Cryptocurrencies and taxes may not be a heavenly game, but taxes seem inevitable and the U.S. Internal Revenue Service (IRS) has made it clear that it will go after those who don’t come forward. With subpoenas from the IRS on Coinbase, Kraken, Circle, and Poloniex, as well as other enforcement efforts, the IRS is on the hunt. The IRS sent 10,000 letters of various versions asking for compliance, but all were push words to encourage taxpayers to comply.
The IRS crypto hunt is often compared to the IRS offshore account hunt more than a decade ago. Unfortunately, it is unclear whether there will ever be a crypto amnesty that mimics the offshore voluntary disclosure programs the IRS developed for offshore accounts.
Related: More IRS crypto reports, more dangerous
The IRS made its first major announcement about cryptocurrencies in the 2014-21 notice, classifying them as property. This has significant tax consequences, underscored by dramatic price volatility. The sale of cryptocurrencies can result in profit or loss and is taxable. But buying something with cryptocurrency can also generate taxes. The same applies to the payment of employees or contractors. Even paying taxes with cryptocurrencies can generate more taxes.
We have seen crypto audits by the IRS and several states (particularly the California Franchise Tax Commission), and many more are sure to follow. At least for now, there are alternatives to tax filing and tax prosecution that can make the process easier than it was in the beginning. Everyone tries to minimize taxable crypto profits and defer taxes when legally possible.
However, it is easy to get confused about tax treatment and have tax views that can be difficult to defend if you get caught. With that in mind, here are some of the things I’ve heard that I’ll call crypto tax myths.
Legend 1
You cannot owe taxes on cryptocurrency transactions unless you are given an IRS Form 1099. If you did not receive a Form 1099, you can tick the box on your tax return that you will not transact cryptocurrencies.
Real: Taxes may still be owed even if the payer or broker fails to submit a Form 1099 return. But if you’ve been audited and your best defense is not to report your transactions because you didn’t receive a Form 1099, that’s weak.
Myth 2
If you hold your crypto in a personal wallet instead of an exchange, you don’t have to report the crypto on your tax return.
Real: Private wallet or exchange, the tax rules are the same. The incentive to disguise property by transferring assets to anonymous holding structures is not new. When Swiss banks began disclosing their US account holders to the IRS and the US Department of Justice, many US taxpayers tried everything, but almost everyone had to pay, often with hefty fines. The IRS Form 1040 Cryptocurrency Questionnaire is not limited to cryptocurrencies held through exchanges. If you say “no” even if you hold crypto in a personal wallet, you could potentially make a false statement on a signed tax return under threat of perjury. You can bet you will never get caught, but thousands of US taxpayers with bank accounts in Switzerland can testify how bad this bet can end up.
Legend 3
If you hold your crypto through a trust, LLC, or other entity, you do not owe any taxes on crypto transactions and you are not required to report them. That being said (the myth continues), the income generated by LLCs is tax free.
Real: Ownership of cryptocurrency by an organization can keep your tax-free income. However, unless the company is qualified (and registered) as an exempt company, the company itself has tax reporting obligations and may owe taxes. For tax purposes, LLCs are taxed as corporations or partnerships, depending on your practice and tax choices. Sole proprietorship limited liability companies are not valued, so the LLC earnings will eventually be paid back to the sole proprietor. If your company is an overseas company, there are complex US tax rules that may hold you directly responsible for some of the income generated in the overseas company.
Legend 4
If I structure my crypto sale as a loan (or any other non-sale), I don’t need to report the proceeds.
Real: Think about lending or selling cryptocurrencies. The IRS and the courts have strong doctrines for ignoring fraudulent transactions. Do you get the same cryptocurrency that you lend back? Do you charge interest on the loan and pay tax on the interest when you receive it? Some loans may not hold up. And if you sell crypto and get a promissory note, it can make your taxes even more difficult with the installment selling calculations.
Legend 5
Cryptocurrency exchanges are a type of trust in that you cannot unilaterally change the policies of the exchange. For tax reasons, you do not have any crypto in your account and you do not have to report any transactions via an exchange.
Real: The IRS didn’t say anything about it. The IRS guidelines suggest that the IRS considers taxpayers to be in possession of cryptocurrencies held through their wallet accounts. It seems very unlikely that the IRS would consider cryptocurrencies held through an exchange account owned by the exchange itself (as a trustee) and not owned by the asset holder. Taxpayers typically own their assets through accounts held by institutions such as bank accounts, investment accounts, 401 (k) s, IRAs, etc.
In most cases, tax law treats the taxpayer as the owner of the funds and assets held through these accounts. Some special accounts like 401 (k) s and IRAs have special tax rules. And an account that qualifies as an escrow account isn’t necessarily a good tax return. Trust beneficiaries, especially foreign trusts, have strict reporting requirements. So before treating crypto exchanges as trusts, be careful what to expect. The term trust does not mean that the income generated in the trust is exempt from income tax.
Legend 6
The amendment by Congress to Section 1031 of the Tax Code, which restricts similar exchanges to tangible assets, makes crypto exchanges non-taxable.
Real: Section 1001 of the Tax Code states that taxable income results from the “sale or other sale of assets”. Selling real estate of any kind for cash or other real estate can generate a taxable profit. The IRS says cryptocurrencies are owned, so trading cryptocurrencies against other cryptocurrencies sells crypto for the value of the new cryptocurrency.
Before the changes to Section 1031 went into effect in 2018, crypto-to-cryptocurrency swaps could be accepted as a similar exchange under Section 1031. Rejection Policy for Certain Cryptocurrency Swaps. That’s not a precedent and doesn’t include the waterfront, but it does tell you what the IRS thinks. In any case, now that Section 1031 restricts the same exchange treatment to in kind, crypto-to-cryptocurrency swaps are taxable unless they fall under another exemption.
Takeaways
Every taxpayer has the right to plan his affairs and transactions in such a way that he seeks to minimize taxes. But they should be wary of quick fixes and theories that sound too good to be true. The IRS seems to believe that many crypto taxpayers are not complying with tax laws and that it is worth looking to the future and cleaning up the past. Be careful out there.
Robert W. Wood is a tax attorney and represents clients worldwide from Wood LLP’s San Francisco office, where he is a managing partner. He is the author of numerous tax books and is a regular contributor to Forbes, Tax Notes and other publications.
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Key myths about crypto tax debunked
Cryptocurrencies and taxes may not be a heavenly game, but taxes seem inevitable and the U.S. Internal Revenue Service (IRS) has made it clear that it will go after those who don’t come forward. With subpoenas from the IRS on Coinbase, Kraken, Circle, and Poloniex, as well as other enforcement efforts, the IRS is on the hunt. The IRS sent 10,000 letters of various versions asking for compliance, but all were push words to encourage taxpayers to comply.
The IRS crypto hunt is often compared to the IRS offshore account hunt more than a decade ago. Unfortunately, it is unclear whether there will ever be a crypto amnesty that mimics the offshore voluntary disclosure programs the IRS developed for offshore accounts.
Related: More IRS crypto reports, more dangerous
The IRS made its first major announcement about cryptocurrencies in the 2014-21 notice, classifying them as property. This has significant tax consequences, underscored by dramatic price volatility. The sale of cryptocurrencies can result in profit or loss and is taxable. But buying something with cryptocurrency can also generate taxes. The same applies to the payment of employees or contractors. Even paying taxes with cryptocurrencies can generate more taxes.
We have seen crypto audits by the IRS and several states (particularly the California Franchise Tax Commission), and many more are sure to follow. At least for now, there are alternatives to tax filing and tax prosecution that can make the process easier than it was in the beginning. Everyone tries to minimize taxable crypto profits and defer taxes when legally possible.
However, it is easy to get confused about tax treatment and have tax views that can be difficult to defend if you get caught. With that in mind, here are some of the things I’ve heard that I’ll call crypto tax myths.
Legend 1
You cannot owe taxes on cryptocurrency transactions unless you are given an IRS Form 1099. If you did not receive a Form 1099, you can tick the box on your tax return that you will not transact cryptocurrencies.
Real: Taxes may still be owed even if the payer or broker fails to submit a Form 1099 return. But if you’ve been audited and your best defense is not to report your transactions because you didn’t receive a Form 1099, that’s weak.
Myth 2
If you hold your crypto in a personal wallet instead of an exchange, you don’t have to report the crypto on your tax return.
Real: Private wallet or exchange, the tax rules are the same. The incentive to disguise property by transferring assets to anonymous holding structures is not new. When Swiss banks began disclosing their US account holders to the IRS and the US Department of Justice, many US taxpayers tried everything, but almost everyone had to pay, often with hefty fines. The IRS Form 1040 Cryptocurrency Questionnaire is not limited to cryptocurrencies held through exchanges. If you say “no” even if you hold crypto in a personal wallet, you could potentially make a false statement on a signed tax return under threat of perjury. You can bet you will never get caught, but thousands of US taxpayers with bank accounts in Switzerland can testify how bad this bet can end up.
Legend 3
If you hold your crypto through a trust, LLC, or other entity, you do not owe any taxes on crypto transactions and you are not required to report them. That being said (the myth continues), the income generated by LLCs is tax free.
Real: Ownership of cryptocurrency by an organization can keep your tax-free income. However, unless the company is qualified (and registered) as an exempt company, the company itself has tax reporting obligations and may owe taxes. For tax purposes, LLCs are taxed as corporations or partnerships, depending on your practice and tax choices. Sole proprietorship limited liability companies are not valued, so the LLC earnings will eventually be paid back to the sole proprietor. If your company is an overseas company, there are complex US tax rules that may hold you directly responsible for some of the income generated in the overseas company.
Legend 4
If I structure my crypto sale as a loan (or any other non-sale), I don’t need to report the proceeds.
Real: Think about lending or selling cryptocurrencies. The IRS and the courts have strong doctrines for ignoring fraudulent transactions. Do you get the same cryptocurrency that you lend back? Do you charge interest on the loan and pay tax on the interest when you receive it? Some loans may not hold up. And if you sell crypto and get a promissory note, it can make your taxes even more difficult with the installment selling calculations.
Legend 5
Cryptocurrency exchanges are a type of trust in that you cannot unilaterally change the policies of the exchange. For tax reasons, you do not have any crypto in your account and you do not have to report any transactions via an exchange.
Real: The IRS didn’t say anything about it. The IRS guidelines suggest that the IRS considers taxpayers to be in possession of cryptocurrencies held through their wallet accounts. It seems very unlikely that the IRS would consider cryptocurrencies held through an exchange account owned by the exchange itself (as a trustee) and not owned by the asset holder. Taxpayers typically own their assets through accounts held by institutions such as bank accounts, investment accounts, 401 (k) s, IRAs, etc.
In most cases, tax law treats the taxpayer as the owner of the funds and assets held through these accounts. Some special accounts like 401 (k) s and IRAs have special tax rules. And an account that qualifies as an escrow account isn’t necessarily a good tax return. Trust beneficiaries, especially foreign trusts, have strict reporting requirements. So before treating crypto exchanges as trusts, be careful what to expect. The term trust does not mean that the income generated in the trust is exempt from income tax.
Legend 6
The amendment by Congress to Section 1031 of the Tax Code, which restricts similar exchanges to tangible assets, makes crypto exchanges non-taxable.
Real: Section 1001 of the Tax Code states that taxable income results from the “sale or other sale of assets”. Selling real estate of any kind for cash or other real estate can generate a taxable profit. The IRS says cryptocurrencies are owned, so trading cryptocurrencies against other cryptocurrencies sells crypto for the value of the new cryptocurrency.
Before the changes to Section 1031 went into effect in 2018, crypto-to-cryptocurrency swaps could be accepted as a similar exchange under Section 1031. Rejection Policy for Certain Cryptocurrency Swaps. That’s not a precedent and doesn’t include the waterfront, but it does tell you what the IRS thinks. In any case, now that Section 1031 restricts the same exchange treatment to in kind, crypto-to-cryptocurrency swaps are taxable unless they fall under another exemption.
Takeaways
Every taxpayer has the right to plan his affairs and transactions in such a way that he seeks to minimize taxes. But they should be wary of quick fixes and theories that sound too good to be true. The IRS seems to believe that many crypto taxpayers are not complying with tax laws and that it is worth looking to the future and cleaning up the past. Be careful out there.
Robert W. Wood is a tax attorney and represents clients worldwide from Wood LLP’s San Francisco office, where he is a managing partner. He is the author of numerous tax books and is a regular contributor to Forbes, Tax Notes and other publications.
Follow the Youtube Channel | Subscribe to telegram channel | Follow the Facebook page
