William Malson, Associate Member, University of Cincinnati Law Review
Bitcoin, the most widely known cryptocurrency, is a digitally secure store of value that exists as a shared public ledger, allowing fast and cheap transactions worldwide that never pass through a bank. During its early years, it was unclear how government regulatory agencies would deal with this new technology. To the casual observer, it’s currency. If you ask the U.S. Commodity Futures Trading Commission what it is, Bitcoin is a commodity. If you ask the Internal Revenue Service (“IRS”), it’s property. Ask Jeffrey Dorfman, professor of economics at the University of Georgia, and it’s an asset. For tax purposes, the answer is clear: it’s property. But taxing bitcoin is difficult. In 2018, the IRS ramped up its efforts to tax cryptocurrency with the Virtual Currency Compliance campaign designed to address taxpayer noncompliance with IRS guidance. Earlier this year, it began sending letters to thousands of taxpayers that may have failed to report income from cryptocurrency. But the recent enforcement is based on faulty information. This article explains how bitcoin is taxed, the problems with IRS data, and how recent IRS action will push cryptocurrency further underground, making taxation even more difficult.
II. How Bitcoin is Taxed
Bitcoins (“BTC”) are stored on digital “wallets” that can be sent to and from someone else’s “address” within that wallet. This is called a transaction. However, the nature of the transaction—and the tax implications—depend on the purpose behind it. For purposes of this article, transactions are broken apart into three categories: transfers, payments, and swaps.
A transfer is when bitcoin is sent from one address to another without changing ownership. For example, if I send bitcoin from my personal wallet to an exchange, I’ve transferred those coins—but they still belong to me. A payment is when bitcoin is used to pay for something, like wages, your AT&T phone bill, or college tuition. A swap is when bitcoin is exchanged for U.S. dollars or another cryptocurrency, similar to exchanging U.S. dollars for a foreign currency. For example, an owner of bitcoin might want to swap one of their BTC for an equivalent amount of U.S. dollars or another cryptocurrency like ether (“ETH”), created in 2014. That swap would result in one less BTC for the original owner and about $10,170 or 47 ETH. This swap has resulted in no capital gain or loss for either party until the value of BTC or ETH changes and another swap is made.
As of 2014, the IRS considers cryptocurrency, including bitcoin, to be property, rather than currency, for federal tax purposes. Transfers are not taxed. Taxpayers who receive cryptocurrency as payments must determine the fair market value of that currency on the date of payment and pay tax on any gain in value between the payment date and the date that cryptocurrency is sold for cash.
III. The “Swap” Problem
The problem for users arises when swaps occur on an exchange, a platform for merchants and consumers to buy and sell cryptocurrency. Cryptocurrency exchanges operate in the U.S. as payment settlement entities that require them to send users and the IRS Form 1099-K if, for the calendar year, the gross amount of that user’s total reportable payment transactions exceeds $20,000, and the total number of such transactions exceeds 200. But the “gross amount” of swaps does not correspond to the capital gain or loss for the user. For example, if a user bought one bitcoin for $10,170, and then sold it back at the same price, the exchange would record on Form 1099-K that the “gross amount” of those swaps was $20,340 (assuming the other reporting criteria are met). Until recently, users who swapped currencies on exchanges could ignore this altogether and continue to report capital gains and losses using Form 8949 and Schedule D (Form 1040). In this case, the capital gain would be zero. But the IRS thinks otherwise.
The IRS announced on July 26, 2019 that it had begun sending letters to more than 10,000 taxpayers with cryptocurrency transactions, acquired through various compliance efforts, that “potentially failed to report income and pay the resulting tax from [cryptocurrency] transactions or did not report their transactions properly.” Letters 6173, 6174, and 6174-A explain that the receiving taxpayer either may not know the reporting requirements for transactions, may not have met their tax filing, or may not have properly reported their transactions. But the IRS is relying on inaccurate data to generate these letters: cryptocurrency exchanges simply can’t provide tax reports like traditional stock exchanges.
IV. The Reporting Problem
Bitcoin is decentralized. There is no central bank, no administrator, no governing organization—no controlling body whatsoever. Users can swap currencies and incur great capital gains or losses independently of exchanges. Information obtained by the IRS will only reflect what occurs on a particular exchange. And if the IRS relies on exchange-reported Form 1099-Ks, users might incorrectly be on the hook for millions of dollars. But that hasn’t stopped the IRS.
By August 2019, users reported receiving IRS Notice CP 2000, notifying the taxpayer that their tax return information doesn’t match data reported to the IRS. While the notification isn’t an audit, it works the same way: taxpayers must respond by the deadline given on the form and either agree to pay the proposed tax, penalties and interest, or compile and mail a response with documents proving your position. If the IRS is not able to accept a taxpayer’s explanation, it will issue Notice CP 3219A, which must be challenged in court.
V. Unless the IRS Wants Bitcoin to Go Underground, it Should Focus on Guidance
Cryptocurrency exchanges are centralized. They have corporate offices, hold users’ cryptocurrencies, and are regulated by various government entities. With the recent wave of enforcement, the IRS will incentivize further development of decentralized exchanges, making enforcement almost impossible.
A decentralized exchange is a market that does not rely on third parties to hold users’ funds. Swaps are peer-to-peer, enabling the exchange of one cryptocurrency for another directly between users. In essence, the exchange does not exist: it is a hub of information, not currency. As the number of companies accepting bitcoin continues to grow—and the number of users along with it—the IRS will be less able to harvest data of taxable transactions. Cryptocurrency itself continues to advance in privacy protocols, making the tracing of coins along the public ledger increasingly difficult.
The last official guidance from the IRS occurred in 2014. On May 16, 2019, IRS Commissioner Charles Rettig sent a letter to U.S. Representative Tom Emmer stating its intention to publish new guidance “soon.” If the IRS fails to provide reasonable guidance for users and maintains its current course of enforcement, it may drive affected users to decentralized exchanges and currencies with greater privacy protocols, resulting in fewer traceable transactions and less tax revenue.
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The IRS uses the term “virtual currencies,” including non-crypto virtual currencies.
IRS has begun sending letters to virtual currency owners advising them to pay back taxes, file amended returns; part of agency’s larger efforts, IRS (Jul. 26, 2019), https://www.irs.gov/newsroom/irs-has-begun-sending-letters-to-virtual-currency-owners-advising-them-to-pay-back-taxes-file-amended-returns-part-of-agencys-larger-efforts [https://perma.cc/8JUG-2VU7].
While “bitcoin,” “BTC,” or “coins” refer to the individual bitcoins being transferred, “Bitcoin” means the underlying network on which transfers take place.
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As of Sept. 20, 2019. The actual exchange rate can vary wildly.
See IRS, supra note 2, at 2.
Id. at 2-3.
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Letter from IRS Commission Charles P. Rettig to U.S. Representative Tom Emmer, U.S. House of Representatives: Tom Emmer (May 16, 2019), https://emmer.house.gov/sites/emmer.house.gov/files/5.16.2019%20emmer%202019-11771.pdf [https://perma.cc/M58Y-PLBN].