What Every Tax Preparer NEEDS to Know About 21st Century Money
By David Klasing, Esq. M.S. – Tax, CPA
What Is Bitcoin?
The U.S. Treasury identifies Bitcoin as a decentralized virtual currency. It was created in 2009 by an individual (or group) using the alias “Satoshi Nakamoto.” It exists independently of any virtual world, and can be transferred without a central bank, clearing-house or other third-party administrator, successfully reducing transaction fees and other charges. By removing any central authority, Bitcoin gives each person the ability to directly and freely choose with whom to associate, interact or exchange.
Transactions are made directly between sender and receiver, and verified by network nodes using a public ledger. The verification process is entered through the system through a process called “mining.” “Miners” solve increasingly complex mathematical equations to authenticate transfers, and are compensated for their services with newly-created bitcoins.
Approximately 15 million bitcoins have been mined thus far. As of March 2016, the average price of Bitcoin was $415. A finite number of bitcoins are available for generation, to be capped at $21 million. Experts anticipate the last bitcoin’s issuance will be reached in 2140.
At its most basic level, Bitcoin is a relatively new technological means to transfer assets pseudo-anonymously over the Internet but some individuals use bitcoins to commit tax evasion. Bitcoin is a relatively new technology that is sometimes referred to as a digital currency or as a cryptocurrency. While Bitcoin is one type of digital currency competitors include Litecoin, Dogecoin, Peercoin, Quark, NXT, and others. Users of Bitcoin and similar digital currencies can send and receive money over a decentralized network that relies on a public ledger known as a “block chain” to authenticate and verify transactions. For many users of the service, using bitcoin is akin to utilizing a digital wallet, however, additional complexity lurks beneath the surface of user-friendly Bitcoin wallet interfaces.
How it Works
Users Can Contribute Computing Resources to “Mine” Bitcoins
Traditional forms of hard currency, currency backed by gold or other precious metals are subject to constraints on the supply of money. While this fact is less relevant for fiat currencies, it is highly relevant for Bitcoin due to the artificial scarcity specifically designed into the model. That is, there will never be more than, roughly, 21 million Bitcoins. However, all 21 million coins have not yet been discovered. Therefore, users can “mine” for Bitcoins which will inject new Bitcoins into the money supply.
Stating that people “mine” for bitcoins somewhat obfuscates the relationship, however. What is actually occurring is that people are choosing to contribute computing power to maintain the public ledger (blockchain) containing all Bitcoin transactions ever conducted. Thus, for work performed in keeping the Bitcoin network running and functioning as expected, contributors can be awarded compensation in the form of Bitcoin.
Individuals who have been awarded Bitcoin from mining activities have realized income and a taxable gain. Depending on the circumstances, the bitcoin miner may owe self-employment taxes on the bitcoin income. Similarly, individuals and businesses who accept Bitcoin as payment must also generally pay taxes on this income. However, due to 2014 IRS Guidance detailing Bitcoin tax treatment, any individual who holds or uses Bitcoin is required to engage in fastidious record-keeping. A failure to do so can subject one to a number of informational reporting and other tax penalties.
Tax Implications and Reporting Requirements
The tax implications of using Bitcoin may seem similar to shares of stock or securities in that records need to be maintained in order to track basis of each bitcoin; however, wash sales likely do not apply to bitcoins since they do not meet the definition of a stock share.
The IRS did indicate that the normal basis rules would apply to bitcoins, therefore Bitcoin users would have the option to sell their assets on a first-in-first-out (FIFO) basis, a last-in-first-out (LIFO) basis, or a selective cost-basis method. In a rising market, LIFO will produce the lowest tax liability, while FIFO will do so in a falling market.
Besides maintaining records for tracking basis, taxpayers should also be aware that if they are paid with bitcoins for their services, the bitcoins constitute self-employment income and therefore subject to self-employment tax.
Further, a person who in the course of a trade or business makes a payment using virtual currency may have a Form 1099-MISC reporting requirement if the value is $600 or more to a non-exempt recipient. Accordingly, backup withholding could apply.
What to Do When the IRS Wants My Client’s Bitcoin Trade History
Many people who have bought, sold, or traded Bitcoin or other digital currencies are aware that the IRS has taken an interest in their activities. While many people may believe that their Bitcoin activities were a mere hobby that could not possibly result in negative tax consequences, the reality suggests that users of Bitcoin who have failed to account for capital gains and other tax obligations could face penalties and fines. If your client engaged in a scheme to avoid or evade income taxes, however, penalties can be much harsher and may include a federal prison sentence.
Court Granting of IRS John Doe Summons Means the IRS Is Likely to Obtain Coinbase Account Data
Many people have heard that the IRS was attempting to obtain the account records of Coinbase users. While many people are aware of this fact, they may not understand what a John Doe summons is or its likelihood of success. As a starting point, it is essential to recognize that the IRS has previously used this tactic to successfully crackdown on the fraudulent use of offshore credit cards and foreign accounts and entities to commit offshore tax evasion. In several subsequent enforcement proceedings against taxpayers, the John Doe summons was the first step in discovering the accountholder’s real world identity.
Have they already started to turn things over?
Thus, in this case, it is highly likely that Coinbase will be required to turn over relevant account information relating U.S. citizens, tax residents, and others with U.S. tax obligations. In fact, on November 30, 2016, a federal court granted the IRS’s request. While Coinbase and individual account holders have vowed to fight the release of this information, it is highly likely that the IRS will prevail. Once the IRS has this data, it will likely engage in processing to identify taxpayers who have concealed income, failed to pay capital gains or income and self-employment taxes, or otherwise engaged in improprieties with Bitcoin.
What Steps Should I Take if I’m Worried about a client with Unpaid Bitcoin Tax?
If your client has sold Bitcoin, been paid for work performed in Bitcoin, paid employee wages in virtual currency, or engaged in an array of other transactions it is prudent to have your client seek the advice and guidance of a tax attorney. You should instruct your client to contact a tax lawyer because if you are concerned about their potential criminal tax charges, only the attorney-client privilege is sufficient to protect the disclosures your client will need to make when seeking legal guidance. If your client makes these same disclosures to you and the government subsequently decides to prosecute your client, it is extremely likely that the IRS will subpoena you as government witness number one against your client which is a conflict of interest that could lead to malpractice litigation.
Failed to Report Bitcoin on a Client’s Taxes?
The IRS is on the Hunt for Bitcoin Tax Evaders. In 2016 the Department of Justice filed a broad request in federal court requesting the identities of all customers who bought virtual currency from Coinbase, the largest Bitcoin exchange in the U.S., between December 31, 2013, and December 31, 2015.
The document is referred as a “John Doe” summons, which can only be served by the IRS after federal court approval. The summons provided that there is a reasonable basis for believing that United States taxpayers have failed to comply with the internal revenue laws.
A statement from an IRS Senior Revenue Agent, David Utzke, outlined three cases in which persons used Bitcoin to evade taxes, including one involving Coinbase customers. Two companies were identified as misreporting purchases of Bitcoin as technology expenses, rather than treating them as property, or inventory.
Although the summons’ main objective is to pursue larger offenders, small-time Bitcoin users are of interest, since they likely are not recording their virtual currency transactions properly.
Taxpayer Criminal Exposure for Failure to Comply
Most Bitcoin users were not aware that they were supposed to record their gains and losses as taxable events each time they made purchases with their bitcoins or sold them for money. Because of the recent John Doe summons, they are at risk for tax evasion. Consequently, they may be subject to penalties for failure to comply with tax laws. Underpayments attributable to virtual currency transactions include accuracy-related penalties and information reporting penalties. However, penalty relief may be available to taxpayers and persons required to file an information return who can establish reasonable cause.
Potential Tax Practitioner Criminal Liability
Tax preparers that are aware a client had taxable Bitcoin or other Virtual Currency transactions and counsels against reporting this activity are at risk of conviction for several different tax crimes. It is important to emphasize the obvious that tax evasion is a very different concept than tax avoidance is. Tax avoidance involves the careful, legal structuring of one’s affairs so his or her tax liability is legally reduced or minimized. Tax avoidance is legal. As one famous judge put it, “one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934). Tax evasion, by contrast, is not legal and it involves the willful attempt to avoid paying one’s tax liability after it has been incurred.
A tax practitioner can be found guilty to the same extent as the taxpayer who owes the taxes. This is because the scope of tax evasion is defined broadly in Section 7201. Specifically, Section 7201 provides that tax evasion includes a person’s attempt “in any manner”—including helping another— “to evade or defeat any tax” or its payment (emphasis added). Thus, the statute allows the IRS to prosecute a person for the evasion of another’s tax liability. The defendant need not be the taxpayer in question.
To successfully prosecute a violation of the aiding or assisting provisions for aiding or assisting another to file a false form, the government must prove beyond a reasonable doubt that;
- The defendant aided, assisted, procured, counseled, or advised the preparation or presentation of a document,
- The document was false as to a material matter,
- The defendant acted willfully.
Charges under this provision are most often brought against, accountants, bookkeepers and others (including an entity’s employees) who prepare or assist in the preparation of tax returns. However, the statute is not limited solely to the direct preparation of a return, but is much broader in that the statute reaches any intentional conduct that contributes to the presentation of a false document to the IRS.
Case law in this area provides the following examples:
- An individual who sold discounted winning horse or dog race tickets to others for cash, thereby causing the filing of a false Form 1099s, as well as the individuals who signed government forms provided to the racetracks that falsely stated that he or she was the winner of the horse or dog race;
- A person who knowingly prepared overstated appraisals to substantiate overstated deductions for charitable contributions;
- Persons who fabricate and then sell fictitious invoices to others to support nonexistent deductions;
- A breeder who, in furtherance of a fraudulent tax shelter, signed back-dated contracts for the purchase of livestock;
- An employee who prepared false books and records that were eventually used to prepare the entity’s returns;
To be charged under these provisions, one need only assist in the preparation of, and need not sign or file the actual false document. The statute has thus been applied to individuals who communicate false information to their return preparers, thereby causing the tax preparer to file a false return. On the other hand, the statute specifically provides that the taxpayer who signs and files the return or document need not know of, or consent to, the false statement for the aiding and abetting statue to be brought against the preparer. For example, a tax preparer who inflates deductions, understates income, or claims false credits on a client’s return may be charged with aiding and abetting, even if the taxpayer for whom the return is prepared is unaware of the falsity of the return he signed and filed. Moreover, a tax preparer who utilizes information provided by a client that the preparer knows to be false in the preparation of a return can be criminally charged with assisting in the preparation of a false return.
FALSE AS TO MATERIAL MATTER
The courts that have ruled on what constitutes a material matter have held materiality to be a matter of law to be decided by the court and not a factual issue to be decided by the jury.
To establish willfulness in the delivery or disclosure of a false document, the government need only show that the accused knew that the law required a truthful document to be submitted and that he or she intentionally violated the duty to be truthful. The crime of aiding or assisting in the preparation or presentation of a false return or document requires that the defendant’s actions be willful in that the defendant knew or believed that his or her actions were likely to lead to the filing of a false return. The Ninth Circuit (the appeals court for Southern California and thus controlling precedent) has held that the government must prove not only that the accused knew that the conduct would result in a false return, but must additionally establish that tax fraud was in fact the objective of the allegedly criminal conduct.
STATUTE OF LIMITATIONS
The statute of limitations for the crime of aiding or assisting the preparation or presentation of a false return or other document is six years. The statute of limitations for charges involving delivery or disclosure of a false document starts to run from the date the document is disclosed or submitted to the IRS.
Examples of evasion of assessment type convictions of practitioners:
In United States v. Wilson, 118 F.3d 228 (4th Cir. 1997), the court considered the evidence that the government introduced against the defendant that he (the defendant) attempted to mislead the IRS or conceal the taxpayer’s assets. The court considered the following evidence, among others: (1) that the defendant “prepared and executed false, backdated notes;” (2) that he “participated in a meeting where he discussed removing money from [another’s] bank accounts in order to prevent the IRS from attaching the money;” (3) that he provided the IRS revenue officer misinformation; (4) that he “prepared numerous corporate documents for [various parties], knowingly named “strawmen” as officers and directors;” and (5) that he instructed someone “how to funnel money” from one person to another to make it look like one of the parties had made an investment when he had not in fact done so.
In R.J. Ruble, DC N.Y., 2009-2 ustc, a well-known attorney was convicted of income tax evasion for designing and marketing a tax shelter. The government proved that attorney either knew or alternatively consciously disregarded the fact that the tax shelter he designed and marketed lacked economic substance. There was no business purpose to employ the shelter other than to obtain a tax benefit, and that there was no reasonable probability that the shelter would result in any profit apart from the anticipated tax benefits.
Examples of evasion of payment type convictions of practitioners:
In R. Huebner, CA-9, 95-1 ustc a practitioner who routinely serviced tax protesters by drafted sham promissory notes and then claiming the fake debt on the protestor’s bankruptcy petitions to remove IRS wage levies was convicted of aiding and abetting attempted income tax evasion. The practitioner created false claims indicative of financial distress, with the purpose of frustrating the government’s collections under its levies. Convictions for conspiracy to defraud the United States were also sustained because the false assertions provided the required affirmative act with the intent to deceive the government.
A line of cases, with some variations among the circuits, have held that when a return preparers accepts checks from their clients with the understanding that the funds are to be used to pay the client’s tax liability, any diversion of the earmarked funds for the return preparers’ personal use coupled with a failure to pay the tax is a criminal attempt to evade tax.
Exposure of Tax Practitioners to “tax obstruction” under (§7212):
The crime known as “tax obstruction” is found in IRC § 7212, which actually lists several crimes. However, there is one clause in this statute—known as the “Omnibus Clause”—that is the focus here. An Omnibus Clause violation exists when someone (anyone) “in any way corruptly . . . obstructs or impedes, or endeavors to obstruct or impede, the due administration” of the tax laws. § 7212.
To establish a Section 7212(a) omnibus clause violation, the IRS must prove three elements beyond a reasonable doubt: (1) that the defendant made a corrupt effort, endeavor, or attempt (2) to impede, obstruct, or interfere with (3) the due administration of the tax laws (Internal Revenue Code). U.S. v. Wood, 384 Fed. Appx. 698 (10th Cir. 2010).
Exposure of Tax Practitioners to “aiding or assisting a false return” under IRC § 7206(2):
The crime known as “aiding or assisting a false return” is codified in IRC § 7206(2), which essentially makes it a felony for someone to “willfully aid . . . assist, procure, counsel, or advise” someone in the preparation of a document (e.g. a tax document) that is “materially” false.
Broken up into its elements, the government must prove five things, each one beyond a reasonable doubt: (1) the defendant aided, assisted, procured, counseled, or advised another in the preparation of a tax return (or another document in connection with a matter arising under the tax laws); (2) that tax return (or other document) falsely stated something; (3) the defendant knew that the statement was false; (4) the false statement was regarding a “material” matter; and (5) the defendant aided, assisted etc. another willfully (that is, with the intent to violate a known legal duty).
One thinks here of a CPA, enrolled agent, or other tax preparer who is trying to help his or her client pay less tax, but that person (the taxpayer himself or herself) was not involved in the tax preparation process. But the tax crime of aiding another to prepare a false document captures more than just CPAs and enrolled agents. It includes anyone who prepares false documents—for example, an appraiser who values a business interest for tax purposes, or a tax shelter promoter. An appraiser might have to discern the value of a partial interest in a business or other asset contributed to a charity. An inflated value would achieve a higher charitable deduction to the taxpayer, but if that value is not defensible, the appraiser could be charged with “aiding in the preparation of a false return” under § 7206(2).
How to Help Your Clients Avoid Possible Criminal Tax Prosecution.
In a Criminal tax context, the CPA should be very diligent that the client does not share any information with the CPA in regards to possible criminal actions. The CPA should use zeal to make sure that the client does not put the CPA in a position where he or she can be a possible witness against the client. The client should be told to discuss the matter with a tax attorney at the first possibility of a fact pattern that indicates criminal tax exposure.
As a preparer, the CPA can help clients avoid criminal tax prosecution by knowing the procedures that the IRS uses to prosecute taxpayers. Most criminal tax investigations start as regular audits of returns in which the Examiner discovers possible taxpayer fraud.
The Internal Revenue Manual instructs IRS personnel on how to identify indicia of fraud during routine examinations. See IRM Part 25. The IRM instructs the agent to look for signs such as taxpayer or representative procrastination, uncooperative attitude, quick agreement to proposed audit adjustments or desire to immediately closing the case. Many other indicia of fraud, commonly called “badges of fraud” are identified in the IRM. Any one or a combination of these “badges of fraud” may then be interpreted as indicia of fraud and subject the taxpayer to a potential fraud investigation.
Once a Revenue Agent decides that there is a high indication that fraud is involved in a civil examination, they will ordinarily contact employees within the IRS called Fraud Referral Specialists. The Fraud Referral Specialist’s job is to determine whether this is solely a civil issue in each examination, or whether the case should be referred to the Criminal Investigation Division for development for possible criminal prosecution. In the past, a Revenue Agent would suspend the audit without telling the taxpayer or the CPA the reason for the sudden and unexplained suspension. This made the seasoned and enlightened CPA’s job easy since the CPA would recognize the tell-tale signs that his client’s audit most likely has gone criminal. The seasoned and enlightened CPA would then consider withdrawing from the representation and refer their client to consult with a reputable criminal tax attorney.
However, in 2009, the IRS changed their fraud procedures in a very quiet manner by not publicizing the change and by instituting the use of parallel criminal investigations while the civil audit is still ongoing creating a dangerous scenario for both the CPA and his or her client. The Revenue Agents are instructed not to tell the taxpayer, or his representative that a criminal investigation has started or is ongoing. These types of audits are commonly called “eggshell audits” in the Tax Controversy Representation legal community.
This change in policy obviously makes the CPA’s representation in an audit much more critical in minimizing his or her client’s criminal exposure and thus creates much more malpractice exposure for the CPA. The CPA, now, more the ever, needs to be very diligent in regards to being cognizant of the additional risks faced by his or her client considering this policy change. CPAs should investigate for any issues in a client’s fact pattern that could turn criminal prior to the outset of a routine civil audit. If indicia of fraud is detected the CPA should advise the client of the possibility that the issue may silently turn criminal during the civil examination and advise the client to consult with a tax attorney. It is also advisable that the CPA seek the counsel of an experienced tax attorney themselves about whether it is a good idea to continue representation considering all the facts of the case especially where the client refused to seek legal counsel.
Teaming up With a Tax Attorney to Solve a Current or Potential Client’s Criminal Tax Issues.
The CPA can still play a major and invaluable role in the context of the Kovel Agreement. The 2nd Circuit case US v. Kovel, basically established that a CPA or accountant call fall under the attorney-client privilege by having the attorney, rather hire the CPA, rather than being directly hired by the CPA. In Kovel, the accountant in questions was a former IRS agent, and he was hired by a law firm to advise the law firm’s clients. The clients were under IRS investigation, and they subpoenaed Kovel to testify against the clients. Kovel refused and he was sentenced to a year in prison. The 2nd circuit then overturned the decision, and stated that the accountant is privileged, if hired by the lawyer.
The Kovel agreement will protect all communications and work papers of the CPA from discovery by the IRS summons enforcement or production at trial, since now all these papers fall under the attorney work product doctrine.
The application of Kovel has been somewhat limited by the subsequent US v. Adlman case, where the court basically stated that the work product protection applies only to materials in anticipation of litigation. In Adlman, the corporation’s accountant prepared a study for the entity’s attorney, and the study basically assessed what the outcome would be in the event of a litigation, before the IRS ever audited the company. The trial court concluded that the main purpose of the report was not made in anticipation of litigation.
The court of appeals vacated and remanded the trial court’s decision, and basically stated that the documents included “mental impressions, conclusions, opinions and theories” and that it did not lose its protection as work product just because it was prepared as a business decision. Because of the nature of the study, which evaluated the tax implications and a large tax loss which would have resulted in a refund, litigation with the IRS was almost certain.
Another thing the 2nd circuit stated in Adlman is that the IRS also must make a showing that the documents are otherwise unavailable.
A CPA in his own practice may establish a Kovel relationship with an attorney. In the Kovel setting, the CPA will provide valuable services to the attorney in anticipation of any possible litigation.
Another way in which the CPA and attorney may team up is through voluntary disclosures to the IRS. In a voluntary disclosure, the client will come into your office, state that he cheated on his taxes, but that he wants to make things right.
Once again, the CPA’s first responsibility will be to tell the client to not discuss the matter with the CPA, and consult a tax attorney. Although the purpose of the voluntary disclosure is to prevent cases from becoming criminal, a tax attorney needs to be consulted for various reasons. First, the attorney will need to identify whether the client is eligible for a voluntary disclosure. The attorney needs to contact the IRS with the client’s information and do a “pre-check” to see whether the client can enter the voluntary disclosure process. If the client is accepted in the pre-check stage, the voluntary disclosure can begin. If the client is not accepted, it may mean that a criminal investigation has already begun.
In the voluntary disclosure process, the attorney will use the services of the CPA to amend all false and incorrect previous returns and submit these returns with the extra income, and the penalty calculation associated with the disclosure to the IRS.
While many Treat Bitcoin as Currency, for Tax Purposes, the IRS Considers It Property
In a 2014 document, Notice 2014-21, the IRS announced that Bitcoin and similar digital currencies should be considered property rather than a form of currency. The IRS based this decision on the basis that virtual currency is not legal currency in any jurisdiction. The IRS’s determination that Bitcoin is property means that users of the virtual currency are subject to capital gains taxes.
That is, consider a shopkeeper who is branching out into the digital world. He sets up a website where he accepts bitcoin as a form of payment. When a customer makes a payment in the form of Bitcoin, the shop owner must keep a record of the Bitcoin’s fair market value at the time of receipt. Then, when he or she sells or uses Bitcoin to engage in a subsequent transfer, the fair market value of the Bitcoin must be recorded to determine the capital gain or capital loss on the transaction. When dealing in Bitcoin, tax professionals can help taxpayers legally minimize the tax impact of such transactions by selecting an appropriate accounting method for market conditions.
Bitcoin Tax Record Keeping
If a client has Bitcoin Income, advise them of the IRS tax record keeping requirements
If a client has taken an interest in Bitcoin due to the underlying technology, due to customer demand, or because it seemed like a good investment opportunity, there are certain record keeping requirements taxpayers must satisfy. While the exact records taxpayers keep, and submit to the IRS will vary based on their use of Bitcoin, we can examine a few typical cases to illustrate the various records that a taxpayer must keep to maintain compliance.
All Holders of Bitcoin Must Record and Account for Capital Gains
Regardless of how your client uses or intends to use Bitcoin, if they accept and hold Bitcoin, they are very likely to incur an obligation to pay capital gains taxes. This is due to the fact that, in 2014, the IRS held that Bitcoin and other virtual currency must be treated as property rather than as currency. When holding property, your client must account for capital gain. The capital gain is accounted for by recording a starting value when the property is obtained and a closing value when the property is sold or transferred. As you know, the difference in value is the gain. Generally, gain is realized and comes due in the tax year where the property, in this case Bitcoin, is sold or transferred.
When Bitcoin is Used to Pay Employees, advise your client that they must keep their Payroll Tax Records
Some businesses may elect to pay employees in the form of Bitcoin. Paying employees in Bitcoin or other digital currencies does not relieve a business owner and responsible parties of their obligation to account for, collect, hold, and pay over payroll taxes. As tax preparers, you need to advise your clients, to keep employment tax records for a minimum of four years. However, when records are connected to property, the IRS states that records should be kept until the period of limitations expires for the year in which the taxpayer disposes of the property.
Your client has received Bitcoin as Income, What Records do they need to keep?
If your client was paid in Bitcoin for services performed and is not an employee, it is highly likely that the client will need to account for capital gains, income tax, and self-employment taxes. While basic details for capital gains and income tax are set forth above, a self-employment obligation can be reported via Schedule SE of IRS Form 1040. Tax preparer can utilize the 1099 provided by your client’s employer to determine the correct numbers to report. Once again, since the reporting is connected to property, it is prudent to advise your clients to keep records for the latter of four years or until the period of limitations expires for the year in which the taxpayer disposes of the property.
Can a tax professional Appeal a Bitcoin Tax Determination by the IRS on behalf of a client?
If a client’s Bitcoin tax issue has already been assessed by the IRS, the agency may have launched an audit. The audit may uncover an array of tax improprieties that result in additional tax due. Alternatively, the IRS may have decided to impose additional tax due to a failure to pay capital gains taxes, employment taxes, self-employment taxes, income tax or other tax obligations related to Bitcoin and other virtual currency — with interest — due to the alleged tax compliance failures by your client.
The appeal of IRS tax determinations is typically available. However, the exact form of appeal that is available will depend on where in the assessment and collection process is your client’s matter. Please do your research before filing an appeal because certain appeal options can limit the taxpayer’s ability to file a further appeal in the federal courts.
A client’s Right to Appeal Unfavorable Bitcoin and Other Tax Determinations.
If a client disagrees with the conclusion reached by the IRS, your client has the right to file an appeal. However, strict time limits apply. Taxpayers who fail to file a timely appeal may lose their ability to do so.
However, in general, following the IRS audit and subsequent determination, your client will receive a written letter setting forth the taxpayer’s appeal rights. The 30-day letter will set forth the IRS’s determination and the taxpayer’s right to appeal. Your client should respond to this letter, but if he or she does not, a 90-day Notice of Deficiency will be issued to the taxpayer.
Should a client decide to appeal to Tax Court, the taxpayer or an attorney licensed to practice in Tax Court may elect to file for a small case review. Small case review is available when the amount in controversy is $25,000 or less. Additional appeal options are also available including an appeal in federal court.
The Collection Process Is Also Subject to Appeal
If your client’s matter has already moved beyond the assessment phase and the IRS is attempting to collect on the debt, collection appeals are often available. Collection appeals options include Collection Due Process (CDP) and the Collection Appeals Program (CAP). Each appeal program has a different focus and can impact your client’s subsequent appeal options.
What Happens if the IRS Thinks a client is using Bitcoin to Commit Tax Evasion?
In recent years, many people have become interested in emerging financial applications of cryptography and decentralized peer-to-peer networking. While the first digital currency to leverage these and other technologies, a score of competing cryptocurrencies have since emerged on the scene. Some of the benefits of Bitcoin and similar technologies include:
- There is no bank, credit card processor, or other middleman to take a cut of the payment.
- Transactions are verified and authenticated before money is ever transferred.
- Users do not need access to special hardware, payment cards, or other single-purpose devices to use cryptocurrency.
- User’s identities are protected to a certain extent.
The last bullet point is particularly noteworthy. While Bitcoin and similar digital currencies are often advertised as “anonymous” the fact of the matter is that this generally refers to the fact that people can send and receive money without directly revealing personally identifiable information.
However, far too many people misinterpret that last point and believe that once money is “in” Bitcoin, it is invisible to the IRS and U.S. government. This is a faulty assumption by your clients can lead to an audit, tax enforcement actions, and even criminal tax evasion charges.
Bitcoin Does Not Provide Perfect or Reasonable Anonymity in Many Scenarios
Bitcoin functions by making a public ledger containing all transactions ever conducted available. Thus, by nature, all transactions are publicly available. Thus, there is no such thing as a “private” Bitcoin transaction. Rather, a level of anonymity is preserved by disassociating a user’s identity with the public transaction – however a record of the transaction time, amount, and other information is always kept publicly. The problem that exists is when users sign up with popular Bitcoin wallet services, their identity is revealed in an e-mail. For users who use Bitcoin in this method, it is no more anonymous or private then a bank transaction.
The IRS Is Using John Doe Summons to Unmask Cryptocurrency Account Holders
The IRS is aware of this potential vulnerability in the Bitcoin security and anonymity model and is attempting to leverage it to reveal the identity of all customers of the largest Bitcoin exchange, Coinbase. The summons requests “the identities of United States Coinbase customers who transferred convertible virtual currency at any time between December 31, 2013, and December 31, 2015.” This tactic was used to successfully crack down on UBS, offshore tax evasion, PayPal, and a number of credit card companies.
By sending the John Doe summons, the IRS seems certain that it will uncover at least some individuals engaged in tax evasion because the summons profess a reasonable basis for believing that United States taxpayers have failed to comply with the internal revenue laws.
What you should advise a client to do if he/she had a Coinbase or Bitcoin Wallet Account in 2014, 2015, or 2016 and Failed to File and Pay Taxes?
If a client had a Coinbase account or otherwise mined, held, traded, or engaged in transactions involving Bitcoin, it is essential that steps are taken to mitigate the potential consequences your client faces and he/she may need to file an FBAR. This may include amending past tax returns, filing missed returns, or making a voluntary disclosure. The IRS has already taken steps to identify those taxpayers who are utilizing Bitcoin and cryptocurrency to commit tax evasion. As the IRS continues to gather information from an array of domestic and international financial institutions, it is highly likely that it will become increasingly aggressive in its enforcement activities. Again, it is important for the CPA to know when to “punt” to a tax attorney on this issue.
Can Bitcoin Trading Create an Obligation to Pay Capital Gains Taxes?
For a multitude of reasons, Bitcoin and similar digital cryptocurrencies have captured the attention of both technology evangelists and financial traders. To start, Bitcoin represents the first foray into currencies of this type where no governmental or single body has control of the currency and its supply. Therefore, Bitcoin is significant from a purely technical – in both a computing and monetary sense — point of view. However, Bitcoin and its successors are also interesting in the fact that there is still significant volatility in the markets. This presents the opportunity for savvy traders to take short- and long-term positions.
However, due to the nature of Bitcoin and decisions made by the IRS and U.S. Treasury mining, holding, and trading Bitcoins can subject an individual to capital gains taxes. All individuals who hold or have held Bitcoin and similar cryptocurrencies will be or are subject to capital gains tax and other informational reporting requirements.
Why Does Mining, Trading, or Converting Bitcoin to US Dollars Result in Realization of Capital Gain or Loss?
The reason why Bitcoin miners and traders need to be cognizant of capital gains taxes and related record-keeping and reporting requirements can be traced back to a 2014 IRS Notice. In IRS Notice 2014-21, the basic tenets of Bitcoin taxation are set forth. Essentially, the notices states that while the IRS recognizes that Bitcoin is utilized as a digital currency, for tax purposes it will not be treated as a currency. Rather, Bitcoin and similar cryptocurrencies will instead need to be treated as property for tax purposes.
Since Bitcoin and similar currencies are treated as property, capital gains taxes apply when gain is realized. Thus, when a person mines Bitcoin or otherwise comes to hold Bitcoin, he or she must record its fair market value. Then, when the Bitcoin or portion thereof is transferred to another, the fair market value should be recorded again. The change in value is used to compute the gain or loss realized. While capital gains taxes apply to Bitcoin transactions, tax preparers can help their clients minimize this tax by determining and applying the accounting method most likely to produce favorable results.
Potential Penalties a client can face for a Failure to Pay Bitcoin Capital Gains Taxes
When filing taxes, a taxpayer will be expected to provide adequate documentation supporting his or her calculations. A failure to keep and provide records could lead to facing penalties under IRC Sections 6721 and 6722. A failure to calculate capital gains can also lead to accuracy related penalties under 26 U.S. Code § 6662 – Imposition of accuracy-related penalty on underpayments. In scenarios where it appears that the taxpayer is willfully engaged in systematic tax fraud, the IRS is likely to refer the matter to IRS CI for work-up to criminal prosecution. In situations like these, the Bitcoin trader, (your client) could even face felony tax evasion charges carrying a federal prison sentence.
Are Bitcoin Miners Required to Pay Self-Employment Tax?
Many Bitcoin miners who first took up an interest in the activity did so out of an earnest and profound interest in the underlying technology and a desire to be an early adopter. However, following the spike in a value of Bitcoin in 2014, individuals who were more motivated by the potential to make money were more likely to engage in substantial operations. However, surprisingly to many individuals, regardless of whether your client intended to start a business and make money, your client is still subject to self-employment and income taxes when a profit is realized.
Income Earned Is Typically Subject to Either Payroll Taxes or Self-Employment Taxes
Generally speaking, and absent an exception to this rule, all income earned or provided as remuneration for goods or services is subject to tax. When an individual performs work for compensation, they usually do so on one of two bases: as an employee or as an independent contractor. When a person performs work as an employee, their employer is required to account for, collect, and pay over payroll and related employment taxes. However, when an individual works as a 1099 independent contractor, the employer will not withhold Social Security, Medicare, or other taxes.
The self-employment tax is intended to account for the fact that 1099 workers do not have these taxes automatically deducted from a paycheck or payment for services. If your client earned service related income and their employer did not deduct payroll taxes, there is a high likelihood that your client is an independent contractor. Independent contractors, in most cases, are required to pay self-employment taxes. Many independent contractors are required to make quarterly tax payments or face a penalty for a failure to make timely payment.
Is your client’s Bitcoin Mining Operation a Business or a Hobby?
Regardless as to whether your client considers their bitcoin mining a business or a hobby, your client will need to pay self-employment tax when their net self-employment income is greater than $400 in any tax year. However, if the IRS determines that your client’s bitcoin mining activities constitute a business, your client may be able to reduce their tax liability through tax deductions and credits for business expenses. This option is not available if the IRS considers your client’s operations to merely constitute a hobby. However, the criteria the IRS uses to determine whether an activity constitutes a for-profit business may produce unexpected results for taxpayers who do not familiarize themselves with the criteria. For instance, any activity that has turned a profit in at least three of the last five tax years, including the current year, is presumed to be a for-profit business whose losses can be used to offset other income.
The fact is regardless of whether your client sets out to make money or was simply in the right place at the right time, your client will need to pay taxes on their income. Due to the nature of many bitcoin mining operations, there is a reasonable to high likelihood that bitcoin miners are required to pay self-employment taxes.
Do “Miners” Have to Pay Tax After Being Awarded a Bitcoin or other Virtual Currency?
In an incredibly simplified sense, Bitcoin and many other virtual currencies work by following a distributed model where interested third parties devote computing resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger. Third parties are incentivized to provide CPU and GPU cycles used to maintain the virtual currency’s network, through the concept of “mining.” That is, in exchange for providing computing power, they can be awarded a certain amount of Bitcoin, Dogecoin, Quark, or other relevant virtual currency.
In short, yes, bitcoin miners are required to pay tax on virtual currency received. Every individual who mines bitcoins and receives something of value for the use of their computing resources is required to pay tax even if the amount earned does not trigger a reporting statement. As set forth more fully in IRS Publication 525, income can come in many forms. Bitcoin and similar virtual currencies are simply one additional type of income that is taxed as property.
Mining Bitcoin Can Create both a Self-Employment & Income Tax Obligation
While companies can incur business tax obligations for mined bitcoins, the more common scenario involves a miner who is working independently toward a shared mining pool. When a taxpayer engages in “mining” activity as a trade or a business as a “non-employee”, the net income gained through these activities constitutes self-employment income and is subject to the self-employment tax. Chapter 10 of IRS Publication 334, Tax Guide for Small Business, sets forth additional information on the self-employment tax. When the self-employment tax applies, the fair market value of virtual currency received for services performed is subject to tax. If the IRS does decide to treat your client’s Bitcoin mining operations as a business, your client may qualify for tax deductions or credits that will offset their tax obligation.
How Does a Business Determine Its Taxes When Paid in Bitcoin?
Some business, most often online business, accept Bitcoin and other forms of virtual currency as payment for goods provided or services rendered. Many businesses feel that offering this method of payment can only help by attracting customers who do not have credit cards, debit cards, or other electronic means of payment. However, Bitcoin and other virtual currencies receive unique tax treatment. Despite frequently being utilized as a medium for exchange, the IRS taxes Bitcoin as property rather than as currency. This results in unique tax treatment that can trip-up even sophisticated business owners.
What Happens When a Customer Makes Bitcoin Purchases?
Since Bitcoin is treated as a type of property, when a customer or client makes a purchase or provides remuneration in the form of bitcoin gain and loss is triggered on both sides. That is, both the business accepting the payment and the business or individual paying in bitcoin are likely to have a reportable tax event as a consequence of this transaction.
This is because the value of a bitcoin will vary over time meaning that most transactions involving Bitcoin will necessarily involve considerations of capital gain and loss. For instance, consider an individual who bought a Bitcoin in the early days, prior to 2014, for $50. When the individual sells that Bitcoin or uses it to pay for a good or service, he or she will be quite happy to learn that at the time this was written 1 Bitcoin was worth roughly $700. Thus, in this example, the seller would realize a capital gain of about $650 at the time of the transaction. Tax is due on the realized capital gain.
On the seller’s side, the business has now accepted a Bitcoin currently valued at $700. Thus, the company has realized $700 in gross income subject to costs and expenses. However, it is absolutely essential for the business to keep a record of the Bitcoin’s fair market value at the time of the transfer. When the business engages in a subsequent transfer involving that bitcoin, it will need to determine its capital gains or loss on the basis of the price at the time of the subsequent transfer. The most important takeaways for tax professionals to advise their business owner clients are to:
- Recognize that bitcoin gives rise to additional capital gains tax considerations.
- Ensure that adequate records are kept so all tax obligations can be satisfied.
What Can Happen When a Client Fails to Keep Records and Pay Taxes on Bitcoin Transfers?
In the most basic sense a failure to properly account for the tax obligations relating to the acceptance of bitcoin can result in significant unsatisfied tax obligations, penalties, and interest. However, the failure to account for this obligation often results in less than optimal business tax planning. Depending on market conditions, the method of basis accounting can have a profound impact on the company’s overall tax liability. Furthermore, in certain scenarios, self-employment income and tax obligations may arise.
The worst-case scenario involving a failure to account and pay all tax on bitcoin transactions involves the IRS interpreting the actions as criminal tax evasion. The IRS is aware that due to pressures applied in the offshore tax enforcement area through FBAR and FATCA, some individuals explored Bitcoin as a means to conceal income and assets. Since Bitcoin is decentralized and not generally subject to government oversight, the IRS recognizes the potential for abuse and proceeds aggressively. Taxpayers who make mistakes regarding Bitcoin risk getting caught up in the IRS dragnet and facing serious tax penalties.
Can your client Face Tax Penalties for Mistakes Made with Bitcoin?
The allure of Bitcoin as a potential next step in payment methods and systems can blind even sophisticated individuals to the tax obligations that might arise due to their use. Unfortunately, individuals who engage in financial and other transactions without first considering the tax implications and consequences of such actions are likely to make mistakes and errors. These mistakes and errors often open the door to an audit and facing significant new tax liability, fines, and penalties. In extreme situations, the taxpayer may be accused of committing tax crimes, like tax evasion, that carry a federal prison sentence.
Your client’s Failure to Handle Bitcoin Tax Obligations Can Result in Punishment
The IRS is targeting Bitcoin transactions and assets due to the potential for abuse by taxpayers that is presented by this technology. The IRS is well aware that some taxpayers may be attempting to use Bitcoin to conceal income and assets thereby illegally reducing their tax liability. As such, the IRS has taken a particularly aggressive stance against potential Bitcoin-based tax fraud announcing that penalties can apply to all taxpayers – even those taxpayers who only engaged in noncompliance prior to the release of IRS guidance on March 25, 2014.
Bitcoin Errors Can Result in Tax Accuracy Penalties under IRC 6662
26 U.S. Code § 6662 – Imposition of accuracy-related penalty on underpayments, states that for certain underpayments of tax an additional penalty of up to 20 percent of the unpaid liability can be assessed. For instance taxpayer negligence, mistakes regarding valuation of property or liabilities, and undisclosed foreign financial assets are all grounds where § 6662 authorizes an additional penalty.
Furthermore, a substantial underpayment of tax can also trigger additional penalties under Section 6662. A substantial understatement of tax occurs when there is an understatement of tax of exceeding the greater of exceeds the greater of 10 percent of the tax required to be shown on the return for the taxable year, or $5,000.
Your client’s Failure to Report Virtual Currency Transactions Can Also Result in Punishment
Since Bitcoin is characterized as property for tax treatment purposes, it is possible to realize capital gains and losses. Therefore, making and maintaining adequate records that track the value of the asset over time are essential to any adequate tax handling. Taxpayers who fail to make and keep these records may be subject to punishment under IRC Sections 6721 and 6722.
IRC § 6721 sets forth the penalties and punishments for taxpayers who fail to file correct and accurate informational returns. Furthermore, §6722 sets forth the punishments that can be imposed when a taxpayer fails to furnish correct and accurate payee statements. While the foregoing penalties can be imposed for Bitcoin tax mistakes, the consequences faced can often be mitigated through a show of reasonable cause.
The IRS May Advance Tax Evasion Charges for Bitcoin Errors
If your client’s activities and practices show a pattern of noncompliance, willfulness, or other signs of tax fraud it is possible that their matter may be referred to IRS Criminal Investigations. Your client may end up being charged with criminal tax evasion. As a felony, tax evasion carries a federal prison sentence along with harsh financial penalties. Even if your client did not intend to commit tax evasion a series of unexplained transactions, misstatements, and other potential indicators of fraud may convince the auditor that a closer look is required.
California Man Makes More than $1 Million Through Bitcoin Home Purchase.
Many people are somewhat perplexed when they find out that the IRS does not consider Bitcoin to be currency. After all, isn’t Bitcoin a medium of exchange that is typically utilized to buy and sell goods and services? While the use of Bitcoin does often closely mirror the use of cash, credit cards, and other common methods of payment there are important differences that distinguish Bitcoin (and similar forms of electronic currency) from cash and other forms of currency.
For one, while Bitcoin is often used like cash, it is not regulated or otherwise controlled by a national treasury or other governmental or quasi-governmental agency. Furthermore, the supply of currency can typically be manipulated by the Treasury. In Bitcoin, the supply of bitcoins is finite and set per a predefined algorithm. Finally, unlike cash, Bitcoin is not legal tender. Unfortunately, these differences are rather abstract and it is often difficult for people to conceptualize this difference. The following scenario is mean to highlight how Bitcoin is different from cash and other forms of currency and the tax obligations these differences can create.
Wrapping up How the IRS treats Bitcoin.
As stated before, in March 2014, the IRS issued Notice 2014-21, which addressed its treatment of Bitcoin transactions and exchanges. The notice provided a brief guide to the underlying tax and reporting issues surrounding virtual currency.
The IRS treats Bitcoin and other virtual currency as property, not currency. Its rationale behind such treatment is due to the fact that there is no government backing or regulation behind virtual currency. Since virtual currency does not have legal tender status in any jurisdiction, it cannot be treated as currency.
Due to its treatment as property, if a person or entity uses bitcoins to make purchases, the exchanges would trigger a gain or loss for both the recipient and the spender. For example, if someone bought a bitcoin for $100 and then later spends it when the bitcoin has risen in value to $150, he or she would realize a $50 gain, a reportable taxable event.
Another example, if a person receives bitcoins as payment for goods or services, such as U.S. based “miners” as aforementioned, then he or she must include the fair market value of the bitcoins in his or her gross income, as of the date of receipt. The fair market value at the time of receipt also represents the stand-alone basis of each bitcoin. Later, if the person decides to spend the bitcoins, he or she would be taxed on the gain or loss occasioned by a change in the bitcoin value between the date of receipt and the date of expenditure.
Many people have treated bitcoins as an investment, rather than using them for buying and selling goods and services. Either treatment requires that they must keep records of their transactions to report the gains and losses upon sale.
Is Bitcoin or a Bitcoin Wallet Reportable for Purposes of FBAR, FATCA?
Over the course of the last several years, Bitcoin has moved from something of a promising curiosity to a technology that many see as applicable to an array of industries and endeavors. At the heart of Bitcoin and similar digital currencies, such as DogeCoin and Etherium, is a concept known as the block chain. The block chain is essentially a digital equivalent of a public ledger. The public ledger contains a record of all transactions carried out within this blockchain. Computers that contribute resources to the blockchain continually check the propriety of transactions by computing hash values. The open, public, and verifiable nature of a blockchain means that future applications could range from financial and banking transactions at major international financial institutions to recording deeds and other public or private records.
However, the blockchain and, by extension, Bitcoin are still primarily a means of storing value digitally. As an application of the blockchain that straddles the line between currency and property, the use of Bitcoin can have tax and tax reporting impacts. Tax professionals can help taxpayers who mine Bitcoin, hold or conduct transactions in Bitcoin, avoid potentially costly mistakes regarding failures to report Bitcoin assets.
What Are the FBAR and FATCA Reporting Obligations?
The obligation to file a Report of Foreign Bank Account (FBAR) is found in the Bank Secrecy Act. While the duty to file FBAR has long been enshrined in U.S. law, the obligation was largely ignored for the early portion of its existence. However, in the mid-2000s, Congress amended the Bank Secrecy Act to include penalties for non-compliance. When taxpayers fail to report FBAR – even accidentally – they are subject to a potential penalty of up to $10,000 per a violation. When IRS agents believe that noncompliance was willful in nature, penalties escalate to the greater of $100,000 or 50 percent of the account balance. The duty to file FBAR exists any time the aggregate balance in covered foreign accounts exceeds $10,000.
The duty to file FATCA was established through the Foreign Account Tax Compliance Act passed by Congress in 2010. Penalties are also harsh for failures to comply with this informational reporting law. Unlike FBAR, there is no bright-line rule setting forth when a taxpayer must file. Rather, a taxpayer must first determine his or her tax filing status and residency. Depending on these factors, the taxpayer will be able to hold different amounts of foreign assets before a duty to report is triggered. In general, married taxpayers filing jointly and living abroad can control the most assets before they are required to report. In contrast, sole filers who live in the United States can hold the least foreign assets before he or she incurs an obligation to report.
Taxpayers can be obligated to report a single account on both FBAR and FATCA. Reporting an account under one regime does not satisfy the independent duty to report under other offshore disclosure laws. FBAR obligations are properly reported through a timely filing of FinCEN Form 114. FATCA obligations are satisfied by a timely filing of IRS Form 8938.
What Does Virtual Currency Have to Do with Foreign Accounts and Taxes?
While we characterize Bitcoin as “digital currency” above and this is the fashion that people are most accustomed to thinking about Bitcoin, this does not comport with how the IRS views Bitcoin. In IRS Notice 2014-21, the IRS indicated that it was aware of “virtual currencies” and the ways in which people typically utilized these currencies. The IRS announced that despite people’s propensity to treat Bitcoin as a currency in certain scenarios, Bitcoin would be treated as property for federal tax purposes.
To understand what Bitcoin must do with foreign account reporting obligations, first, consider the different ways one can store Bitcoin. A user of the currency could print out his or her full or partial bitcoin and carry it around like cash in his or her wallet or purse. The user could also store his or her Bitcoins in a digital account known as a Bitcoin wallet.
This distinction is important because hard currency, real estate, precious metals held directly, personal property, and certain covered benefits programs are not reportable for purposes of FBAR or FATCA. However, once these assets are placed in a foreign financial account, they become reportable for purposes of FBAR and FATCA. Since users of Bitcoin can place the value of their Bitcoins in an account that may be held overseas, this would seem to be an area of some concern.
Second, also consider the tax nature of property versus that of currency. When an item is considered property for tax purposes the concepts of capital gains and capital loss must be accounted for. When Bitcoin gains in value during the time a person holds it, the gain in value must be computed and reported. Typically, there will also be tax due on the gains in the form of the capital gains tax.
What Guidance Has the IRS Issued on the Potential Duty to Report Bitcoin for Purposes of FBAR and FATCA?
Considering the potential penalties that can be imposed for FBAR and FATCA compliance failures, the IRS’s guidance on the issue cannot be described as anything but anemic and inviting tax controversy. In 2014, Rod Lundquist, a senior program analyst for the Small Business/Self-Employed Division indicated that the IRS would not require Bitcoin to be reported as part of FBAR. He elaborated by adding that that “FinCEN has said that virtual currency is not going to be reportable on the FBAR, at least for this filing season [emphasis added].” The IRS later clarified this statement in response to a reporter’s inquiry. It clarified that virtual currency accounts also fell under the non-reportable guidance.
Despite the unofficial nature of this guidance, this is still the only statement taxpayers must guide their offshore account reporting. And this statement was explicitly limited to the context of a single tax filing year.
Recent enforcement actions taken by the IRS may suggest the possibility that the IRS is reconsidering its approach to Bitcoin and foreign account informational disclosures. In November 2016, the IRS filed a John Doe summons seeking information relating to U.S. account holders who had Coinbase Bitcoin transactions between 2013 and 2015. The IRS’s summons states that it is “responsible for monitoring ways in which United States taxpayers evade their United States tax obligations.” In the subsequent paragraph, the IRS suggests that use of digital currencies makes the user “subject to fewer third-party reporting requirements.” This language would seem to suggest that at least some users have adopted virtual currency because they believe they can avoid reporting requirements potentially including FBAR and FATCA.
How Should you advise a client to Approach this Uncertainty Regarding Bitcoin and Taxes?
Taxpayers face an array of tough choices when it comes to protecting themselves against potential future liability because of a failure to report Bitcoin on FBAR or FATCA. Different circumstances may suggest or require different handling. Know your clients, and be knowledgeable of their options because taxpayers typically have different preferences when it comes to acceptable levels of risk.
At the more conservative end of the spectrum of potential approaches, taxpayers could align their handling of Bitcoin to comport with that of gold, hard currency and real estate. That is, these assets are generally not reportable for foreign account purposes when held directly, but become reportable when they are stored in a foreign financial account. Under this type of approach, a taxpayer who carries around a printed Bitcoin would not report Bitcoin for purposes of FBAR or FATCA. However, a taxpayer who has placed the value of his or her bitcoin in a virtual wallet hosted overseas should include Bitcoin for purposes of aggregation and reporting. This type of approach would, at the least, provide the taxpayer with a reasonable approach to an unsettled issue.
At the more aggressive end of the spectrum, taxpayers could continue to apply the statements made by Rod Lundquist back in 2014 to the current tax year. Consult with your clients before they adopt this or any other approach to satisfy FBAR or FATCA duties.
As taxpayers, have become more accustomed to foreign disclosure obligations, the IRS has expanded tightened up reporting procedures. Furthermore, the IRS has stated that it reserves the right to make voluntary disclosure programs, through which taxpayers can mitigate offshore penalties and consequences, less favorable. Considering the recent enforcement actions targeting Bitcoin users for suspected tax evasion and offshore tax fraud, it is only a matter of time before the IRS further tightens the offshore tax reporting regimes.
Is it Possible to do a 1031 exchange with Bitcoin, Ethereum, or other Electronic/Crypto Currencies?
Individuals who were quick to recognize the opportunity presented by cryptocurrencies like Bitcoin, DogeCoin, and Ethereum have likely rode the market to significant gains as capital from China and other developing nations have flooded the market. People who bought or mined Bitcoin due to an interest in the underlying technology or because they saw an investment opportunity may be looking to diversify their cryptocurrency holdings. In any case, they may consider changing the overall balance of digital currencies held to increase the likelihood of investment gains or hedge against potential volatility.
For individuals already holding Bitcoin or other digital currency, engaging in a like-kind exchange under Section 1031 of the U.S. Tax Code can be a viable means of exchanging one type of currency for another. Engaging in a like-kind exchange can provide tax deferral benefits for transactions that would otherwise generate capital gains taxes and be a means to much needed diversification amongst the different types of digital currencies that tend to be very volatile. Working with a Bitcoin tax attorney can ensure that you maintain tax compliance even while minimizing the tax impact of a transaction.
What Is a 1031 Exchange and What Are its Benefits?
A 1031 exchange can allow an individual or a business to exchange productive property for like-kind property. Most commonly, individuals will utilize a 1031 transfer to exchange like types of real property. That is, an investor may exchange one type of investment property for another type of investment property. The investor is free to pursue other investment or business goals provided that the property remains an investment property. However, an individual may not exchange investment property for a personal residence. Furthermore, there are limitations on “dealers” or other persons handling “stock in trade” leveraging a 1031 exchange.
The main benefit of engaging in a 1031 exchange is to defer liability on capital gains taxes that would otherwise be incurred at the time of sale. In deferring taxes, a property owner can reinvest the capital towards other productive uses.
Can A 1031 Exchange Apply to Bitcoin and Digital Currency?
Since a 1031 exchange is typically associated with the sale of property or real property, it may seem somewhat of a stretch to consider whether the concept can apply to digital currency. However, the IRS has issued guidance holding that Bitcoin and similar digital currencies will not be treated as currency for tax purposes. Rather, Bitcoin and similar cryptocurrencies should be considered property for tax purposes.
As property, Bitcoin, Ethereum, DogeCoin, and other types of crypto currency are subject to capital gains taxes and related record-keeping requirements. Since Bitcoin is treated as property and capital gains taxes apply, a 1031 exchange may produce favorable tax benefits if the variations of crypto currencies involved are held to be like kind. See conclusion below: However, the 1031 exchange is only available when the holder of the digital currency meets certain qualifications.
For one, the holder of the digital currency must hold the capital asset for business or investment purposes. In addition, the holder of the Bitcoin or other digital currency must not be a dealer or otherwise treat the asset as inventory or stock in trade.
In the context of an individual trading Bitcoin for Ethereum, a 1031 transfer is likely appropriate if the exchange is deemed to be like-kind in nature. However, if that individual was a professional currency trader or otherwise in the business of trading currencies, then it is unlikely that he or she would be able to leverage this type of transfer absent an exception or unusual circumstances.
While it is crystal clear, the IRS excludes assets treated as inventory or stock in trade from Section 1031 treatment, as would be the case where a 1031 is attempted by a bitcoin dealer or professional trader, making 1031 effectively unavailable, no explicit guidance has been issued to clarify whether one digital currency is “like kind” with another. That being said, it remains a question whether Bitcoin is like kind with Ethereum, for example, and thus would qualify for a 1031 exchange. Additionally, the receipt of “boot” or other non-like kind property, I.E. cash, gold or silver can cause a portion of the gain potentially qualifying for 1031 deferral to be disallowed. While it would seem at present logical that Section 1031 would apply to cryptocurrencies as they are deemed capital assets, this treatment cannot be confirmed without specific Federal and State guidance on the question of whether one cryptocurrency is like kind with another.
Under the Internal Revenue Code certain types of assets do not qualify under the 1031 exchange regulations by being specifically labeled “non-like kind”. At the time of publishing, differing types of virtual currencies have not been identified as “non-like kind” or like kind with one another. Since no guidance on this subject currently exists, 1031 exchanges of differing types of cryptocurrency, while not outright prohibited, is not guaranteed to be a tax-free exchange. The conservative approach would be to not claim section 1031 on an exchange of one digital currency for another. If a taxpayer choses to be aggressive and claim the benefits of 1031 during this type of an exchange, this uncertainty should be adequately disclosed on a return taking a position that an exchange of one cryptocurrency for another should qualify for 1031 to minimize potential penalties that could apply.