Businesses that have been investing in cryptocurrencies like Bitcoin and Ethereum are dealing with uncertainty regarding crypto accounting and taxes as the Securities and Exchange Commission and the Internal Revenue Service, along with government agencies abroad, are going to expect them to account for their holdings and to pay appropriate taxes.
Last month, President Biden signed an executive order on “ensuring responsible development of digital assets,” which includes cryptocurrency and other assets such as nonfungible tokens, or NFTs. And recently, the SEC issued a Staff Accounting Bulletin on accounting for the obligations to safeguard crypto assets that an entity such as a crypto exchange holds for users.
The IRS, meanwhile, has been focusing more on cryptocurrency as a means of tax avoidance, requiring taxpayers in recent years to answer a question at the top of the tax form asking if at any time during the previous year they received, sold, exchanged or otherwise disposed of virtual currency. More recently, the Treasury Department issued a Greenbook spelling out the tax-related aspects of the Biden administration’s fiscal year 2023 budget request with a number of tax proposals related to digital assets and cryptocurrency.
Clients have been asking their accounting firms for advice about cryptocurrency and whether to accept it from customers, invest in it themselves, and what the tax implications are.
“Capital markets types of companies are thinking about what the future of this type of technology means,” said Jay Schulman, national leader for blockchain and digital assets at RSM US LLP. “We have financial institutions, banks, credit unions, and entities like that asking themselves the question, ‘Should I be offering the ability to offer my customers to buy Bitcoin, as an example, through the bank or through the credit union?’ One of the things that they acknowledge and we advise them is that none of this stuff is quick. If you’re thinking about it now, it could be well into next year, if not the year after, before it rolls out.”
The tax implications are still in flux for cryptocurrency as well as NFTs, which can be digital artworks or collectibles recorded on a blockchain digital ledger, some of which have increased in value while others have become worthless. Investors and companies that produce NFTs need to be considering both the current and possible future value when it comes to taxes.
“One consideration is making sure that if you’re going to put it on your books as an investment, understand the tax implications,” said Schulman. “Two is simply wanting to go buy Bitcoin, but then there’s the really complicated things like decentralized finance or NFTs. Calculating the tax basis can be a real challenge and oftentimes we try to get in front of that with our clients and have those discussions early on.”
Clients who want answers when it comes time to file their taxes may be disappointed if the responses are not clear-cut or advantageous. “It’s not unusual to show up 10 or 15 days before your taxes are due with a pretty complicated scenario where the client didn’t really understand how it works,” said Schulman. “As we see companies offering products in this space, how do you offer the product without giving the customer undue capital gains? For example, a company wants to issue an NFT to everybody who shows up at the door, and all of the NFTs are exactly the same. When you show up at the door, you get this NFT, and for the first couple of customers that show up at the door, there’s no market for it, so that NFT is worth nothing. But it turns out that over time there’s a market for these NFTs, for whatever goofy reason, and now that NFT is worth something. Well, if I show up 10 days later, and this NFT is now worth $10, when I go to collect it, you’ve just saddled me with $10 in capital gains. Ten dollars is nominal, not that big of a deal. When you get to some of these companies that are really thinking about big projects, that can actually have a pretty substantial tax impact.”
The Treasury Department’s Greenbook contained a number of proposals that could affect how companies account for digital assets like NFTs and cryptocurrency.
“There were a number of things related to digital assets in general,” said Denise Hintzke, a managing director in the Financial Services Tax practice at Deloitte Tax who leads the Global Information Reporting practice as well as the Foreign Account Tax Compliance and Common Reporting Standard Initiative. “The first is they’re proposing an amendment to the securities-lending rules that would include digital assets as a category of assets that could be included in nonrecognition treatment for securities lending. In the absence of that, a number of courts were taking positions that if the terms of the loan or the assets didn’t strictly follow what was laid out in the regulations, they were excluding it from nonrecognition. From the IRS standpoint, that sometimes has negative connotations. If it’s not excluded, it’s treated as a sale, which sometimes can be bad for the actual individual that owns the asset. But from the IRS side, it’s not always good either because if they treat it as a sale, then any income that’s flowing through on the assets doesn’t have to be recognized by the person that actually holds the security and lends it out. Then it also puts somebody in a position of potentially being able to accelerate gains when they really haven’t given up true ownership of that security.”
The Biden administration is proposing to close that potential loophole. “What they’re talking about doing here is basically amending Section 1058, which is the securities-lending section, to apply to digital assets and basically require any lenders to account for the income of the loaned assets in a manner that clearly reflects what that income is, provide appropriate basis adjustments to the contracts, and then also clarify that certain loans — this piece is broader than digital assets — that are for a fixed term can also be subject to nonrecognition treatment,” Hintzke explained. “It would be effective, if this was put into the regulations, beginning after Dec. 31, 2022, at the end of this year.”
The proposed changes also include mark-to-market rules. “The next place where they talk about digital assets is in the mark-to-market rules,” said Hintzke. “They’re talking about amending Section 475 in this case, which are the mark-to-market rules for securities dealers, to basically say that they’re adding an additional category for digital assets that a dealer or trader will now be subject to mark-to-market treatment if they are actively traded or if there are derivatives or hedges on those assets that are actively traded. In this particular situation, they’re saying under the proposal that the digital asset is not actually going to be considered a security or a commodity for the purposes of this section. They’re going to add a brand new set of special rules that specifically apply to this third category. It’s not like they're just going to say, ‘OK, digital assets are subject to the same mark-to-market rules that have been out there for all securities and commodities.’ This will be a brand new section with its own specific rules.”
The bipartisan infrastructure bill that Congress passed last November included a provision requiring annual reporting from crypto brokers of digital asset transfers over $10,000 in value, starting in January 2023, as a way to curb tax evasion. “There’s been a lot of concern from the IRS that this is an area where there could be the ability for people to under-report income,” said Hintzke. “You saw the first sign of that in the change to the law that was made late last year that basically said that cryptocurrency is now going to be subject to 1099 reporting under Section 6045 on what we believe is going to be a form called the 1099-DA for ‘Digital Asset’ beginning in 2023 or for trades during 2023, so the first reporting would actually be in 2024. We’re waiting for the IRS to actually release the regulations that will provide the when, where, and how around that. The law now says digital assets will be treated just like a security whenever there is a sale or a trade.”
The Biden administration also included in the Build Back Better Act last year a provision that would include digital assets under the wash-sale rule, which says that if a security is sold at a loss, but then it’s repurchased within 30 days, the initial loss can’t be claimed for tax purposes. The Build Back Better package never passed in Congress, but that provision may come back in future legislation as a way to discourage tax abuses.
“Digital assets right now are being used to manufacture losses and, because they’re not subject to wash sale, that means you could turn around, sell the digital asset, use the loss, then purchase it back within seconds, and really not have an economic difference in what your position is and yet have created a tax loss. You cannot do that with a security,” said Hintzke. “Securities have special rules that say there has to be an actual economic impact on you. They do that by having a certain number of days between when you can sell and buy back the same or a similar security. It was proposed that digital assets would get pulled into the wash-sale rules. That bill didn’t pass yet, but I’m pretty sure it will pop its head up someplace else.”
The administration may also clamp down on securities lending when it comes to crypto. “The proliferation of lending in this cryptocurrency space has just been going crazy,” said Hintzke. “They’re taking a look and saying, well, you’ve got this new set of assets here that people can use to get around some of the well-formulated requirements that have been in place to protect the tax system from these types of transactions in the security industry. When I look at mark to market, I think that is more in line with just the ease of administration and making it more consistent with how certain parties would have to treat these assets for accounting purposes. The way this is right now, because they’re not included in Section 475, you likely would have to mark-to-market this for accounting purposes, and yet for tax purposes, you wouldn’t be marking to market and therefore you’d have this difference.”
Looking for guidance in crypto accounting and taxes
Clients need to be looking at what they can do a year from now or even five years from now, but companies often have more urgent questions about the proper accounting and tax treatment of crypto, or simply what to do with their employees and customers.
“We’ve had a couple of our clients call us up and say our employees would like to receive their paycheck in Bitcoin,” said Schulman. “How do we pay our employees with Bitcoin? Or at a retail type company, we’ve had requests to pay for services or goods using Bitcoin or another cryptocurrency. How do we do that?”
While many of the queries have come from financial institutions and retailers, RSM has also been hearing from nonprofit clients. “In the nonprofit space, it’s really hard to look at a donation and say, ‘Gosh, no, thank you,’” said Schulman. “This has really challenged nonprofits to say, are we comfortable accepting cryptocurrency as a form of donation? How do we do it in terms of compliance? And then what do we do? Do we actually accept that? Do we hold the cryptocurrency or do we work with an intermediary who’s going to take it on our behalf, turn it into cash and deposit it into our bank account?”
Schulman sits on the American Institute of CPAs’ Digital Assets Working Group, which developed nonauthoritative guidance that’s being widely used while practitioners await more authoritative and specific guidance from the Financial Accounting Standards Board on how to value crypto assets. For right now, the assets are generally valued at their original price, rather than how they would be valued under mark-to-market rules as if they were sold. They are classified as an “indefinite-lived intangible asset.”
“I've heard people say it’s my fault that I have an indefinite-lived intangible,” said Schulman. “I can promise you that as a working group we followed the existing written guidance and said, what is this? And we ended up with an indefinite-lived intangible. As the accounting rules are written today, that is the proper designation. An indefinite-lived intangible is the lower of costs or market, so when a company puts that on their books, that doesn't represent the fair market value of that asset, and the FASB is looking to think about what the long-term implications are. I’m not going to weigh in on what the FASB should do. We wrote a comment letter on that.”
Possible FATCA changes
Another tax-reporting area that may come into play is FATCA, the Foreign Account Tax Compliance Act that was included in the HIRE Act of 2010, which required foreign financial institutions and certain non-financial foreign entities to report on the assets of their U.S. account holders to the IRS or else face penalties of up to 30% of their income from U.S. sources.
“FATCA was put into place to help identify U.S. people that are holding accounts offshore and then avoiding putting that information on their tax returns,” said Hintzke. “Digital assets were not included in that definition of financial assets. That means you could have a digital asset account sitting in a foreign country and there would be no reporting required. There have been all kinds of questions raised over the last couple of years whether or not these companies that are trading in digital assets or holding wallets are financial institutions under FATCA? And the answer is no, not the way that it’s currently drafted. And then also are digital assets a financial instrument? Again, no, not the way it’s currently drafted. So if you’ve got a big hole in the reporting, where you're seeing more of a move into these digital assets, people could potentially start sheltering their money there. You take it out of a regular bank account or a regular securities account which is now getting reported to the U.S. government. You put it in something with digital assets and then it's not being reported.”
The administration is looking at two provisions related to FATCA that may be changed under a potential revamp that some are calling FATCA 2.0.
“One of them would be expanding the scope of the rules to basically say anybody that would be defined as a broker under this new amended Section 6045, this broad definition of who's now going to be a broker for U.S. reporting, will also be a broker for purposes of FATCA,” said Hintzke. “It’s going to expand the types of foreign financial institutions that need to do FATCA reporting.”
Under FATCA, there is also a requirement for individuals, if they're holding an account outside the U.S. valued at more than $50,000, to report it to the IRS on their tax return. That requirement also could be expanded.
“That today is limited to bank accounts and security accounts,” said Hintzke. “They’re expanding that reporting also to say you would now have to disclose if you had an account that was holding digital assets outside of the U.S.”
Another FATCA-related requirement involves the IRS reporting back to foreign tax authorities about the assets of their citizens according to the intergovernmental agreements that the Treasury Department signed with other countries to implement FATCA.
“At the end of the day, if this goes through, it may have the biggest impact on U.S. industry,” said Hintzke. “As part of FATCA, the U.S. entered into intergovernmental agreements with all of these foreign countries and, as part of those agreements, to get the countries to cooperate with this whole idea of sending information to the U.S. government, they agreed to provide reciprocal information. For the last six or seven years, the refrain back from the U.S. has been we’re providing everything we have. We only have limited information about foreign investors in the U.S. that we can be providing back to these foreign countries. U.S. source dividends and U.S. source interest are really the only things that get reported because that is all that is required under the current information reporting rules in the U.S.”
The proposals would expand the type of information being reported on a reciprocal basis to foreign tax authorities. “There are really four primary things that they’re now talking about,” said Hintzke. “One is that as part of the reporting that a U.S. financial institution or bank would have to do whenever they’ve identified a foreign investor, they would have to include account balances for anything that was deemed to be a financial account: a securities account, a bank account, etc. The second is that they would make not only U.S. source income reportable but non-U.S. source income reportable as well. And the third is that they would start requiring reporting of the sale or redemption of any securities. That means that the U.S. government would now have account balance information. They would have information about any non-U.S. source of income that was flowing through the United States, and they would have sales proceeds that they could then exchange with these foreign governments in order to continue to keep the foreign governments happy with sending the information about the U.S. accounts to the U.S.”
Another proposal would look at pass-through entities such as limited liability companies formed in states like Delaware that have looser disclosure requirements and require them to report on non-U.S. owners.
“Today they’re treated as if they’re a U.S. entity and therefore there’s no information collected about who that underlying person is or what country they’re in or what type of income they’re receiving, so none of that information is getting sent over to the foreign countries, or on U.S. trusts where there are foreign people behind it, which has just proliferated since CRS [Common Reporting Standard] went into place,” said Hintzke. “They would have to now look through those, identify who the non-U.S. people are, disclose that, and identify these income payments that are being made to them. If this were to go through, and I think ultimately at some point it will have to because of the demand they’re getting from these foreign countries to provide reciprocal information, this is going to be a huge change to the U.S. financial institutions in terms of their reporting.”
She is unsure how quickly such proposals would be approved, and they are bound to run into fierce political opposition. But she believes they are inevitable.
“I would tell you at some point they’re going to have to do something similar to this because otherwise FATCA totally falls apart,” said Hintzke. “They have these intergovernmental agreements, which are almost like treaties with countries, where they’ve agreed to start providing this reciprocal information, but they don’t have the reciprocal information. This is their attempt at trying to deflect it. They’re going to have to get this in some place. Otherwise, FATCA in general and the whole concept of the IGAs is going to collapse.”
Meanwhile, the Organization for Economic Cooperation and Development has its own proposal for reporting crypto assets. “What’s going on at the same time actually came out about a week before the Greenbook,” said Hintzke. “The OECD has been looking at digital assets as well, probably for the last year. They released a document for comment about five days before the Greenbook, which will expand CRS, the Common Reporting Standard rules, which are sort of the foreign equivalent of FATCA, to include digital assets, to require reporting of balances in digital asset accounts, and trades of digital asset accounts and things like that. That’s a request for comments on this proposal, and they’ve been moving pretty quickly. As a matter of fact, the only reason they didn’t issue that even sooner is they were holding off a little bit waiting for the IRS to get that legislation [the Build Back Better Act] through at the end of last year. And so they now are actively moving forward to amend CRS to pull in digital assets as well as money transfers. There were a number of things that were actually in that commentary.”
The changes could be far-reaching. “It’s not just the U.S.,” said Hintzke. “You’re talking about the OECD and all the countries that are participating there. The U.S. Treasury has been at the table. They’ve sat in all those meetings. Everyone that I’ve participated in, there’s been somebody from the U.S. there and they’re part of the discussions, and there has been a lot of discussion all along about this reciprocal exchange of information. I realize this is just a Greenbook and sometimes Greenbook stuff just kind of fizzles and you never hear anything about it. But I think this is going to keep popping up until something gets done because without it you would have a situation where FATCA would just not work anymore. The other countries would start to pull out and say, ‘We’re not going to send this information. You’re not sending us what we want.’”
Another move on the international front is the development of digital currencies by governments such as China, which offers a digital yuan. The U.S. is also looking into the possibility of such a move, but this week Treasury Secretary Janet Yellen cautioned it would likely take years as she described a broad set of principles for regulating digital assets (see story). For now, regulators have embarked on a six-month review.
“The Chinese users are incredibly digitally enabled,” said Schulman. “It’s going to be interesting to watch the adoption of that digital currency. But how we in the United States use things digitally is different. It’s two different cultures when it comes to digital adoption. I think that we in the United States absolutely should be forward-thinking when it comes to innovation, like a token that represents a physical dollar. But we also shouldn’t be chasing what other people are doing. A lot of banks get concerned about a digital dollar, and it’s really interesting how China chose to implement its digital yuan. The only place that a citizen can get the digital yuan is from their bank. As we think about what ultimately might happen here in the United States, it certainly seems like a likely scenario that if the Federal Reserve were ever to issue a digital dollar, some people have in their head that they would go to the Federal Reserve to get their digital dollar. While I believe that most likely we will continue to use the banking framework that we have, and I’ll likely get my digital dollar from my bank, that’s an important concept as we think about how this is going to mature over the next couple of years.”
Crypto is a fast-evolving technology that is bound to lead to more tax and accounting questions from clients in the years ahead.
“I like to think that we’re about 1997 or 1998 in internet terms,” said Schulman. “We need to take a long view here. I like to think about this as the next generation of the internet, and this is going to be around for a long time, so I don’t want to be thinking about what we should be doing today or tomorrow, but what’s going to hold up to the test of time, and let’s try to get it right the first time.
For more information on tax aspects of cryptocurrency, the IRS issued IRS Notice 2014-21, IRB 2014-16, as guidance for individuals and businesses on the tax treatment of transactions using virtual currencies.
The IRS also published Frequently Asked Questions on Virtual Currency Transactions for businesses and individuals who hold cryptocurrency as a capital asset and are not engaged in the trade or business of selling cryptocurrency.
We here at Tax Problem Solver know cryptocurrency and we're here to protect traders from errors in cryptocurrency tax reporting and potential audits. So if you're involved in cryptocurrency and not sure where you stand with the IRS, please get in touch and we'll help you get things sorted out. Virtual currency is not a loophole or way around the IRS in any way.
Contact me by one of the methods below in the blue box, or you can email me at Larry@TaxProblemSolver.com and we can dive into your specific issues and solve them. You can also click here to book a free consultation with me or a member of my team.
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