In the four years since the Internal Revenue Service issued Notice 2014-21, the mining and use of cryptocurrency tokens — and, to some extent, their value — has risen to record levels. In Notice 2014-21, the IRS said that cryptocurrency is not currency, but property, which gives rise to tax issues when the currency is exchanged for something else.
“When you exchange currency for currency, it’s not a taxable transaction,” said Ryan Losi, a CPA and executive vice president of CPA firm Piascik. “But when you exchange property for property, it is a taxable event.”
To add some clarity to the landscape, the American Institute of CPAs has sent the service some suggested FAQs to update practitioners and taxpayers on the unsettled issues that have arisen during the time that has elapsed since Notice 2014-21 was issued.
“It’s good that the AICPA came out with suggested FAQs,” said Selva Ozelli, CPA, Esq., a New York-based practitioner. “In the absence of specific IRS guidance, the industry can follow it knowing there is at least a reasonable basis for their position.”
For starters, the AICPA addressed the expenses of mining virtual currency. Since Notice 2014-21 concludes that the fair-market value of a virtual currency as of the date of receipt is includible in gross income, the AICPA suggests this means that mining is similar to a service activity, rather than a production activity where income is not realized until disposition of the property. Therefore, it is appropriate to treat the costs of mining virtual currency in a similar way to expenses incurred in providing other services, according to the institute. Thus, the costs of acquiring virtual currency through mining or similar activities should be expensed as they are incurred.
“The distinction between mining gold and mining cryptocurrency leading to this result is that when you mine for gold you already own the land or the mining rights, whereas when you mine cryptocurrency, you are performing services and getting paid for your services with coins,” said Mary Voce, a shareholder at law firm Greenberg Traurig. “That’s the theory behind it.”
Piascik’s Losi believes that this position concedes too much. “I don’t think income from mining cryptocurrency should be treated as service income,” he said. “There have to be two parties for income to be from a service, but when you mine there’s only one party. I agree that you should be able to expense the costs, but I don’t agree with the premise that it is a service and is taxable upon receipt.”
For Ozelli, the most pressing issue answered by the AICPA suggestions concerns the foreign reporting requirements for virtual currency. “If cryptocurrency is sitting in a wallet, not on an exchange, there’s no reporting requirement,” she said. “But if it’s in an account on an exchange where it can be translated to fiat currency, then there may be FBAR [Report of Foreign Bank and Financial Accounts] and FATCA [Foreign Account Tax Compliance Act] reporting requirements. A lot of cryptocurrency exchanges have moved to Malta.”
“Some investors might not even know the difference between an exchange and a wallet, or where the exchange is located. They have a responsibility to do due diligence,” she added.
“People really need to pay attention to what they’re signing up for and where it’s located,” agreed Michael Barbera, a CPA and principal at Boston-based CPA firm Edelstein.
An IRS analyst for the Small Business/Self-Employed Division said in June 2014 that virtual currency accounts were not reportable on Form 114 (FBAR) for tax years ending in 2014, but no guidance was provided for future years.
The FAQs’ suggested questions and answers on foreign reporting requirements are as follows:
Question: Are taxpayers who hold virtual currencies and/or fiat currencies, on centralized virtual currency exchanges operating in a jurisdiction other than the U.S., required to report the value of the virtual currencies if the reporting threshold is met for both FBAR and FATCA compliance?
Answer: Yes. The value of virtual currencies should aggregate with fiat currencies and any other assets required for reporting under both FBAR and FATCA if their respective reporting thresholds are met.
Question: Are virtual currency wallets where taxpayers own, control, and are in possession of private keys for their own virtual currency wallets considered a Foreign Financial Institution for purposes of both FBAR and FATCA compliance?
Answer: No. Virtual currency wallets are owned and controlled by the taxpayer when in possession of the private key for that particular wallet. In this case, the virtual currency is considered cash which resides wherever the taxpayer resides and is therefore not considered a Foreign Financial Institution or subject to either FBAR or FATCA compliance.
Wallets can differ regarding the reporting requirements, according to Barbera. “A wallet that’s on the individual’s hardware, such as a flash drive, would not subject the individual to foreign reporting requirements,” he said. “But if the wallet is on software, it can be housed overseas, and it could be subject to reporting requirements.”
The volatility of cryptocurrency value can cause problems for some taxpayers, since FBAR requires reporting if, at any time during the year, the value in an account exceeded $10,000.
“If a person invested $2,000 in a cryptocurrency, and later checked and it had gone up to $8,000, they might think there is no requirement to report the account,” observed Pallav Raghuvanshi, an associate at Greenberg Traurig. “It might have exceeded $10,000 and gone back down. Unless a person is tracking the value on a current basis, they may run afoul of the reporting requirements without knowing it.”
Penalties for failure to file may run as high as $100,000 per account, or 50 percent of the account value, per year. While there is a reasonable-cause exception for non-willful violations, the penalty for willful violations can be staggering. In 2013, Ty Warner, the inventor of Beanie Babies, paid more than $53 million in FBAR penalties.
Under the Offshore Voluntary Disclosure Program, taxpayers could pay a one-time penalty of 27.5 percent of the balance in the overseas account, with no criminal prosecution. However, the OVDP is set to wind down in September 2018.
“A practitioner should always ask clients if they have any foreign accounts,” said Barbera. “We send out one-pagers asking them about any foreign assets.” The volatility in value of some virtual currencies may catch a taxpayer unawares, Barbera observed, recalling the case of a client’s son who got into bitcoin little by little, then put it on the backburner and forgot how much he had: “He was surprised when he found that his holdings had increased to more than $5 million.”
It is not always evident where a particular exchange is located, according to Losi. “When you look at your phone, do you know where those phone apps are housed?” he asked. “I would like to see the IRS take a couple of years off before hitting people with fines on cryptocurrency reporting.”