Category: Blog

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If it hasn’t happened yet, it will soon. A client will approach you with questions about how cryptocurrencies should be treated on their tax return and what the Internal Revenue Service has to say about tax reporting related to crypto assets. They will want to know vital information to file their state and federal taxes: what their capital gains or losses are if they sell or buy cryptocurrency if profits are considered taxable income, and many more interesting, and at times challenging, questions about their cryptocurrency transactions.

Understanding blockchain and distributed ledger technology and IRS Notice 2014-21 are quickly becoming everyday terms for many tax professionals. For the client, understanding that crypto is, in fact, a capital asset (for most taxpayers) and that there are crypto tax ramifications when buying goods or services with digital assets may be uncharted territory for them.

As the excitement grows about the potential upside of owning crypto, investors in the United States and abroad are clamoring for attention about handling a gain or loss of their crypto and what the tax liability will be. Some people understand that crypto is considered a capital asset and not just currency to be spent as they please, and some don’t. 

How Well-Versed Are You in Cryptocurrency?

If you have a long-term relationship with a client and they have started interacting with the crypto market, it would be a good investment to get up to date on tax issues involving crypto assets now that the IRS has an increased stringency for tax reporting. Your clients now expect you, as a trusted advisor, to become their educator on all things crypto. 

How can you best fill this additional role you’re being asked to play? Setting clear expectations with your client is critical to meeting client needs and not losing them to a CPA specializing in crypto. An ever-increasing number of tax professionals see this as an opportunity to win clients from tax advisors that have only surface knowledge of crypto assets.

We’re going to share some of the key points covered in an event sponsored by the American Institute of Certified Public Accountants (AICPA) called “Preparing for the 2020 Crypto Tax Reporting & Compliance Season.”

• Tax Form 1040 is now asking if a taxpayer invests in virtual currency. The question reads, “At any time during 2020, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?” In our opinion, there is no reason to suspect that this same question won’t be asked for tax year 2021.

Clients should be encouraged now to alert you if they have invested in cryptocurrency in 2021. You can then help them gather the personal information they’ll need to have for you the next time you file your taxes for them.

• Most virtual currency exchanges are not issuing a Form 1099-B. This form provides the investor with information concerning capital gains and losses. Since 1099-B’s are required for traditional asset brokerages (think Robinhood and E-Trade), crypto investors may not be equipped to or aware that they must keep and provide accurate records to inform their tax professional of trading activity.

Many crypto exchanges do not issue a Form 1099-B, as those exchanges believe the regulations do not explicitly apply to them. Some have chosen to issue Form 1099-B’s proactively, but such exchanges are few and far between, further emphasizing the need for accurate record keeping. 

The burden now is on the taxpayer to record all information concerning transactions and then communicate that information to ensure you can accurately file state and federal taxes.

Keeping detailed and accurate records is vital for clients. Some major exchanges only allow individuals to access 90 days of transaction market data. The client with transactions dating back longer than three months ago will likely not have the information you’ll need; they must know that they need to keep their own records of their transactions.

Adding to this necessity for accurate and complete recording is that some exchanges have been hacked in the past, causing them to deny access to any transaction data by individuals while they correct the situation. 

• Advisors need to know the language of crypto, what constitutes a taxable/deductible event, and what doesn’t. For example, the sale of currency is taxed differently than mining. Your clients need to make you aware of various transactions they engaged in so you can help them assemble the necessary information for every transaction.

Taxable/Deductible events include:

• Air drops
• Charitable donations of cryptocurrency
• Compensation
• Hard forks
• Interest income
• Mining income
• Receipt of crypto as compensation for services
• Rewards (equivalent to credit card loyalty or referral rewards)
• Staking Income
• Use of crypto to purchase goods and services

Non-taxable events include:

• Gifting cryptocurrency (this may trigger a gift tax filing requirement, which may cause the transaction to be taxable)
• Receipt of cryptocurrency after coin swap/migration
• Receipt of cryptocurrency as a gift

When a dependent of the taxpayer invests in virtual currency and doesn’t file an individual tax return, all information regarding their investment must be reported on their parent’s tax return. This pertains to the general question about virtual currency investments on the first page of Form 1040.

And, along with understanding the language of crypto and the tax code concerning it, you’re also faced with the IRS’ practice of targeting non-compliance by taxpayers for crypto asset transactions. They especially seem to be looking for individuals who haven’t reported their virtual currency transactions and investments. As their advisor, you should make your client aware of these potential risks and reinforce the importance of providing you with all necessary documentation to guarantee compliance.

Conclusion

The popularity and enthusiasm over digital currency continues to grow, and many individual investors are starting to invest in crypto assets to reap the rewards from this emerging sector. The regulatory environment surrounding these assets continues to evolve, and your clients who invest in crypto need to be made aware of any updates to tax guidance, which you can communicate to them.

It’s incumbent upon professional tax advisors to become fluent in terms of crypto. If you aren’t already, your clients will be using words like blockchain and mining, and they’ll expect you to understand precisely what they’re referring to. Doing your homework on crypto and keeping current is mandatory to maintain clients and gain new ones. 

Luckily, Lukka has a variety of resources to help you in your crypto education. Lukka Library is a content database filled with articles, educational resources, and position papers from some of the industry’s foremost thought leaders on crypto tax and many other subjects. If you’re looking for a software solution to manage your clients’ and their transaction data, LukkaTax for Professionals provides you with an easy-to-use, affordable solution. Manage any number of clients and only pay $40 when you generate their tax reports needed for filing.

Author: Olya Veramchuck, Director Tax Solutions in Tax & Regulatory Affairs at Lukka

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On Tuesday, August 10th, the Senate approved the much-debated Infrastructure Bill, a cornerstone of President Joe Biden’s agenda. The bill is estimated to raise $28 billion from digital asset investors by applying new information reporting requirements on participants in the digital asset industry.

Current Guidance with Section 6045

Generally, under Section 6045 rules, those falling under the definition of a “broker” are required to issue Form 1099 to report gross proceeds on a transaction-by-transaction basis together with their customers’ names, social security numbers, and other relevant information. The language of the bill expanded the definition of a broker to include “any person… effectuating transfers of digital assets, including any decentralized exchange or peer-to-peer marketplace.” 

This development has a significant impact on many participants of the digital asset ecosystem, particularly within DeFi, and would likely put a strain on the entire industry. 

Section 6045’s Reporting Requirements

Complying with Section 6045 information reporting requirements may not prove possible for many as they have no visibility to the parties sending or receiving digital assets. The approved bill’s language has an extensive net covering miners, services that stake digital assets, node operators, validators, smart contracts, open source developers, hardware and software wallet manufacturers, DAO token holders, and others. This also touches individual investors who are either: 

• Buying or selling crypto from other individuals
• Trading crypto for crypto through a crypto exchange (or equivalent) as crypto/crypto trades are simply two transfers occurring at the same time that a broker or dealer facilitates, most often through the use of technology or through a DEX, where there may not be an institution and only technology facilitating exchange between individuals

This would effectively require affected individuals to report at the level of institutions. Transactional reporting is easily done by traditional financial institutions , where it is clear who the broker is (for example, an intermediary like Vanguard) and who the customers are (for example, investors in Vanguard mutual funds). 

The issue was recognized by a number of Senators, including Senators Wyden, Toomey, and Lummis, who advocated revising the language to exclude miners, hardware and software wallets providers, and limit the reporting obligations to the parties who can actually report (for example, crypto exchanges). 

However, the narrowed scope was determined to reduce the projected revenue by approximately $5.17 billion. Despite Senator Portman tweeting that an agreement was reached on “an amendment to clarify IRS reporting rules for crypto transactions without curbing innovation or imposing information reporting requirements on stakers, miners, or other non-brokers,” the language remained in the originally proposed form.  

The passing of the bill without narrowing down the definition of a broker may potentially result in the outflow of talent and innovation overseas as venues owned and administered by foreign persons are out of reach of US reporting rules. This could materially limit the economic benefits of the digital assets industry in the United States compared to the global economy. 

Because the Treasury and the IRS are yet to issue any formal guidance on the taxation of digital assets, it is not unreasonable to expect at least 18-24 months of preparation time before the new rules come into effect. Currently, the law is expected to be implemented in 2023.

Author: John Cunningham, McLane Middleton, P.A.

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1. Introduction

Internal Revenue Code section 199A provides qualified taxpayers who are owners of domestic pass-through businesses with annual federal income tax deductions of up to 20% of the  “qualified business income” of their businesses simply for owning them. Qualified taxpayers include owners of virtual currency exchanges and of businesses engaged in virtual currency mining, staking, delegating, and consulting. 

However, as explained in the numbered paragraphs below, the owners of many pass-through  businesses must undertake potentially major restructuring of their federal tax arrangements and their other arrangements, including even personal arrangements, in order to maximize their entitlement to section 199A deductions.  

2. Discussion
3. Section 199A Qualifications

1) Types of qualified taxpayers. Qualified taxpayers include individuals and certain types of trusts, even if they are purely passive owners of domestic pass-through businesses. And these taxpayers may be either U.S. citizens or non-U.S. citizens who are subject to U.S.  federal income tax. 

2) Domestic businesses. Domestic businesses mean, in general, businesses that derive some or all of their income from work they do in the U.S. or from U.S. customers. 

3) Pass-through businesses. Pass-through businesses mean individuals and entities that are taxable as sole proprietorships, S corporations, or partnerships. Most multi-member LLCs are taxable as partnerships.  

4) Qualified business income. The qualified business income of a pass-through business means its net business income less certain reductions, including reductions of deductible portions of Self-Employment Taxes, and deductions for health insurance benefits and retirement benefits. 

4. Section 199A Rules Relevant To Owners Of Virtual Currency Businesses

1) Taxable income and threshold amounts. Assuming that you are a qualified taxpayer, the  amount of the section 199A deduction to which you are entitled will depend principally on  your taxable income and your section 199A “threshold amount.” The section 199A  threshold amounts for 2020 are: 

a.) For married individuals filing jointly, $326,600; and 

b.)  For all other individuals filing returns, $163,300.  

2) Limits on section 199A deductions. For many owners of virtual currency businesses, section  199A deductions can be substantial—in some cases, thousands or tens of thousands of dollars. However, section 199A limits total deductions under the section (including deductions for dividends from Real Estate Investment Trusts and allocations by certain types of publicly traded partnerships) to 20% of their taxable income less net capital gains, and certain types of corporate dividends. 

3) SSTBs and non-SSTBs. Your section 199A deduction will also depend on whether your business is a “specified service trade or business” (an “SSTB”) or a non-SSTB. SSTBs include all traditional professions, including consultants (including financial consultants), but excluding architects and engineers. Non-SSTBs include all non-professional businesses.  The IRS will probably view virtual currency software engineers as engineers for section  199A purposes.  

4) Employees. Employees of virtual currency businesses cannot qualify for section 199A  deductions. However, these employees can receive them if they convert to the status of independent contractors of these businesses. 

5) Consultants. The IRS will undoubtedly view as “consultants” under section 199A virtual currency businesses and individuals that receive fees for providing their customers with advice about virtual currency issues.  

6) Qualified taxpayers whose taxable income does not exceed their threshold amounts. If your taxable income does not exceed your threshold amount, then, whether your business is an  SSTB or a non-SSTB, your section 199A deduction will be the maximum deduction available under that section—namely, your share of 20% of the qualified business income of your business. 
 

7) Qualified taxpayers within their phase-in ranges. For most businesses whose owners are  within their section 199A phase-in range, their deduction under the section will be the lesser  of: 

a) 20% of their qualified business income; and 

b) 50% of the aggregate W-2 wages paid by their businesses to its employees, including  W-2 wages paid to S corporation shareholder-employees.

The section 199A phase-in range for qualified taxpayers filing jointly is $100,000. For all  others, it is $50,000 

However, the income of sole proprietors and of partners of entities taxable as partnerships are not W-2 wages for section 199A purposes, and the section 199A deductions available to owners of SSTBs within their phase-in range will generally be less than deductions for owners of non-SSTBs. 

8) Qualified taxpayers whose taxable income exceeds their phase-in range. Qualified taxpayers whose taxable income exceeds their phase-in range and whose businesses are non-SSTBs will also generally qualify for the section 199A deduction under the rule summarized immediately above. However, for owners of SSTBs whose taxable income exceeds their phase-in range, no section 199A deduction will be available. 

9) Types of businesses that must restructure. The following are the main types of virtual  currency businesses that must be restructured in order for qualified taxpayers who own them  to receive section 199A deductions: 

a) C corporation shareholders. The owners of all virtual currency businesses that are taxable as C corporations must convert their businesses to a type of business that is taxable as a pass-through business (including LLCs) in order to receive section 199A deductions. 

b) Certain S corporation shareholders. Most virtual currency businesses whose taxable income does not exceed their threshold amount but that are taxable as S corporations must convert their federal tax regimens to that of sole proprietorships or partnerships in order to receive section 199A deductions. The default federal tax regimen of most multi-member LLCs is that of partnerships. 

c) Sole proprietor and partners. Certain sole proprietors and partners of entities taxable as partnerships whose taxable income exceeds their threshold amounts must convert their federal tax regimen to that of S corporations in order to receive section 199A  deductions.  

10) The need for business entity restructuring. Furthermore, section 199A restructuring often requires not only tax restructuring but also business entity restructuring. For example, if your business entity is a state-law business corporation (an “Inc.”), you may have to convert it to an LLC for section 199A restructuring purposes. A number of other considerations may be useful to owners of virtual currency businesses with respect to section 199A restructuring. These include: 

a) The potential to obtain or increase section 199A deductions by dividing entities that provide both SSTB and non-SSTB products and services into an SSTB entity and a non-SSTB entity. 

b) Potential aggregation of two or more separate lines of business to obtain or increase section  199A deductions. 

c) Changing or delaying filing status of individuals, or altering the amount or timing of income recognition, to better manage the income thresholds that regulate entitlement to the section  199A deductions. 

d) Altering the amount or timing of income or deduction recognition to better manage the income thresholds that regulate entitlement to the section 199A deductions.

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John Cunningham is a business and tax attorney licensed to practice in New Hampshire and Massachusetts. He is of counsel to the New Hampshire-based law firm of McLane Middleton, P.A. His practice is focused on LLC law and tax and on assisting clients to maximize their Internal Revenue Code section 199A pass-through deductions.  

John is the author of Drafting Limited Liability Company Operating Agreements, the leading U.S. LLC formbook and practice manual, and of Maximizing Pass-Through Deductions under Internal Revenue Code Section 199A, the only book on section 199A published by a recognized publisher. Both of John’s books are published by Wolters  Kluwer, a global provider of legal, tax, and medical information. The web pages in the Wolters Kluwer website  concerning John’s books are, respectively, https://lrus.wolterskluwer.com/store/product/drafting-limited-liability company-operating-agreements-fourth-edition/ and https://lrus.wolterskluwer.com/store/product/maximizing pass-through-deductions-under-internal-revenue-code-section-199a/

Author: David Shakow, Professor Emeritus, University of Pennsylvania School of Law 

The statements in this paper represent the views of the author only and should not be attributed to the University of  Pennsylvania School of Law. Further, this document should not be treated as legal advice to any reader or to Lukka.

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Normally, gain or loss on a transfer of property to a domestic corporation in exchange for stock is not taxed if the transferors are in control of the corporation immediately thereafter (Section 351). An exception exists when the corporation is foreign.).  No gain or loss is recognized on a transfer of property to a domestic partnership in exchange for an interest in the partnership. It does not matter whether or not the contributing partner controls the partnership (Section 721).

There is an exception to each of these rules where the corporation is an “investment company” or a comparable partnership (Sections 351(e)) and 721(b)). Section 721(b) incorporates the rules of section 351(e), so it is not discussed separately below). An investment company is a company whose assets consist of investment assets listed in section 351(e). The regulations provide a more specific standard and include in the term “investment company” a corporation more than 80% of whose assets are held for investment and consist of readily marketable stocks and securities (Treas. Reg. Sec. 1.351-1(c)(1)(ii)).

The statute and regulations treat many items as stock and securities (Section 351(e)(1)(B)). Would virtual currencies fit under any of these categories? 

One item in the list is foreign currency. IRS Notice 2014-21 reflects the IRS’s position that virtual currency, as described there, is not foreign currency. Thus, bitcoin, Ether, and other similar cryptocurrencies would not fit within this category. However, a number of countries,  including China, have indicated that they might issue their own currency in an electronic form. If any of these discussions come to fruition, it would seem likely that the IRS would accept such a  virtual currency as a foreign currency. This is because, in such an instance, the virtual currency would be legal tender in the relevant country. 

Also included in the list are “interests in any entity if substantially all of the assets of such entity  consist . . . of any assets described in any preceding clause.” One category of virtual currency is  a “stablecoin.” Such a virtual currency is intended to mimic the value of some underlying currency on which it is based. In most structures, the underlying currency is held by the entity issuing the stablecoin. In that structure, it may well be the case that the stablecoin could be treated as an interest in an entity substantially all of whose assets are that currency. Accordingly,  such a virtual currency would be treated as a “stock or security” for purposes of these provisions.  This would seem to be true also of a stablecoin based on US currency since one of the clauses in this provision is “money,” that is, US currency, so an entity issuing a US stablecoin could be holding dollars to back up what it has issued. If it is, the stablecoin would be a “stock or security” for this purpose. 

The term “investment company” is also relevant in the reorganization rules (Section 368(a)(2)(F)). That provision excludes from the reorganizations described in section 368(a) that get tax-free treatment,  reorganizations in which two or more parties to the reorganization are investment companies.  Part of the definition of an investment company for this purpose is that 80% of the value of the company’s assets consists of assets held for investment. All virtual currencies certainly might qualify under that part of the definition. It is noteworthy that, at one point, the IRS proposed regulations that would have incorporated this broader definition of investment company into the definition under section 351(e), discussed above, although that is clearly contrary to the legislative history of section 351(e). At this time, however, those proposed regulations have been withdrawn, and there is no indication that the IRS intends to re-propose them in that form. 

Another part of the definition of an investment company in the reorganization area is that 50  percent or more of its total assets are stock or securities. For this purpose, securities include investments constituting security within the meaning of the Investment Company Act of 1940  (15 U.S.C. 80a-2(a)(36)). IRC Section 368(a)(2)(F)(vii). Included within the definition of security in that provision is “any put, call, straddle, option, or privilege entered into on a national  securities exchange relating to foreign currency.” However, the SEC has not yet held that a  cryptocurrency is a foreign currency for this purpose, nor has it concluded that any general  cryptocurrency (like Ether) is a security.

It has indicated that tokens marketed like stocks are securities that it may regulate in the case of The DAO.  Securities and Exchange Commission, Release No. 81207 (July 25, 2017), available at https://www.sec.gov/news/press-release/2017-131.

The definition of “stock or securities” from section  351(e)(1)(B) is not incorporated in Section 368(a)(2)(F)(vii). Accordingly, as of now,  cryptocurrencies would not be relevant for purposes of this 50% test. 

For purposes of both section 351(e) and section 368(a)(2)(F)(vii), the IRS may at some point indicate to what extent holding virtual currencies affects the application of these definitions.  However, there is no indication that this is an issue of current interest and concern at the IRS.  Accordingly, it does not appear that virtual currencies will be relevant in respect of section  351(e) or section 368(a)(2)(F)(vii) beyond what was discussed above. 

Author: Andrea S. Kramer, McDermott Will & Emery

The statements in this document reflect guidance issued as of March 19, 2020.

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Traders in virtual currency might want to currently deduct trading losses and avoid application of the capital loss limitations that apply to traders. To do so, they would want to elect into the special tax rules found at I.R.C. § 475(f) for electing traders in securities or commodities.  Taxpayers who qualify for either of these trader elections would mark their virtual currency trading gains and losses to market at ordinary income rates. Electing into I.R.C. § 475 means taxpayers would receive ordinary income and loss on positions closed out during the year and on all positions open at the end of the year. In exchange for ordinary tax treatment and for the acceleration of tax on open positions, electing traders can report their losses without applying capital loss limitations, the tax wash sales rule at I.R.C. § 1091, or the tax straddle rules at I.R.C.  § 1092. This Memorandum addresses the analysis that taxpayers who hold virtual currency positions need to make to evaluate whether they are eligible for the I.R.C. § 475(f) election as a  trader in securities or a trader in commodities (collectively, trader elections). For a discussion of  the tax wash sales rule, see McDermott’s Memorandum, “When Virtual Currency Positions Are  Subject to the Wash Sales Rule.” For a discussion of the tax straddle rules, see McDermott’s Memorandum, “When Virtual Currency Positions Are Subject the Straddle Rules.” 

The trader elections depend on meeting two requirements. First, the taxpayers’ virtual currency transactions must qualify for tax purposes as “securities” to make the securities trader election 1 or as “commodities” to make the commodities trader election.2 Second, assuming the trader’s virtual currency transactions meet the I.R.C. § 475 definitions of “securities” or “commodities,”  the taxpayer’s trading activities must rise to the level of active trading under applicable case law. 

Virtual Currency Positions as Securities or Commodities 

To make a valid trader election, virtual currency traders must determine if the particular virtual currency positions they trade qualify as securities or commodities. 

Securities Defined 

A “security” is broadly defined in I.R.C. § 475 to include any (1) share of stock; (2) partnership or beneficial ownership interest in a widely held or publicly traded partnership or trust; (3) debt interest;3 and (4) interest rate, currency, or equity “notional principal contracts” (such as swaps, caps, and floors). A security also includes at item (5) any evidence of any interest in, or any derivative financial instrument in, any currency or security within the terms of items (1) through  (4), including options, forwards, short positions, and similar financial. And, it also includes at item (6) a “position” that is not itself a security under items (1) through (5) but the position is a  “hedge” of such a position and it is clearly identified as a hedge with respect to that security.⁴   There is no requirement that the item, itself, must be “actively traded.” 

Because the items that qualify as “securities” are carefully enumerated in I.R.C. § 475(c)(2), it is not likely that the IRS will try to treat other items as “securities” for purposes of I.R.C. § 475 just because they are treated as securities for federal securities law purposes. It is likely that the IRS will only treat items as securities if they clearly fit into the items that are enumerated. This means that taxpayers who enter into positions in virtual currency need to carefully consider item 5 (set out above) to see whether their positions might meet the definition of that item. For a  discussion of the tax definitions of securities, see McDermott’s Memorandum, “When Virtual  Currencies are Securities for Tax Purposes.” 

Commodities Defined 

The term “commodity” is broadly defined in I.R.C. § 475 to include any commodity that is actively traded for purposes of the straddle rules in I.R.C. § 1092(d)(1).5 For a discussion of the  straddle rules, see McDermott’s Memorandum, “When Virtual Currency Positions are Subject to  the Straddle Rules.” Commodities include physical commodities, derivative instruments in any commodity, and evidences of interests in any commodity. Unlike the I.R.C. § 475 statutorily enumerated definitions of a “security,” which specifically excludes section 1256 contracts, the term commodity specifically includes section 1256 contracts, making them subject to I.R.C. § 475 rather than I.R.C. § 1256. For a discussion of I.R.C. § 1256, see McDermott’s  Memorandum, “Special Tax Rules Apply to Certain Bitcoin Futures and Options and Might  Apply to Other Virtual Currencies in the Future.” As with the definition of security, the commodity definition includes any position that is not itself a commodity if it serves as a hedge with respect to a commodity.  

Although not free from doubt, the IRS “has historically deferred to the CFTC and its predecessor  agencies as to what constitutes a ‘commodity’ for U.S. Federal tax purposes.” ⁶ This makes it possible that I.R.C. § 475 will include actively-traded items that are treated as commodities under the federal commodity laws. For a discussion of the tax definitions of commodities, see  McDermott’s Memorandum, “When Virtual Currencies are Commodities for Tax Purposes.” 

Securities or Commodities? 

Most virtual currencies, in and of themselves, are more likely to be taxed under I.R.C. § 475 as commodities rather than as securities. With that said, there is no definitive answer one way or the other as to whether certain virtual currency positions can be treated as securities or commodities. There are good arguments that certain virtual currency positions are securities and that other actively-traded virtual currency positions are commodities.  

This leads us to the question of which of the two trader elections a virtual currency trader might consider making for appropriate virtual currencies and positions in those virtual currencies.  Which virtual currency positions are securities, and which ones are commodities? This commodity or security definitional conundrum might not ultimately matter if the IRS is willing to allow taxpayers who believe they might fall into both categories to elect under both the securities trader and the commodities trader provisions. Although there is no specific authority for making such a dual election, the author is prepared to explore this possibility with the IRS in appropriate client situations. 

Taxpayers Must be Active Traders 

If a particular virtual currency qualifies as a security or a commodity, electing traders must also meet another requirement. Their activities must be substantial and carried on in a continuous and regular basis. Trader tax status is a fact-based determination, subject to the taxpayer’s actual facts and circumstances.⁷ Traders must profit from daily market movements, not from dividends,  interest, or capital appreciation. IRS Publication 550 identifies some factors to consider,  including the length of holding periods, frequency of trades, whether the taxpayer is engaged in  the activity to produce a principal source of income, and the amount of time the taxpayer devotes to the trading activity.⁸

Trade or Business Expenses  

Traders’ trade or business expenses as deductible under I.R.C. §162. Deductible expenses can include, office rental, other office expenses, salaries, computer equipment, software programs,  Internet access fees, and utilities. 

Application of Trader Elections 

Electing traders receive ordinary gain or loss for their securities and commodities positions that are held in connection with their business of being securities or commodities traders. Because taxes are paid on recognized and unrecognized gains and losses, electing traders can be required to pay tax on gain that, in fact, they may never actually realize. If they continue to hold contracts that were marked-to-market at year end, gains and losses realized in a subsequent tax year are adjusted to reflect gains and losses taken into account in the preceding taxable year. The requirement to mark open positions to market can, therefore, distort income and cause economic hardship if gains that were reported in the first year do not materialize in a subsequent tax year.  

In evaluating the costs of accelerating gains under the mark-to-market regime, electing traders must also evaluate the fact they can deduct their trading losses against trading profits and their ordinary income from other sources. Losses of electing traders are not limited to the standard  $3,000 capital losses amount. 

Elections and Revocations 

Elections into I.R.C. § 475 and revocations of elections are subject to detailed reporting and filing requirements. Late elections or revocations are not generally allowed, except in unusual and compelling circumstances that comply with Treasury regulations and IRS guidance. 

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Taxpayers who are interested in exploring an election into I.R.C. § 475 should consult with their tax advisors about the availability of the election and the federal and state tax implications of making such an election. Many states do not follow federal tax returns in computing state taxes.

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¹ I.R.C § 475(f)(1). 

² I.R.C § 475(f)(2). 

³ I.R.C § 475(c)(2). Although the term “security” does not include section 1256 contracts, such contracts, as defined in I.R.C. §1256(g), can be treated as securities to the extent they qualify as hedges under item (6). For a discussion  of section 1256 contracts, see McDermott’s Memorandum, “Special Tax Rules Apply to Bitcoin Futures and  Options and Perhaps to Additional Virtual Currencies in the Future.” 

⁴ I.R.C § 475(c)(2)(F)(ii). 

⁵ I.R.C. § 475(c)(2)(A). Treas. Reg. § 1.1092(d)-1(c)(1) provides that the actively traded standard requires an established financial market, ranging from an interdealer market to an established financial market.

⁶ NYBA Tax Section, “Report on the Taxation of Cryptocurrency,” January 26, 2020. See, Rev. Rul. 73-158, 1973- 1 C.B. 337 (the word “commodities is used in section 864(b)(2)(B) of the Code in its ordinary financial sense and includes all products that are traded in and listed on commodity exchanges located in the United States.  Furthermore, the word “commodities” includes actual commodities and commodity futures contracts. 

⁷ The trader election will be effective only if the electing taxpayer is a trader in either securities or commodities. For the definition of “trader” to be applied for these purposes, see Chen v. Comm’r, 87 T.C.M. (CCH) 1388 (T.C. 2004);  Arberg v. Comm’r, 94 T.C.M. (CCH) 215 (T.C. 2007); and Holsinger v. Comm’r, 96 T.C.M. (CCH) 85 (T.C. 2008).  See also, Bielfeldt v. Comm’r, 231 F.3d 1035 (7th Cir. 2000), describing the difference between a trader and a  dealer, noting that a “dealer’s income is based on the service he provides in the chain of distribution of the goods he  buys and resells, rather than on fluctuations in the market value of those goods, while the trader’s income is based  not on any service he provides but rather on, precisely fluctuations in the market value of the securities or other  assets that he transacts in.” The courts essentially apply a merchant analogy to determine whether a taxpayer sells securities to customers. See, Bradford v. U.S., 444 F.2d 1133 (Ct. Cl. 1971) [71-2 U.S.T.C. ¶9542]. See also, Kemon v. Comm’r, 16 T.C. 1026 (1951). 

⁸ IRS Pub. 550. See also Paoli v. Comm’r, 54 T.C.M. (CCH) 1574, 1578 (1988); Chen v. Comm’r, 87 T.C.M.  (CCH) 1388 (2004). The phrase “trade or business” is not defined in the Code or Treasury regulations. Various factors are considered, with no one factor dispositive. Elements of a trade or business include (1) activities that occupy “the time, attention and labor” of the taxpayer for the purpose of “a livelihood or profit”; (2) the continuity and regularity of the taxpayer’s activities; and (3) a profit motive. In Commissioner v. Groetzinger, the Supreme  Court held that a professional gambler could be in a “trade or business” if the gambler devotes his full-time activity to gambling and it was his intended livelihood source. In this situation, his activity should be regarded as a trade or  business “just as any other readily accepted activity.” 480 U.S. 23 (1987).

Can Not Paying Taxes on Crypto Related Transactions Reduce GAAP Earnings

Authors: Mindy Herzfeld, Jon Holbrook, Robert Daily of Ivins, Phillips & Barker, Chartered.¹

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Summary 

In 2014, the IRS issued guidance stating that cryptocurrency is property, not currency, for federal tax purposes.  Since the IRS made this determination, hundreds of new types of cryptocurrency have risen to prominence. One is cryptocurrency issued by central banks, which may function as legal tender in certain countries and may one day be used as a medium of exchange. Another is stablecoins, which function like a derivative instrument whose value is based off another commodity or currency. As the marketplace continues to evolve, taxpayers may wish to take the position that some of the newer types of cryptocurrency are currency for tax purposes, which could subject transactions in such cryptocurrency to the tax rules applicable to foreign currency (section 988 gain or loss). 

What is Currency? 

A taxpayer engaging in certain transactions involving foreign currency must recognize ordinary gain or loss as required by section 988. Whether cryptocurrency may be considered “currency” therefore becomes important as part of an analysis as to the amount, timing, and character of gain or loss recognition for tax purposes.  

Blackʼs Law Dictionary states that currency is “[a]n item (such as a coin, government note, or banknote) that  circulates as a medium of exchange,” while Ballentineʼs Law Dictionary notes it is “[p]aper money which passes  at par as a circulating medium in the business community; money whether in coin or paper.” Currency that is recognized by a government is typically recognized as money or “legal tender” in a given location.² The Supreme Court recently noted that “money was ordinarily understood to mean currency issued by a recognized authority  as a medium of exchange.” ³

Although there is no statutory or regulatory definition of currency for U.S. federal tax purposes, the IRS has stated  that “money in its usual and ordinary acceptation is synonymous with currency.”⁴ In two revenue rulings from  the 1970s, the IRS stated that “[c]urrency in its usual and ordinary acceptation means gold, silver, other metals  or paper used as a circulating medium of exchange, and does not embrace bonds, evidences of debt, or other  personal property or real estate.”⁵

More recently, the Department of the Treasury Financial Crimes Enforcement Network (FinCEN) provided the  following definition of currency, which the IRS used as a definition of “real” currency in Notice 2014-21 (which  generally defined cryptocurrency as property):  

the coin and paper money of the United States or of any other country that [i] is designated as legal tender and that [ii] circulates and [iii] is customarily used and accepted as a medium of exchange in the country of issuance.⁶

Section 988: Ordinary Gain or Loss on Transactions Involving Foreign Currency 

Section 988 states that a taxpayer recognizes foreign currency gain or loss when entering into a “section 988  transaction” denominated in a “nonfunctional currency.” The Code provides that a section 988 transaction is one  where a taxpayer: 

1. acquires or becomes an obligor of a debt instrument denominated in a nonfunctional currency;
2. accrues any income or expense in a nonfunctional currency; 
3. enters into a forward contract denominated in a nonfunctional currency; and 
4. disposes any nonfunctional currency.⁷

A nonfunctional currency is defined for this purpose as currency other than the taxpayerʼs functional currency,⁸ and functional currency means the U.S. dollar or the currency used in the economic environment of a “qualified  business unit.”⁹ For simplicity, this paper addresses the section 988 issue from the point of view of a U.S. taxpayer whose functional currency is the U.S. dollar. 

Consider a U.S. taxpayer who buys 800,000 British Pounds at the exchange rate of 1 USD = .8 GBP. The taxpayer would have a basis of $1 million in the British Pounds purchased. If the U.S. taxpayer later sells the 800,000 British  Pounds when the exchange rate is 1 USD = 1 GBP, the taxpayer would only receive $800,000. The taxpayer therefore recognizes a $200,000 ordinary loss because the amount received ($800,000) is less than the basis ($1  million).  

Section 988 provides a de minimis exception for taxpayers who disposed of a nonfunctional currency in a  “personal transaction” where the section 988 gain or loss is less than $200. For example, a U.S. person traveling to London who purchased British Pounds for the trip would not need to recognize any gain or loss if, at the end of her trip, she exchanged British Pounds back for dollars and had less than $200 of foreign currency gain or loss. 

IRS: Virtual Currency is property, not currency 

In Notice 2014-21, the IRS said that “virtual currency is a digital representation of value that functions as a  medium of exchange, a unit of account, and/or a store of value.” The IRS adopted FinCENʼs definition of virtual  currency and noted that although virtual currency “operates like ‘realʼ currency” in some environments, “it does  not have legal tender status in any jurisdiction.” It also said that some virtual currency, like Bitcoin, are  “convertible” virtual currency that have “an equivalent value in real currency” and “act as a substitute for real  currency.”¹⁰

Although the IRS did not specifically address section 988, the Notice said that convertible virtual currencies are  “treated as property” for federal tax purposes and are “not treated as currency that could generate foreign currency gain or loss,” in which case section 988 would not apply to a transaction in a virtual currency. The logic  of Notice 2014-21 could nonetheless be applied to support the conclusion that cryptocurrency which is used as  a medium of exchange and recognized as legal tender in a given jurisdiction could be treated as foreign currency  for tax purposes, in which case section 988 could apply.¹¹

This line of argument is also supported by an FAQ released by the IRS in 2019, which reiterates the governmentʼs  position that virtual currency is a digital representation of value, “other than a representation of the U.S. dollar  or a foreign currency (‘real currencyʼ).” This language suggests that a digital representation of value that represents the U.S. dollar or a foreign currency would not be considered a virtual currency under the IRS  definition. ¹² In addition, cryptocurrency that is considered “real currency” because it is used as a medium of exchange and recognized as legal tender also may not be considered virtual currency under this definition.  

Are any Cryptocurrencies “Currency”? 

Given the tremendous number of new cryptocurrencies that have developed since the IRS released Notice 2014- 21, it no longer seems logical to conclude that no cryptocurrencies are real currency. Specifically, at least two types of cryptocurrencies might be considered “real currency” in which case they could be considered foreign currency covered under section 988: cryptocurrency issued by central governments and stablecoins denominated in foreign currencies. 

Cryptocurrency issued by central governments

In 2014, no country recognized any form of cryptocurrency as valid legal tender. Now, at least four countries have issued some form of virtual currency and seven are testing a digital version that incorporates aspects of cryptocurrency.13 For example, the Marshall Islands government declared in February 2018 that it would “issue a  digital decentralized currency based on blockchain technology as legal tender of the Republic of Marshall  Islands.”14 Government officials have said that the government would launch an initial coin offering as soon regulatory and compliance issues are resolved.15 Note that not all cryptocurrencies issued by governments are issued as legal tender. For example, Venezuela has issued a cryptocurrency which purports to be backed by the countryʼs oil and mineral reserves and which is not legal tender.¹⁶

In order to be currency under the IRSʼs definition, cryptocurrency has to be legal tender and used as a medium of exchange. Guidance issued in other contexts may be relevant here. In Rev. Rul. 76-214, the IRS concluded that two types of bullion gold coins were not currency. Although the gold coins were issued by foreign governments, both coins derived their value on the basis of gold content and did not derive any value from being used as a medium of exchange. Likewise, in 2018, the Supreme Court held that stock options were not “money”  because stock options were not used as a medium of exchange on the date when the relevant statute was enacted.¹⁷ In his dissent, Justice Breyer hinted at the possibility that cryptocurrency could be a medium of  exchange someday: 

What we view as money has changed over time. Cowrie shells once were such a medium but no  longer are; our currency originally included gold coins and bullion, but, after 1934, gold could not  be used as a medium of exchange; perhaps one day employees will be paid in Bitcoin or some  other type of cryptocurrency.¹⁸

An argument to the contrary is that cryptocurrencies have generally been used as vehicles for speculation rather than mediums of exchange. Even if the Marshall Islands were to issue a cryptocurrency used on the islands as a  medium of exchange, it could be seen as sufficiently speculative of an investment to render its customary use as other than as a medium of exchange.  

In short, we do not know how these new forms of cryptocurrency issued by central governments will work in practice. But if they are used as mediums of exchange in the areas where they are recognized as legal tender, it follows that such central bank cryptocurrencies may meet the definition of “currency,” including for federal tax purposes. In that case, the rules of section 988 could apply to govern recognition of foreign currency gain or loss.

Stablecoins 

Stablecoins are cryptocurrencies designed to peg to another cryptocurrency, a type of fiat money (defined as government-issued currency not backed by a commodity), or a commodity. For example, the highest market cap stablecoin—Tether—is a cryptocurrency that purports to be pegged 1-to-1 to the U.S. dollar.¹⁹ Although less prevalent, some stablecoins are pegged to foreign currencies like the Euro²⁰ or Swiss Franc.²¹ Additionally,  it was reported that Facebookʼs anticipated cryptocurrency Libra would be pegged to a variety of foreign  currencies like the Euro, Yen, British Pound, and Singapore Dollar.²²

Because the value of a stablecoin is anticipated to move in tandem with the foreign currency or commodity to which it is pegged, stablecoins function to some extent like derivative instruments. Under the rules applicable to foreign currency transactions, a taxpayer who holds some types of notional contracts may be subject to section  988 gain or loss as if they held a foreign currency directly. The section 988 regulations provide that a taxpayer  that holds certain financial instruments will need to recognize section 988 gain or loss if “the underlying property  to which such other instrument (e.g., the futures contract) ultimately relates [to] a nonfunctional currency.”²³ For  example, a forward contract to purchase British Pounds is subject to section 988, but a contract to settle a wheat  contract in British Pounds is not subject to section 988.²⁴

The regulations applicable to derivative instruments under section 988 may provide a basis for the conclusion that transactions in stablecoins are also subject to section 988. In such case, taxpayers holding stablecoins pegged to nonfunctional currencies could be required to recognize section 988 gain or loss after a section 988  event, discussed above. Thereʼs a separate question regarding the treatment under section 988 of stablecoins redeemable in foreign fiat currency, which may more closely resemble a traditional derivative contract based on foreign currency. Other variations, such as the degree to which the stablecoinʼs value is pegged to the foreign currency, raise additional questions.

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For questions or additional information, please free to contact Ivins, Phillips & Barker, Chartered. 

1717 K Street , NW, Suite 600, Washington, DC 20006

T: 202.393.7600

www.ipbtax.com

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¹ This material was produced for the LukkaTax library. This paper is not intended to be, nor should it be constructed as constituting,  legal or tax advice provided by Ivins, Phillips & Barker, Chartered. Unless otherwise indicated, all “section” or “§” references are to the Internal Revenue Code of 1986, as amended, and all “Treas. Reg. §” references are to the Treasury regulations promulgated thereunder.

² To illustrate the difference between currency and money, take the U.S. dollar. The dollar is currency because it is used as a  medium of exchange and it is also money because it is recognized and backed by the U.S. government (the dollar is also fiat because its value depends on public confidence and has not pegged to any physical object since President Nixon ended the ability to exchange U.S. dollars for gold in 1973).

³ Wisconsin Central Ltd. v. United States, 138 S. Ct. 2067, 2070 (2018).

⁴ Rev. Rul. 76-214, 1976-1 C.B. 218.

⁵ Id.; Rev. Rul. 74-218, 1974-1 C.B. 202.

⁶ Department of Treasury Financial Crimes Enforcement Network, Application of FinCENʼs Regulations to Persons Administering,  Exchanging, or Using Virtual Currencies, FIN-2013-G001 (Mar. 18, 2013).

⁷ I.R.C. § 988(c)(1).

⁸ Treas. Reg. §1.988-1(c).

⁹ I.R.C. § 985(b)(1).

¹⁰ The IRS specifically mentioned that the notice did not apply to other virtual currencies that were not convertible, like airline miles or video game currencies.

¹¹ BNA Portfolio 190-1st: Taxation of Cryptocurrencies, II.B.2.c. (last accessed March 1, 2020).

¹² Id. (citing IRS, Frequently Asked Questions on Virtual Currency Transactions, FAQ #1 https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions (last accessed January 17, 2020)).

¹³ Ted R. Stotzer, Are Central Bank Cryptocurrencies Currency for U.S. Tax Purposes?, 165 Tax Notes Federal 223 (Oct. 14, 2019);  Mike Orcutt, Sweden Is Now Testing Its Digital Version Of Cash, The E-Krona, MIT Technology Review (Feb. 20, 2020),  https://www.technologyreview.com/f/615266/sweden-riksbank-ekrona-blockchain/. 

¹⁴https://rmiparliament.org/cms/images/LEGISLATION/PRINCIPAL/2018/2018- 0053/DeclarationandIssuanceoftheSovereignCurrencyAct2018_1.pdf. 

¹⁵Christine Kim, Why the Marshall Islands is Doing a Pre-Sale for its National Cryptocurrency, Coindesk  (Sep. 12, 2019) https://www.coindesk.com/why-the-marshall-islands-is-doing-a-pre-sale-for-its-national-cryptocurrency.

¹⁶https://www.wsj.com/articles/u-s-bans-use-of-venezuelas-cryptocurrency 1521496566. 

¹⁷Wisconsin Central Ltd. v. United States, 138 S. Ct. 2067 (2018).

¹⁸Id. at 2076 (Breyer, J., Dissenting)

¹⁹ https://tether.to/. 

²⁰ https://cryptoslate.com/coins/stasis-euro/. 

²¹ https://cryptoslate.com/coins/cryptofranc/. 

²² Facebook cryptocurrency: Libra is considering foregoing a currency basket, https://financefwd.com/de/libra-wahrungskorb/.

²³Treas. Reg. § 1.988-1(a)(2)(iii)(A).

²⁴Id.