Keyword: tax

Proof-of-Stake Rewards: Payment for Services or a Baked Cake?

Against the backdrop of rapidly evolving blockchain technology, the IRS has oftentimes been slow to update its related tax guidance, leaving participants in the blockchain ecosystem uncertain about their tax obligations. Perhaps nowhere is this lethargy more pronounced than in the context of the consensus mechanisms that drives the entire blockchain network. Whereas, traditionally, coins rewarded pursuant to proof-of-work mechanisms have been treated as payment for services, an alternative class of consensus mechanisms, called proof-of-stake, may just be different enough to result in deferred taxation. Whether this is true is the subject of a recent legal claim that may, once resolved, shed light on the tax treatment of the increasingly popular proof-of-stake consensus mechanism.

Proof-of-Work Taxation

In 2014, an IRS Notice stated that a person that mines new blocks in a blockchain through a proof-of-work consensus mechanism must include any virtual currency received in connection with such activities in the miner’s gross income at the virtual currency’s fair market value. The ruling had an immediate impact on blockchains, such as Ethereum and Bitcoin, that depend on miners to add new data or ‘blocks’ to the chain. Through the proof-of-work consensus mechanism, miners are challenged to be the first to identify the missing number needed to solve a staggeringly complex hashing algorithm. For the lucky few who succeed, thousands of dollars’ worth of Ether or Bitcoin are awarded and—according to the IRS—taxable on receipt.

In the years following the IRS’s ruling, however, the taxation of mining has been complicated by the gradual adoption of an alternative consensus mechanism referred to as proof-of-stake. Under this method, miners—now typically called validators—are required to “stake” their holdings of a blockchain’s native coin in order to be eligible to win the right to add a new block to the chain. The more coins that a validator stakes, the greater the chance that they will be selected by the blockchain’s validation algorithm to add a new block to the chain. If the selected validator proposes an invalid block, however, the validator’s coins (or portion thereof) will be destroyed. This risk of loss in proof-of-stake validation adds a layer of complexity that is not present under the proof-of-work model, which simply involves the payment of virtual currency in exchange for the use of raw computational power to solve the mathematical puzzle. In addition, token holders will often stake their holdings to allow a third party, a validator, to use their tokens to validate the transaction as part of the proof-of-stake consensus mechanism. A welcome feature of proof-of-stake validation is that it requires considerably less energy than proof-of-work validation.

Whether this new feature is enough to challenge the taxability of any tokens or coins generated by the validation process has remained an open question that has only recently been publicly considered by the IRS.

The Jarretts—Answers at Last?

Sometime in 2019, Joshua Jarrett decided to participate on the Tezos blockchain as a validator. Jarrett staked his holdings in the native coin—Tezos—and as luck would have it, he won the right to propose new blocks on the Tezos chain. In return for validating the next block on the Tezos chain via the proof-of-stake consensus mechanism, Jarrett received 8,876 Tezos coins and dutifully paid $3,293 in federal taxes on the gain reported on his and his spouse’s joint federal income tax return.

A year later, the Jarretts had a change of heart and sought a $3,293 refund by filing an amended tax return. The Jarretts took the belated position that the coins were not taxable, using the “creation of an asset” theory. They argued that “new property—property not received as payment or compensation from another person but created by the taxpayer—is not and has never been income under U.S. federal tax law.” The Jarretts further reckoned that “[l]ike the baker or the writer, Mr. Jarrett will realize taxable income when he first sells or exchanges the new property he created, but the federal income tax law does not permit the taxation of the Jarrett’s [sic] simply because Mr. Jarrett created new property.”  The IRS denied the Jarretts’ refund claim, and the Jarretts filed a refund suit in the Middle District of Tennessee. Had the Jarretts taken the position on their original return that the reward was not taxable upon receipt, the IRS would have had been required to assess the unpaid tax. If the Jarretts wanted to challenge the assessment, they would have had to do so in the Tax Court. The IRS (and often many taxpayers) prefers to litigate technical issues in the Tax Court because of the court’s technical expertise.

The government countered that Joshua Jarrett never created new Tezos coins. Rather, in line with the tax treatment applicable to proof-of-work, the government argued that “Jarrett exchanged Tezos tokens for goods and/or services during 2019.” As such, Jarrett received the coins as payment for successfully proposing new blocks to the Tezos chain, and those coins were indeed taxable on receipt.

In something of an about-face, at the start of 2022, the government relented and offered to refund the Jarretts, as they had initially requested. However, unwilling to accept the government’s offer, the Jarretts have since elected to press on in order to force a definitive ruling on the taxability of virtual currency generated from proof-of-stake consensus mechanisms. The case is scheduled for trial in March 2023, and a final ruling may not take place until then.

Nonetheless, the Jarretts’ case is important to the blockchain industry as many chains have adopted, or are in the process of migrating toward, a proof-of-stake consensus mechanism, including Ethereum. The government’s initial concession appears to provide some basis to argue that perhaps an alternative tax treatment is appropriate, but the IRS may simply want to identify a taxpayer that did not report the tokens as taxable, assess a deficiency and force the taxpayer to sue in Tax Court. Blockchain participants, however, will have to wait for a firmer, and much needed, answer.

Infrastructure Law Adds Important Crypto Provisions

The Infrastructure Investment and Jobs Act, enacted on November 15, 2021, also known as the Bipartisan Infrastructure Law (the “BIL”), adds many important provisions regarding the development of the United States’ infrastructure network. These provisions are sorely overdue and are welcomed by many.

But lesser attention has been given to several provisions related to the taxation of cryptocurrency transactions. Unlike prior IRS guidance, the provisions all deal with the reporting of crypto transactions. The proper reporting of crypto transactions is important to the U.S. Treasury, as it serves to ensure that taxpayers properly report and pay tax on crypto-related income.

Three crypto-related tax provisions were added to the Internal Revenue Code (the “Code”). While each of the provisions has a delayed effective date, the information gathering required by some of the provisions will take place beginning January 1, 2023, less than 12 months from now.

1. Amendment to Broker Reporting. Code Section 6045 deals with reporting requirements imposed on brokers to the IRS. Brokers are required to report the gross proceeds from transactions in which they are involved to both the taxpayer and the IRS. The reporting is made on Form 1099-B, “Proceeds From Broker and Barter Exchange Transactions.” The definition of broker is very broad under Code Section 6045, and includes a dealer, a barter exchange and any person acting as a middleman. If the item subject to reporting is a “covered security,” the broker must report the customer’s adjusted basis in such security and whether any gain or loss with respect to such security is long-term or short-term. Covered securities are further defined to include “specified securities.” These include stocks, bonds, commodities and any financial instruments with respect to which the Secretary of the Treasury determines that adjusted basis reporting is appropriate.

The purpose of reporting under this provision is to allow the IRS to cross-check the information filed by the broker with the information filed by the taxpayer. The failure to report or the failure to provide the statements to the named taxpayer may subject the broker to penalties of up to $3 million a year, or more, if the failure is due to the intentional disregard of filing requirements. Willful failure to file is a misdemeanor.

The BIL makes two significant changes to Code Section 6045. First, the BIL modifies the definition of broker to include “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” The use of the phrase “on behalf another person” is perplexing because the broker already includes a “middleman” concept. On its face, the updated provision would require miners, software developers, transaction validators and node operators to provide the required information as such parties provide services in connection with crypto transactions.

The BIL also amends Code Section 6045 by including “digital assets” in the list of specified securities. Under the BIL, the term “digital asset” means “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology as specified by the Secretary.” As enacted, the provision would include a fairly broad category of digital assets, including traditional cryptocurrencies, such as bitcoin, as well as non-fungible tokens. The Secretary of the Treasury has broad authority to exempt types of transactions.

The definition of digital asset is significant as that term is used in a number of other provisions in the Code.

The amendments to this provision have a delayed effective date. The amendments are effective for returns required to be filed, and statements required to be furnished, after December 31, 2023. However, the information gathering will need to commence beginning January 1, 2023.

2. Amendment to Broker-to-Broker Reporting. Code Section 6045, discussed above, deals with broker transactions with customers. Code Section 6045A, in turn, deals with the reporting of transactions between brokers. It is designed to allow the transferee broker to report the information that the originating broker would otherwise be required to report. It requires every applicable person who transfers to a broker a security which is a covered security to furnish information so that the transferee can provide the gain or loss and basis reporting information that is required under Code Section 6045. The BIL includes an amendment to Code Section 6045A providing that returns shall be furnished with respect to any transfer (which is not a part of a sale or exchange executed by such broker) which is a digital asset from an account maintained by such broker to an account not maintained by, or an address not associated with, a person that such broker knows or has reason to know is also a broker. Thus, the provision expands the reporting to “broker-to-non-broker” transactions.

The amendment is effective for returns required to be filed, and statements required to be furnished, after December 31, 2023. But, once again, the information gathering systems must be in place for transactions taking place beginning January 1, 2023.

3. Reporting of Cash Transactions. Code Section 6050I requires any person receiving cash to report the receipt of the cash to the IRS. It applies when a person in the course of a “trade or business” receives cash of $10,000 of more. Cash includes foreign currency. It also includes, “to the extent provided in regulations,” any monetary instrument (whether or not in bearer form) with a face amount of not more than $10,000. The provision would apply, when say, a person goes into a car dealer and buys a car for cash. The person receiving the cash is required to file a Form 8300, Report of Cash Payments Over $10,000 in a Trade or Business, within 15 days of receipt of the cash. The return requires the reporting of the name of the person from whom the cash is received, the taxpayer identification number, the person’s address and occupation. Form 8300 may be filed with the IRS or electronically through FINCEN. The person making the return must also provide a copy of the return to the person whose name is on the return.

The requirement to report cash transactions is buttressed with fairly steep penalties. Penalties apply for the failure to file Form 8300 with the IRS and the failure to provide a copy to the named taxpayer. Failure to comply can result in penalties of up to $3 million a year, or the greater of $25,000 or the amount received if the failure is due to the intentional disregard of filing requirements. Willful failure is a felony.

The BIL amends Code Section 6050I to apply to persons receiving digital assets, cross-referencing the definition contained in Code Section 6045. On its face, this would include digital assets received for validating transactions or other services relating to crypto transactions. One of the problems that this introduces in the world of decentralized finance transactions is the difficulty of identifying the purchaser if the transaction is made through a smart contract rather than from an identifiable person.

Here, again, the amendment is effective for returns required to be filed, and statements required to be furnished, after December 31, 2023.

* * * *

Several legislators, including Senator Wyden, Chair of the Finance Committee, have introduced bills seeking to narrow the provisions, most notably the definition of “broker,” but these bills did not gain traction. As matters now stand, the impact of these provisions is uncertain, as much will depend on whether Treasury issues regulations seeking to narrow the scope of the provisions.

HMRC’s New Approach to Cryptoassets – Tax First, Define Later

The UK tax authority, Her Majesty’s Revenue & Customs (HMRC), has taken a further step towards tackling perceived tax avoidance in transactions involving cryptoassets. Specifically, according to press reports, exchanges such as eToro, Coinbase and CEX.IO have received letters from HMRC requesting customer and transaction data.

The move follows HMRC’s most recent policy paper, “Cryptoassets for Individuals,” published in December 2018, which in turn built on the brief general guidance published by HMRC four years earlier in 2014. The 2018 policy contains the statement that HMRC will apply the relevant income or capital gains tax provisions by looking at the factual details of each circumstance rather than by reference to terminology.

While the policy paper does distinguish between exchange tokens, utility tokens and security tokens, in practice we expect HMRC to focus on a transaction’s factual elements, rather than the description of the cryptoassets.

In contrast to HMRC’s approach, the UK financial regulator, the FCA, has recently revamped its classification of cryptoassets, clearly defining which ones among them would not fall within the scope of its regulatory regime, the Financial Services and Markets Act 2000. HMRC is yet to comment publicly on this development, but it is hoped that HMRC will follow suit and provide taxpayers with more certainty in determining their tax obligations in relation to cryptoassets.

Interestingly, on the other side of the Atlantic, the U.S. Internal Revenue Service (IRS) was also reported to have sent compliance letters to holders of cryptocurrency, warning them of the consequences of their potential non-compliance with relevant tax obligations. It is not clear whether the letters are limited to those taxpayers identified in the Coinbase Summons in 2016. The IRS believes that in 2017 up to $90 billon in cryptocurrency gains went unreported. On the Chain authors have written on the topic previously here, here and here.

While the IRS confirmed in 2014 that virtual currency ought to be treated as property for tax purposes, HMRC has, so far, used the word “property” only to describe cryptoassets for inheritance tax (IHT) purposes. Whether a similar approach will be taken for other UK taxes is yet to be confirmed and cannot be assumed.

The Financial Committee of the City of London Law Society published a paper that provided a potential framework for legal classification of cryptoassets. According to the Committee, exchange tokens could constitute a new category of personal property that is neither a “chose in possession” nor a “chose in action,” subject to the Supreme Court extending the notion of personal property to such assets.

In order to tap into the value generated by cryptoassets, HMRC’s approach has been to treat cryptoassets as property in relation to IHT and as “assets” in relation to other taxes. This approach is potentially quite unclear for taxpayers if we consider that, at the time of writing, there is no legislative basis (judicial or statutory) for the classification of cryptoassets as property. The fact that HMRC has recognized cryptoassets as property only in relation to IHT, and not for other UK taxes, adds to the uncertainty.

This uncertainty, coupled with the fact that most taxing legislation was drafted before digital assets even existed, means there is an urgent need for clarification on their legal status.

This is relevant to all value-generating actions involving cryptocurrencies, including the UK tax treatment of:

  1. options on tokens – will this mirror the taxation of options over shares?
  2. ICOs – will these be taxed in the same way as IPOs? and
  3. the transfer of tokenized shares – will these fall within the scope of stamp duty?

At the moment, there is no clear answer.

One thing does seem certain, however – blockchain is a harbinger of a new way of generating value and its potential will be fully leveraged only when the tax and legal frameworks around it have reached a serviceable level of cohesion. How and when this will be achieved is difficult to say.

The 2019 Token Taxonomy Act: A Path to Consumer Protection and Innovation Takes Shape

We’ve previously written that the Token Taxonomy Act first introduced to Congress by Representatives Warren Davidson (R-OH) and Darren Soto (D-FL) on December 20, 2018, was a welcome legislative initiative designed to provide a regulatory “light touch” to the burgeoning digital asset industry. The bill expired, however, with the termination of the 115th Congress, leaving open the question of what any future blockchain regulatory proposals, would look like. The industry’s questions were answered on April 9, 2019 when Representatives Davidson and Soto introduced the Digital Taxonomy Act of 2019 (DTA) and the Token Taxonomy Act of 2019 (TTA) to the 116th Congress. The DTA and TTA represent expanded efforts to clarify regulation and spur blockchain innovation in the United States.

According to Representatives Davidson and Soto, the DTA is meant to add jurisdictional certainty to efforts to combat fraudulent behavior in the digital asset industry. As such, the DTA grants the FTC $25,000,000 and orders it to prepare reports on its efforts to combat fraud and deceptive behavior. The DTA also specifically carves out from its purview the authority of the CFTC to regulate digital assets as commodities subject to the Commodities Exchange Act.

The 2019 TTA, with the backing of four bipartisan representatives in addition to Davidson and Soto, is similar to last year’s model. Besides defining digital assets and exempting them from certain securities law requirements, the 2019 TTA maintains proposals to amend the Investment Advisers Act of 1940 and the Investment Company Act of 1940 so that certain regulated entities can hold digital assets. Like the 2018 version of the TTA, the 2019 TTA would also allow the sale of digital assets to qualify for the benefits of Internal Revenue Code Section 1031 like-kind exchange provisions and for the first $600 dollars of profit from digital asset sales to be tax-free.

The TTA also has important updates. The most prominent change is the definition of a “digital asset.” As we’ve previously discussed, the 2018 version of the TTA required that a digital asset’s transaction history could not be “materially altered by a single person or group of persons under common control” to qualify for exemption from securities laws. Because of the unavoidable possibility of a 51% attack, which would alter a token’s transaction history, the language created the possibility that proof of work- and proof of stake-based tokens would not be eligible for regulatory relief, thus limiting the bill’s benefits.

In the re-proposed TTA, however, the newly proposed language of Section 2(a)(20)(B)(ii) requires that the transaction history, still recorded in a mathematically verifiable process, “resist modification or tampering by any single person or group of persons under common control.” Thus, any digital asset, even those subject to 51% attacks, may be exempt from certain securities law requirements, although the language appears to require that a governance or security system underline the token’s consensus system.

Another important update is the TTA’s proposed preemption of state regulation of the digital asset industry by federal authorities. While the TTA would still permit states to retain antifraud regulatory authority, it largely strips states’ rights to regulate digital assets as securities. Representative Davidson’s press release on the bill specifically cites the “onerous” requirements of the New York BitLicense regulatory regime as a reason for the inclusion of this provision.

Critics have been quick to point out that the bills, while well intentioned, leave many unanswered questions and therefore may not provide the regulatory certainty the bills’ authors hope to effect. And even a perfect bill would face an uphill battle in getting enacted these days. But the digital asset industry should nonetheless take comfort in the growing contingent of legislators who take seriously the imperative to balance consumer protection and blockchain innovation.

The Token Taxonomy Act: A Fatal Drafting Ambiguity

As we’ve previously written, the Token Taxonomy Act (TTA) is an ambitious and potentially impactful piece of legislation that, by exempting digital tokens from the securities laws, might remove regulatory inhibitions from the maturing digital token industry. The bill is not without fault, however. As it stands, the language of the bill requiring that a digital token’s consensus be inalterable is ambiguously written and the SEC could use a strict interpretation to preclude many digital assets from qualifying as digital tokens.

The proposed additional language of Section 2(a)(20)(B) of the Securities Act of 1933 reads that to qualify for the exemption, a digital token:

(i) must be recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and

(ii) after consensus is reached, cannot be materially altered by a single person or group of persons under common control.

In other words, a digital token must use an inalterable and objectively verifiable process. This language is designed to include in the definition only those digital tokens that are or will be in widespread enough use so that no one single party can influence the nature of the outstanding tokens in a way that adversely affects digital token holders.

The proposed language creates the possibility that the SEC could strictly apply the requirement that a token “cannot” be materially altered. As it stands, proof-of-work and even proof-of-stake digital assets are susceptible to a 51% attack, which could alter the digital token’s consensus. “Proof-of-work” and “proof-of-stake” refer to different systems used to verify and process transactions on a blockchain.

A “51% attack” is an event in which a party takes control of the requisite computer power underlying a token’s blockchain such that the party can control the token platform’s operation. Typically, a party seeking such control needs to possess 51% of the outstanding tokens, but the threshold amount can be lower for individual digital assets. A party that has successfully executed a 51% attack can change the ledger history so that it can, for example, double-spend tokens.

The SEC could negate the potential application of the TTA because the recent 51% attack against Ethereum Classic shows that the risk of attack against proof-of-work digital assets, especially those with a low market capitalization, is real. And although the proof-of-stake system makes a 51% attack prohibitively expensive, the SEC could justifiably claim that it is theoretically possible. An irrational, non-economic actor could still stage a 51% attack against a proof-of-stake digital asset with an intent to destroy it rather than to make profit.

In the end, the ambiguity in the bill’s language might not have a deleterious effect. It is hoped that a regulator would not strictly interpret the bill’s language to exclude the intended beneficiaries because of a hypothetical possibility of a 51% attack. So, too, the digital asset industry will likely continue to innovate new and more secure protocols that could potentially eliminate the threat of 51% attacks, making potential exclusion from the bill’s benefits a moot point. Nonetheless, as the TTA undergoes revision, the potential ambiguity in the proposed language should be remedied.

HMRC Publishes UK Tax Guidance on Cryptocurrency for Individuals

On December 19, HM Revenue and Customs (“HMRC”), the UK’s counterpart to the US Treasury, published long-awaited (and arguably long overdue) guidance on the taxation of cryptocurrencies (which it refers to as “cryptoassets”), building on the UK government’s Cryptoassets Taskforce’s report that was published last year. This guidance is welcome in an area of law that needs to play catch-up to apply to income and gains on technology and digital assets. It is important to note that this guidance is limited to HMRC’s view in relation to individuals holding cryptoassets and does not extend to tokens or assets held by businesses. However, HMRC states its intention to publish further guidance in relation to the taxation of cryptoasset transactions involving business and companies sometime in the future.

The guidance confirms that HMRC does not consider cryptoassets to be currency or money for tax purposes and separates cryptoassets into three categories of “tokens”: exchange tokens, utility tokens and security tokens. This guidance focuses on the taxation of “exchange tokens,” a term encompassing assets such as Bitcoin, which presumably it considers to be the most prevalent and widespread. The approach is very similar to the IRS’ approach in this area in Notice 2014-21. HMRC considers that in the “vast majority” of cases, individuals hold (and acquire and dispose of) cryptoassets as part of a personal investment and will, therefore, be liable to capital gains tax. The analysis of whether the cryptoassets are held in the nature of a trade or an investment, and the consequential tax treatment, will largely follow the existing approach and case law but HMRC only expects individuals to be buying and selling cryptoassets with such frequency, level of organization and sophistication such that it amounts to a financial trade in itself in “exceptional circumstances”. If, following the application of the traditional analysis, the cryptoassets are considered to be held as part of a trade, then the Income Tax provisions will take priority over the capital gains tax provisions.

Individuals will be liable to Income Tax (and national insurance contribution, where appropriate) on cryptoassets which they receive from their employer as a form of non-cash payment (and which may be collected via withholding tax) and/or in return for “mining” the cryptoassets, “transaction confirmations” or “airdrops” The guidance describes these transactions and the applicable taxes. As discussed in the guidance, miners are the people that verify additions to the blockchain ledger. They may receive either cryptocurrency or fees for this function. An airdrop is where someone receives an allocation of tokens or other cryptoassets, for example as part of a marketing or advertising campaign in which people are selected to receive them. As pointed out in the guidance, while the receipt of cryptoassets is often subject to the income tax, appreciation will be subject to capital gains tax upon disposition.

In addition to the tax analysis, HMRC points out that cryptoasset exchanges might only keep records of transactions for a short period, or the exchange might no longer be in existence when an individual completes their tax return. The onus is, therefore, on individuals to keep separate and sufficient records for each cryptoasset transaction for the purposes of their tax records.

IRS Advisory Committee Identifies the Need to Enforce Compliance on Cryptocurrency Transactions

A recent report (the “Report”) of the IRS Commissioner’s Information Reporting Advisory Committee (“IRPAC”) has identified the need for additional guidance on cryptocurrency transactions to enforce compliance on cryptocurrency transactions. The Report heavily relies on the recent experience the IRS had in enforcing the Coinbase summons, as recently reported in On the Chain. The IRS explained the problem earlier this year: because transactions in virtual currencies can be difficult to trace and have an inherently “pseudo-anonymous” aspect, some taxpayers may be tempted to hide taxable income from the IRS. IRS News Release, IR-2018-71, March 23, 2018. Taxpayers in this situation are at risk, given that, as recently reported in On the Chain, there is no voluntary disclosure program for taxpayers that have failed to report crypto related income.

In the Report, the IRS estimates that potentially unreported cryptocurrency tax liabilities represent approximately 2.5% of the estimated $458 billion tax gap. The calculation relies upon a recent article by Fundstrat Global Advisers, which sets cryptocurrency-related labilities at $25 billion, based on taxable gains of approximately $92 billon and a noncompliance rate of 50%. The Fundstrat Report estimates that approximately 30% of the investors in cryptocurrency are in the U.S., which is more than $500 billion at the end of December 2017 (up from about $19 billion at the start of January 2017!), according to data from CoinMarketCap.

While the IRS previously addressed certain issues in Notice 2014-21, there remain significant open issues that will need additional analysis and further guidance to refine the reporting of these transactions.  For example, the reports cites the following:

  1. whether virtual currency held for investment is a capital asset;
  2. whether the virtual currency ought to be treated as a security, subject or not subject to the wash sale rules, or affected by mark-to-market implications under section 475 of the Code;
  3. whether a taxpayer may use LIFO or FIFO to determine the basis of virtual currency sold;
  4. how to track basis through activities in the blockchain;
  5. whether broker reporting is required under section 6045 of the Code for transactions using virtual currency;
  6. whether a taxpayer may contribute virtual currency to an IRA; and
  7. whether virtual currency is a commodity.

Also, while an initial reading would suggest that virtual currency would not be considered a financial account for FATCA purposes, various guidance notes issued by foreign jurisdictions for purposes of implementing the Common Reporting Standard (CRS) have indicated virtual currency does represent a financial account.  This inconsistency, the Report notes, between regimes that purportedly try to maintain a high level of consistency will be confusing to withholding agents and subject to inherent error.

Citing the recent Coinbase summons and the failures to report income identified in that case, the Report opines that many, if not most, taxpayers will report their virtual currency activities correctly if they are able to determine their tax implications.  Some taxpayers will be tempted to do otherwise, however, because anonymity is inherent in the structure of the block chain activities.  In light of Coinbase, these taxpayers are likely to use exchanges outside the jurisdiction of the U.S.  The Report notes that it is unclear at present whether the U.S. may obtain information from foreign exchange activities (determining the exact nature of residence of the virtual activities of an exchange is itself vexing under existing source and jurisdiction rules, and leads to issues of whether the activities are sourced to any jurisdiction or are stateless income).

The Report concludes with IRPAC stating that it would be very interested in helping develop information reporting and withholding guidance on these important issues.

https://www.irs.gov/pub/irs-pdf/p5315.pdf

IRS to Virtual Currency Traders: No Formal Voluntary Disclosure Program

The IRS recently announced that it is not planning to establish a formal voluntary disclosure program for taxpayers who have unreported income derived from virtual currencies. Specifically, Daniel N. Price of the IRS’s Office of Chief Counsel stated on November 8, 2018 that he needed to dispel the rumor that had been circulating since last year that the IRS intended to establish a separate voluntary disclosure program for unreported income related to offshore virtual currencies. This is in contrast to the voluntary program that the IRS established for unreported income from offshore financial accounts.

Under IRS guidance from 2014, the IRS classified Bitcoin and other virtual currencies as property (rather than foreign currency). Accordingly, any income from virtual currency transactions is treated as either ordinary income or capital gains, whichever is applicable based on the activity that gave rise to the income (e.g. investment or mining). Because the IRS requires a U.S. taxpayer to report its worldwide income regardless of where that income was generated or where the taxpayer lives, a U.S. taxpayer could have significant income tax liability for its cryptocurrency activities that were conducted and remain offshore. In spite of this substantial U.S. taxpayer exposure, and despite the potentially enormous amount of unreported income from virtual currency activities, the IRS has provided relatively little guidance to taxpayers and tax professionals, given the complexity of the tax issues and reporting requirements triggered by virtual currencies. At the same time, as discussed previously in On the Chain, the IRS is preparing to collect the massive amount of tax from unreported income from Bitcoin-related trades.

The IRS is Closing in on Cases Regarding Bitcoin Income Reporting

Following a several-year court fight, the Internal Revenue Service (the IRS) appears to have obtained a substantial amount of information regarding individuals’ transactions in cryptocurrency, and the agency might be in a position to make criminal referrals of failures to report income from such transactions. In December 2016, the IRS, believing that virtual currency gains have been widely underreported, issued a summons demanding that Coinbase, the largest U.S. cryptocurrency exchange, produce a wide range of records relating to approximately 500,000 Coinbase customers who transferred Bitcoin, a virtual currency, from 2013 to 2015. Formed in 2012, Coinbase has served at least 5.9 million customers and handled $6 billion in transactions. Coinbase did not comply with the summons.

In seeking to enforce the summons in the Northern District of California, the IRS cited the fact that while approximately 83 percent or 84 percent of taxpayers filed returns electronically, only between 800 and 900 persons electronically filed a Form 8949, Sales and Other Dispositions of Capital Assets, that included a property description that was “likely related to bitcoin” in each of the years 2013 through 2015. Presumably, the IRS believes that more than 900 people made gains on bitcoin trading during that period.

On November 28, 2017, the court enforced but modified the summons by requiring Coinbase to provide documents for accounts with at least the equivalent of $20,000 in any one transaction type (buy, sell, send or receive) in any one year from 2013 to 2015. The order required Coinbase to provide: (1) the taxpayer’s ID number, name, birth date and address; (2) records of account activity, including transaction logs or other records identifying the date, amount and type of transaction, i.e., purchase/sale/exchange, the post-transaction balance and the names of counterparties to the transaction; and (3) all periodic statements of account or invoices (or the equivalent).

The IRS appears to be getting closer to the prospect of criminal cases:

  • In March 2018, Coinbase informed 13,000 of its customers that it would be giving information on their accounts to the IRS.
  • At the recent Tax Controversy Institute in Beverly Hills, Darren Guillot, Director (Field Collection), IRS Small Business/Self-Employed Division, said that “[he] has had access to the response to the John Doe summons served on Coinbase, Inc. for two months and has shared that information with revenue officers across the country.”
  • Bryant Jackson, Assistant Special Agent in Charge (Los Angeles), IRS Criminal Investigation Division, recently said that CI has been expecting fraud referrals from the Coinbase summons response.
  • CI and the Justice Department Tax Division have been discussing those anticipated cases and issues that may arise in them, such as proof of willfulness.

It is noteworthy that in Notice 2014-21, the IRS answered a series of questions related to the taxation of cryptocurrency (which it refers to as “virtual currency”). In the Notice, the IRS indicated that penalties would apply for failures related to the reporting of gains under section 6662 and failure to file information returns under sections 6721 and 6722. While the Notice specifically provided that penalty relief may be available to taxpayers and persons required to file an information return who are able to establish reasonable cause, it did not provide any indication as to whether reasonable cause relief would be available for taxpayers who failed to report cryptocurrency-related gains. More recently, on July 14, the Large Business and International division of the IRS initiated a Virtual Currency Compliance Campaign to address noncompliance issues.

While there may be valid reasons for failure to report cryptocurrency-related gains, taxpayers who are among the 13,000 Coinbase customers should be particularly concerned about the penalties that might apply due to the failure to report their gains.