What Is Cryptocurrency for U.S. Federal Income Tax Purposes?
Cryptocurrency is not regulated by a centralized bank or any centralized governmental system. This may come as a surprise. Wouldn’t the government want to make sure that what seems to be a medium of exchange akin to a currency is regulated? And shouldn’t the U.S. Internal Revenue Service (“IRS”) weigh in on how it is treated for tax purposes?
The various arms of the U.S. government have been arguably slow to act in this area, but some guidance has been provided. Notably, in 2013, the Financial Crimes Enforcement Network (“FinCEN”) issued guidance regarding the treatment of persons who use convertible virtual currencies or make a business of exchanging, accepting, and transmitting them. FinCEN took the position in such guidance that, depending on the type and extent of activities involved, such persons may be treated as “money service businesses” (“MSBs”) and accordingly are required to comply with FinCEN’s regulations that require maintaining an anti-money laundering program as well as meeting registration and various reporting requirements. FinCEN distinguishes between “users” of cryptocurrency (i.e., those who may use cryptocurrency to make a purchase of goods or services) and “exchangers,” who engage in the business of cryptocurrency. Users are not subject to the MSB rules, whereas exchangers are. This is not a dissimilar structure from the use of “real money” or “actual currency,” in that those people spending money to buy goods and services are not subject to FinCEN’s regulations, whereas a bank or other agency facilitating the exchange of real money, holding deposits of real money, and performing other similar actions would be subject to FinCEN’s regulations.
The Commodity Futures Trading Commission (“CFTC”) has also weighed in with its view, stating in 2015 that Bitcoin and other virtual currencies are “commodities.” Section 1a(9) of the Commodity Exchange Act, as amended, defines “commodity” to include, among other things, “all services, rights and interests in which contracts for future delivery are presently or in the future dealt in.”
After years of waiting for the IRS to act, taxpayers received some cryptocurrency tax guidance. The IRS released Notice 2014-21 on March 25, 2014 (the “Notice”). We’ll discuss the Notice in detail below. It is highly relevant to analyzing the tax aspects of initial coin offerings.
In September 2016, the U.S. Treasury Inspector General for Tax Administration (“TIGTA”) released a report on the use of virtual currencies in taxable transactions and additional actions that are needed to ensure taxpayer compliance (the “Report”). The Report acknowledges the Notice, but states that “there has been little evidence of coordination between the responsible functions to identify and address, on a program level, potential taxpayer noncompliance issues for transactions involving virtual currencies.” The Report further finds that the IRS had not coordinated efforts among its various divisions to ensure taxpayer compliance in virtual currency tax reporting or to coordinate examination or investigations specific to virtual currency tax noncompliance. The Report concludes by recommending a series of actions that the IRS should take, including developing certain coordinated virtual currency strategies, providing updated guidance to reflect the necessary documentation requirements and tax treatments for the various uses of virtual currencies and revising third-party information reporting documents to identify the amounts of virtual currencies used in taxable transactions. We have yet to become aware publicly that the IRS has implemented all of the Report’s recommendations, but the Report gives reason to believe that the IRS has already undertaken some preliminary work to implement at least some recommendations made in a prior draft of the Report.
In February 2018, Coinbase, Inc. (“Coinbase”) notified a group of approximately 13,000 customers that it received a summons from the IRS regarding their Coinbase accounts.
Coinbase is one of the world’s largest virtual currency exchanges, so this was a highly significant occurrence. Coinbase was ordered to provide the taxpayer identification numbers, names, birth dates, addresses and certain historical transaction records with respect to customers engaged in certain higher-value transactions (specifically, those with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive)) during the years 2013 through 2015. Clearly, the IRS is getting more interested in the tax gap that may be attributable to noncompliance in virtual currency tax reporting.
Most recently, on March 23, 2018, the IRS released IR-2018-71, in which it reminded taxpayers that virtual currency transactions are taxable by law just like transactions in any other property. The IRS emphasized that taxpayers should report virtual currency transactions to the extent required under the principles of the Notice or else risk liability for tax assessment upon audit, including when appropriate liability for penalties and interest.
SARAH-JANE MORIN is Of Counsel to Morgan Lewis, in San Francisco. She focuses her practice on representation of public and private companies, private equity funds, venture capital funds, real estate funds, portfolio companies, and real estate investment trusts in the tax aspects of complex business transactions and fund formations, including domestic and cross-border investment strategies, sponsor investment strategies, limited partner investment strategies, mergers, acquisitions, integration, buyouts, recapitalization, debt and equity restructurings, and ongoing operations and tax compliance issues. Additionally, she advises on international tax issues, including the tax aspects of offshore vehicles (CFC/PFIC regimes), anti-deferral rules (Subpart F), withholding, cost sharing, and transfer pricing.