all of their holdings, they report their gain or loss as they would with any other capital asset. Capital gain or loss is short-term or longer-term, depending how long the virtual currency has been held.

The fair market value of the virtual currency is used to determine basis as well as what is received in the transaction; it is reported in U.S. dollars.

• If there is a cryptocurrency exchange. The published value of the cryptocurrency can be used to determine fair market value. For example, the published value of Bitcoin is readily available.

• If there is no cryptocurrency exchange. For cryptocurrency used in a peer-to-peer transaction or some other transaction not facilitated by a cryptocurrency exchange, fair market value is determined as of the date and time the transaction is recorded on the distributed ledger, or would have been recorded on the ledger if it had been an on-chain transaction. The IRS accepts as evidence of fair market value the value as determined by a cryptocurrency or blockchain explorer that analyzes worldwide indices of a cryptocurrency and calculates the value of the cryptocurrency at an exact date and time. If an explorer value is not used, it is up to the taxpayer to establish that the value you used is an accurate representation of the cryptocurrency’s fair market value.

There is a question on Form 1040 that every individual must answer “yes” or “no”: “At any time during 2021, did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?” Leaving the answer blank can delay the processing of a return and the receipt of a refund where applicable.

Businesses

Businesses are increasingly using virtual currency to pay employees, independent contractors, and suppliers. They are also accepting payment for their goods and services in virtual currency. Again, reporting is done as if payments were made in “widgets” or any other property. Businesses must figure gain or loss when paying with virtual currency or receiving payment in virtual currency. For example, the medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes. Thus, the fair market value of virtual currency paid as wages, measured in U.S. dollars at the date of receipt, is subject to FICA tax and federal FUTA tax and is reported on the employee’s Form W-2, Wage and Tax Statement. The employer recognizes gain or loss when using the virtual currency to pay wages.

A business on the cash method of accounting that is being paid in virtual currency for the performance of services recognizes income when received. In an on-chain transaction, the receipt of the virtual currency is on the date and at the time the transaction is recorded on the distributed ledger.

Special situations

Hard forks? Soft forks? Airdrops? These are special situations for which the IRS has provided some guidance (Rev. Rul. 2019-24).

Hard fork. A hard fork occurs when a cryptocurrency undergoes a protocol change resulting in a permanent diversion from the legacy distributed ledger. This may result in the creation of a new cryptocurrency on a new distributed ledger in addition to the legacy cryptocurrency on the legacy distributed ledger. If no new cryptocurrency is received, whether through an airdrop (explained below) or some other kind of transfer, there is no taxable income. This tax treatment is much like that for a stock split. But where a new asset is received, the transaction is taxable. For example, the receipt of Bitcoin Cash (BCH) as a result of the Bitcoin (BTC) hard fork was taxable (Chief Counsel Advice 202114020).

Airdrop. An air drop distribution of cryptocurrency to multiple taxpayers’ distributed ledger addresses. If a hard fork is followed by an air drop in which new cryptocurrency is received, then there is taxable income in the year of receipt.

Soft fork. A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency. Because soft forks do not result in the receipt new cryptocurrency, the soft fork does not result in any income.

Looking ahead

At present, virtual currency cannot be used to pay federal tax obligations. But some states are moving in this direction. For example, in early March, Colorado enacted a measure to accept payment in virtual currency for income taxes and certain licenses and permits (when this will begin is uncertain). Wyoming passed a bill to authorize the creation of state-issued “stable token,” a form of digital currency. Florida is working on allowing businesses to pay their taxes in virtual currency, although there is no date when this will begin.

The Department of Labor issued guidance (Compliance Assistance Release No. 2022-01, 3/10/22) cautioning fiduciaries to “exercise extreme care” before adding cryptocurrencies to the menu of investment options in 401(k) and other retirement plans. So, while the DOL notes that this investment option is speculative and volatile, it has not barred fiduciaries from offering them to plan participants.

The Infrastructure Investment and Jobs Act (P.L. 117-58) added new requirements for “brokers” to report digital asset transactions occurring in 2023 and later years. This means a party facilitating the transfer of cryptocurrency on behalf of another must report this on Form 1099-B, Proceeds From Broker or Barter Exchange Transaction. Businesses that receive cryptocurrency worth more than $10,000 in a single transaction must report this on Form 8300, Report of Cash Payments Over $10,000 Receive in a Trade or Business. There is much uncertainty about this new reporting rule. Who/what is a broker? In a Feb. 11, 2022, a letter to six Senators from Treasury Assistant Secretary for Legislative Affairs Jonathan Davidson said that its position is that crypto minors and other “ancillary parties who cannot get access to information that is useful to the IRS are not intended to be captured by the reporting requirements for brokers.” Other unanswered questions: What are digital assets (does the term include non-fungible tokens, or NFTs)? Will taxpayers have to complete Form W-9 so that brokers can report transactions under a taxpayer’s identification numbers (e.g., Social Security number)?

Rules are evolving

The tax rules for cryptocurrencies and other digital assets continues to evolve and more legislation and IRS guidance is expected. For now, find additional information on virtual currency at www.IRS.gov/virtualcurrency, which contains a link to FAQs on virtual currency transactions.

Sidney Kess, CPA-attorney, is of counsel at Kostelanetz & Fink. Thomas J. Riggs, JD, CPA, MAS, a tax partner and managing director of financial services tax at PKF O’Connor Davies, assisted in the preparation of this article.