It is almost tax time and individuals are trying to get their records in order to either file on their own or to give to tax preparers to calculate what they may owe to Uncle Sam.  Increasingly important is how individuals should handle cryptocurrency and its taxation.  The IRS is becoming gradually more aware of this electronic blockchain-based virtual form of value and with that awareness comes the expectation that individuals will comply with the applicable tax laws surrounding cryptocurrency.

But first, what is cryptocurrency?  Cryptocurrency is an anonymous virtual code which uses mathematics to build onto itself and uses peers to verify each transaction, making it very difficult to reverse. It holds inherent value based on perception and is backed by no tangible asset or government.  It is also surprisingly difficult for the tax law to classify and describe.  The IRS has issued a single notice on cryptocurrency for guidance, Notice 2014-21,[1] within which it classifies virtual currency as property and not an actual currency.  It has made this classification because cryptocurrencies are not backed by an official government and, therefore, cannot fit the definition of currency.  That classification is not a perfect fit.  Critics point out that it does not squarely fit the definition of property since its virtual nature makes it, unlike property, impossible to actually possess.

Since the IRS considers cryptocurrency to be property, that means it is subject to capital gains taxation when sold or used to purchase something, or subject to income taxation when received as compensation.  Like capital gains and income taxation of other types of property, these taxes are only triggered with a transaction or other realization event.  The definition of transaction or realization event for these purposes can be far reaching, including converting cryptocurrency to US dollars or other cryptocurrency forms, buying it, selling it, spending cryptocurrency to pay for a good or service, receiving cryptocurrency as payment for a good or service, and mining cryptocurrency, which additionally qualifies as self-employment triggering other tangential taxes.

Some states are beginning to regulate cryptocurrency drawing criticism from some fintech[2] professionals who say that the new red tape will stifle the fledgling cryptocurrency industry.  Such has been the case in New York, where a robust regulatory regime has caused fintech innovators to move to other tax domiciles.  Nevertheless, the Uniform Law Commission, a non-profit organization whose purpose is to draft model legislation that can be adopted by states in an effort to streamline and unify specific legal practice areas across the country, has developed a set of model laws for virtual currency.  It is currently optimistically waiting for more state legislatures to begin enacting its model code.

Although state laws may be slow to regulate, the IRS has been clear about one thing: it expects taxpayers to report their cryptocurrency tax liabilities in good faith and accurately or face the penalties.  In its Notice, it plainly states that taxpayers who fail to comply with tax laws may be subject to accuracy-related and information reporting penalties.  In a not so gentle reminder [3] a few years after the Notice, the IRS warned taxpayers that failing to properly report cryptocurrency tax consequences may constitute tax evasion and filing a false return.  Criminal convictions for these offenses carry penalties of up to five years in prison plus a $250,000 fine and three years in prison plus a $250,000 fine, respectively.

There are two main ways for cryptocurrency users to get into trouble.  The first is by not reporting at all, but since at least one cryptocurrency provider is now required to report transactions over $20,000,[4] the anonymity required for criminals to get away with this type of crime could be starting to erode.  The second way is by underreporting gains or overreporting losses.  Since the value of virtual currencies is constantly in flux, if an individual does not accurately record his basis at the time of the transaction, he or she can insert whatever value works later on a tax return to evade taxation.

Basically, that means the IRS expects taxpayers to do their best to properly report in good faith all gains and losses on cryptocurrency transactions.  This is sometimes challenging because unlike other investments, no one is keeping an historical track of the identities of the individuals behind these transactions.  Part of the appeal of cryptocurrency is its clandestine movement of value, but this anonymity also means that the individual user must figure out his or her own tax obligations.  Experts suggest keeping a detailed log of all cryptocurrency transactions to easily calculate realized gains and losses.  For tax reporting purposes, cryptocurrency users need to have the date of the transaction, how much they paid for the cryptocurrency, how much they received when they sold the cryptocurrency, the cost of completing the trade, and the net gain or loss.

The IRS recognizes there are gray areas around cryptocurrency taxation, and if a taxpayer does his or her best to properly and accurately report transactions, a mistake will probably not rise to the criminal level.  The IRS cannot put off the fact that cryptocurrencies are becoming more widespread, and with the model codes put out by the Uniform Law Commission and increasing state recognition, it is probable that more tax guidance will soon be issued.  Ohio even allows businesses to pay their state taxes with bitcoin—maybe the federal government will be next.

[1] https://www.irs.gov/pub/irs-drop/n-14-21.pdf

[2] Financial Technology, or Fintech, is an industry using technological advances in order to improve traditional finance methods.

[3] https://www.irs.gov/newsroom/irs-reminds-taxpayers-to-report-virtual-currency-transactions

[4] https://techcrunch.com/2017/11/29/coinbase-internal-revenue-service-taxation/