Author: Brett R. Cotler, Seward & Kissel LLP
This Memorandum discusses a general, high-level approach to applying the U.S. federal income tax law to transactions involving cryptocurrency (“crypto”).1 As a rule of thumb, where no affirmative guidance applies to a set of facts, taxpayers and their advisers often draw analogies to situations with clearer tax outcomes to determine a reasonable position. This is especially true for crypto since there are no tax cases and very limited sub-regulatory guidance available.
This memorandum describes a framework approach to applying general principles of U.S. federal income taxation to cryptocurrency. Section I provides examples of the taxation of certain non-crypto transactions. Section II analogizes the examples in Section I to cryptocurrency. Sections III and IV discuss the general taxation of common crypto transactions and survey existing authorities that directly discuss crypto.
I. Taxation of a Medallion
Forget for the moment that this Memorandum is about crypto. Imagine you are a former Division I college pitcher. You were not good enough to make the big leagues but you are good enough to dominate at the county fair and other contests that ask participants to throw balls or bean bags at milk jugs and other targets. Because of your skills, you usually win the grand prize at these contests, which is always a beautiful medallion. Imagine further that there is a secondary market for these medallions. Last week, when you won a medallion, an identical medallion had sold on eBay for $7.
For tax purposes, you have $7 of gross income, which you report for tax purposes. This is also self-employment income, which is subject to the additional self-employment tax. You also take $7 tax basis in the medallion.
Later, you sell your medallion for $10. You have $10 of gross income after the sale. Net income is the sale price less your basis in the medallion. Therefore, your net income from the sale is $3. This is the gain that you are taxed on.
Later, the buyer sells your medallion for $15. It is also clear that this person has $15 of gross income, and $5 of gain, on which he is taxed.
The person who bought the medallion for $15 uses it to pay an employee for her services. However, at the time the medallion was “paid” to the employee, it had appreciated in value to $20 (i.e., the price at which other identical medallions were selling on eBay). The employee is taxed on $20 of wage income, which becomes her basis in the medallion. The employer also has $5 of taxable gain, which is the difference between its value of $20 at the time of payment and the employer’s cost basis of $15.
II. Medallions or Bitcoin?
Take the above example and let’s change a few facts. Instead of baseball, you are really good at math and computer science. Instead of games of skill, it is a competition to solve a very complex math problem. Instead of a medallion, it is a virtual representation of a medallion. All of the sudden, we have a framework for the taxation of cryptocurrency.
You are awarded a bitcoin for successfully verifying transactions that occur on the blockchain. The value of the bitcoin at the time of its award is taxable income.2 his amount also becomes your tax basis in the bitcoin.3 If you later sell that bitcoin, the difference between the amount received and your tax basis in the bitcoin is the taxable gain.4 So on and so forth.
III. General Taxation of Cryptocurrency
The tax outcomes for a taxpayer acquiring, holding and selling cryptocurrency depends on the specific facts of the transactions involved.5 Some cryptocurrencies look and act more like a gift card that can be used to purchase services or goods from the crypto’s issuer, while others look and act more like a transactional medium of exchange (currency), and in some cases, a financial product. How the crypto is used by the taxpayer will help determine the tax consequences related to the ownership and sale of the crypto.
- If a person buys cryptocurrency as an investment, the gains from its sale will be taxed as capital gains.6
- If a person is a dealer in cryptocurrency or otherwise uses it in his trade or business, gains from the sale of cryptocurrency will be ordinary income.7
- If the crypto is used to pay for goods or services, the person will be taxed on the difference between his basis in the crypto and the value of the goods or services received.
For many taxpayers, tracking basis is a complicated issue. This is because:
(A) crypto may be bought at different times and at varying price points;
(B) crypto may be traded for other crypto;
(C) the same type of crypto can trade at different prices on different exchanges;
(D) some cryptos do not have a readily determinable U.S. dollar equivalent; and
(E) some taxpayers may not be aware of these tax issues and trade crypto without
For instance, many people buy bitcoin with U.S. dollars on exchange X, transfer the bitcoin to exchange Y and purchase crypto Z using bitcoin. Often, crypto Z will not have a readily determinable U.S. dollar equivalent. A reasonable method to establish the U.S. dollar equivalent of crypto Z is to look at the price of bitcoin on exchange X when crypto Z was purchased on exchange Y (assuming the value of bitcoin on exchange X fairly represents the value of bitcoin on exchange Y). In these circumstances, taxpayers should adopt a reasonable valuation methodology and apply it consistently.
This is a cumbersome method and requires detailed records, but it is reasonable for U.S. federal income tax purposes. Technological solutions exist, such as those offered by Lukka, to assist in this regard.
IV. Authorities on the Taxation of Cryptocurrency
As discussed above, there is very limited guidance specific to crypto. The IRS released two items of sub-regulatory guidance that taxpayers may rely on: Notice 2014-21 and Revenue Procedure 2019-24. There are also references to crypto in internal IRS documents, such as the Internal Revenue Manual, audit guides and internal memoranda. IRS notices, revenue procedures, and other sub-regulatory guidance simply represent the IRS’s official interpretation of the law. No assurance can be given that the IRS is correct in its positions, and if challenged in court, a taxpayer may prevail.
In addition, the IRS maintains a list of frequently asked questions on its website.8 Taxpayers can look to the FAQs to determine a reasonable position, although tax advisers cannot rely on these when drafting formal opinions. This distinction is important in the area of tax penalties. One defense to certain tax penalties is reasonable cause. Following the guidance in the IRS’s FAQs seems to be an easy way to establish a reasonable cause defense to a tax penalty.
For further information, please contact the author, Brett Cotler, at [email protected] and (212)574-1269. Brett is a senior associate in the Tax and Blockchain and Cryptocurrency Practice Groups of Seward & Kissel.
DISCLAIMER: This Memorandum provides general information and does not discuss the tax or legal consequences of any particular transaction(s). Any examples and figures contained herein are intended for illustrative purposes only and not intended as tax, legal or financial advice. In addition, no attorney-client relationship is formed between Seward & Kissel LLP and any person reading this Memorandum.
1 Internal Revenue Service (“IRS”) guidance uses the term “convertible virtual currency” which generally encompasses what many people mean when they refer to crypto. However, the IRS notes that cryptocurrency is a type of virtual currency, which is simply a digital representation of value.
2 I.R.S. Notice 2014-21, Q&A No. 8.
3 I.R.S. Notice 2014-21, Q&A No. 4.
4 I.R.C. § 1001.
5 I.R.S. Notice 2014-21, Q&A No. 1 and 7.
6 I.R.S. Notice 2014-21, Q&A No. 7.
8 https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency transactions