IRS' Criminal Investigation Division Holds Webinar Explaining Virtual Currencies and Their Tax Implications

Siamak Masnavi

On Thursday, the Criminal Investigation (CI) Division of the Internal Revenue Service (IRS), the part of U.S. Department of Treasury dealing with taxation, held a webinar that explained the basics of cryptocurrencies and their tax implications. The presenter for the webinar (called "Understanding the Basics of Virtual Currency") was James Daniels, who is a Special Agent at the CI division and a specialist in the area of cryber crime; he is also very knowledgeable about blockchain technology and virtual currencies. Here are some of the key takeaways from this webinar.

What is Virtual Currency

  • "A digital representation of value that is neither issued by a central bank or public authority, nor necessarily attached to a fiat currency, but is accepted by natural or legal persons as a means of payment and can be transferred, stored or traded electronically."
  • "As of March 2018, there were over 1500 crypto-currencies in circulation."

Bitcoin

  • Bitcoin is very similar to gold.
  • Over the last year, Bitcoin increased by around 1500%.
  • Maximum supply is 21 million.

Ethereum

  • Maximum supply is 100 million.
  • Ethereum's price went up a lot more than Bitcoin during the same time period (2500% vs 1500%).

Ripple

  • Different business model than Bitcoin and Ethereum.
  • Tries to be in the same market as SWIFT (i.e. exchange of money between banks, either internationally or domestically).
  • While cross-border SWIFT payments typically take 3-5 days to arrive, if two banks are part of RippleNet, they can use xRapid (which uses the XRP token) to do such transactions much faster.

Monero

  • With Bitcoin and Ethereum, payment information (sender, receiver, dollar amount, transaction amount) is recorded on public blockchains.
  • An anonymizing cryptocurrency "conceals that information prior to writing it to the blockchain."
  • Monero uses a feature called "Ring Confidential Transaction" (RingCT) to hide that information when it is recorded."
  • Maximum supply is around 18 million.

Smart Contracts

  • "Smart contracts help you exchange money, property, shares, or anything of value in a transparent, conflict-free way, while avoiding the services of a middleman."
  • "The technology can be compared to a vending machine: you drop bitcoin or some other virtual currency into a vending machine, i.e. the ledger, and your escrow, driver's license, or whatever else you were trying to get will come out."
  • "Smart contracts not only define the rules around these agreements in the same way that traditional contracts do, but they automatically endorse those obligations as well."
  • Examples of how smart contracts can be used: "In the government, it is possible to use smart contracts for keeping track of things we want to make sure are secure. One potential thing is your identity -- driver's licenses, social security numbers... These kinds of things can be programmed into a code and written to a blockchain, which then allows this to be actually secure and allows it to be authenticated, if you will, because it is written in way onto the blockchain that can't be changed."
  • "One unique thing with the blockchain is that when you write something to a blockchain, whatever you are writing to it can't be changed; it's encrypted in a way that no-one else from outside can make a modification to it, so you can always rely on the information that is put into the blockchain, which is the entire basis around the virtual currency concept."

Initial Coin Offerings (ICOs)

  • "ICOs may or may not fall outside existing regulatory requirements depending on the nature of the project."
  • ICO issues: can be used for fraud and in Pump and Dump schemes; not allowed to advertise to U.S. investors (since the SEC treats them as unregistered securities); and they are high risk investments.

Tax Implications

On 25 March 2014, the IRS issued a notice ("Notice 2014-21") that "describes how existing general tax principles apply to transactions using virtual currency", and it provided this information in the form of a Frequently Asked Questions (FAQ) guide. Here are a few highlights from this guide:

  • "Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as 'convertible' virtual currency. Bitcoin is one example of a convertible virtual currency."
  • "In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability."
  • "For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency."
  • "Under currently applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes."
  • "A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received."
  • "The [cost] basis of virtual currency that a taxpayer receives as payment for goods or services... is the fair market value of the virtual currency in U.S. dollars as of the date of receipt."
  • "For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied."
  • With regards to exchange of virtual currency for other property, if "the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted [cost] basis of the virtual currency, the taxpayer has taxable gain" and "the taxpayer has a loss if the fair market value of the property received is less than the adjusted [cost] basis of the virtual currency."
  • When a taxpayer sells or exchanges virtual currency, the "character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer." A "taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer" and a " taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer."
  • When "a taxpayer successfully 'mines' virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income."
  • "If a taxpayer’s 'mining' of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute selfemployment income and are subject to the self-employment tax."
  • "Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on by the individual as other than an employee. Consequently, the fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax."
  • "Generally, the medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes. Consequently, the fair market value of virtual currency paid as wages is subject to federal income tax withholding, Federal Insurance Contributions 5 Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement."

 

Featured Image Credit: "Bitcoin" by "Bitcongress" via Flickr; licensed under "CC BY 2.0"