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Beware Unintended Tax Consequences of Crypto Transactions

With fast evolving changes in regulations, taxes and applications, recordkeeping is key.

Cryptocurrency is increasingly being used by individuals to transact business and the day is fast approaching where you may be able to do things like pay your taxes with cryptocurrency.  Indeed, in recent years, Tesla has sold cars for Bitcoin, Sotheby’s sold a Banksy for Bitcoin, NFL players have contracted to be paid in Bitcoin, and cities and states have started initiatives to collect tax or pay employees in cryptocurrencies such as Bitcoin, Ethereum or others.  In addition to these examples, regular employers are considering offering payment of wages to employees in cryptocurrency, accepting cryptocurrency as payment for digital and non-digital assets and services, and the growth of “smart contracts” with Ethereum used as the payment is happening before our eyes. As the use of cryptocurrency expands, clients should consider and be aware of the tax consequences of using cryptocurrency in each of the various transactions.

The Internal Revenue Service considers digital assets, such as cryptocurrency, as property for U.S. federal income tax purposes. Although guidance on cryptocurrency is sparce, the IRS released a FAQ page on its website, Frequently Asked Questions on Virtual Currency Transactions, which provides answers to some of the key fundamental questions regarding cryptocurrency.

Employers and Employees

An employer that pays an employee with cryptocurrency should consider the tax consequences of such payment. The fair market value of virtual currency paid as wages, measured in U.S. dollars, 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. These amounts must be paid in U.S. Dollars and can’t be paid in cryptocurrency. In addition to employment taxes, the employer recognizes gain or recognizes loss based on the value of the cryptocurrency on the day of payment determined by subtracting the employer’s tax basis in the cryptocurrency from the fair market value of the cryptocurrency received as of the moment the transaction is recorded (the “Received Value”). Accordingly, it requires precise recordkeeping by the employer and reporting to the employee. The employee has ordinary income equal to the Received Value, the same as if the employee was paid in cash. The employee then has a new basis, equal to the Received Value of the cryptocurrency, and will recognize gain or loss on a future disposition of the cryptocurrency calculated using the Received Value as the employee’s basis.

A client being paid in cryptocurrency should be aware that there could be adverse tax consequences to receiving cryptocurrency as wages. Any additional appreciation or loss is taxable to the client as capital gain or loss treatment  with the client’s holding period beginning on the date of receipt.

Purchasing Digital & Non-Digital Assets

Bitcoin, Ethereum, and other cryptocurrency has been used to purchase homes, yachts, artwork and other tangible assets. In addition, Ethereum is commonly used to purchase digital assets, including non-fungible tokens (NFTs). A client should consider the tax consequences before purchasing any digital or non-digital asset with cryptocurrency. The IRS has confirmed that the purchase of any assets, whether digital or non-digital, with cryptocurrency is a taxable transaction to the buyer. Stated differently, using cryptocurrency to purchase an asset will be treated as a sale of cryptocurrency for cash and then using the cash to buy the other property for U.S. federal income tax purposes. Thus, the client may have capital gain or loss associated with the purchase of the new asset using cryptocurrency. Client’s should also be aware that many states follow federal income tax treatment in determining income for taxpayers so there could also be a state income tax liability associated with the transaction.

In addition, the IRS has provided a taxpayer friendly rule in allowing taxpayers to select which unit of cryptocurrency they’re using in a transaction (i.e., lot selection).  This allows a taxpayer to utilize either high basis or low basis units of cryptocurrency, and potentially mitigate unfavorable tax consequences when using cryptocurrency to purchase an asset or pay an employee. To benefit from this rule, a taxpayer must either (i) document the specific unit’s unique digital identifier such as a private key, public key, and address, or (ii) maintain and provide records showing the transaction information for all units of a specific virtual currency, such as Bitcoin, held in a single account, wallet, or address. If a taxpayer doesn’t satisfy the documentation requirement, the first in, first out method applies to identify which lot(s) of cryptocurrency was disposed of in the transaction.

Payment of State Taxes

Recently, Colorado announced it will become the first U.S. state to accept cryptocurrency tax payments. Although Ohio considered the idea in 2018, it hasn’t yet announced that it will accept state tax payment. Because the IRS hasn’t provided any guidance or exceptions, clients should consider the payment of state tax liabilities as taxable dispositions of cryptocurrency for federal income tax purposes and report any gain or loss as recognized capital gain or loss on their income tax return. It’s not clear whether Colorado or any other state that accepts tax payments in cryptocurrency will consider those payments, themselves, to be taxable dispositions of the cryptocurrency.

Importance of Record Keeping

As with any other investment asset, record keeping is of paramount importance. As cryptocurrency continues to grow in use, maintaining records to respond to any tax audit will be important. Further, the records may be essential to income tax planning in dispositions of cryptocurrency to identify specific lots for tax planning. Additionally, if a client passes away holding cryptocurrency, having a record available to provide personal representatives, heirs, and trustees will be essential to allow the decedent’s estate to be properly administered.

In 2020, the IRS began requiring that individual taxpayers report any sale or exchange of cryptocurrency during the tax year on IRS Form 1040. The IRS has indicated that failure to properly report these transactions may be an area of focus in future years for criminal prosecution. Clients should be aware that failure to properly report the transaction could result in the statute of limitations for collection, audit or other actions pertaining to that tax year remaining open. 

The world of cryptocurrency and digital assets is fast evolving with many more changes and evolutions in regulations, taxes and applications sure to come. Clients should maintain complete records concerning any cryptocurrency transactions and be mindful of the tax consequences associated with using cryptocurrency as a substitute for cash.

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