Cryptocurrency and Taxation

With all of the major headlines we experienced in 2020, one of the most noticeable was the sudden meteoric rise in the value and popularity of cryptocurrency. Almost everyone has heard of both Bitcoin and Ethereum at one point or another throughout the year as they rose and fell. With all of this attention, we ran into some major questions from our clients: What are these cryptocurrencies, what gives them their value, and what does the IRS have to say about buying and selling them? Let’s unpack all of this together.

What is Cryptocurrency?

Cryptocurrencies are a decentralized form of payment that came about after the Great Recession of 2008. The first cryptocurrency to become widely available was Bitcoin and was engineered by Satoshi Nakamoto. While that’s suspected to not be his real name, his vision endures to this day: to create a currency that had a finite supply that the market could uncover and then use either as a store of value or as a method of payment between one user and another in response to the money printing and stimulus bills being passed by Congress during the recession.

The magic happens through a network of interconnected nodes called blockchain, where all the transactions and all the mining takes place. These interconnected nodes are individual computers connected to the blockchain, and each has its own individual identity. The fact that they are decentralized means that if one or more computers should fail or go offline, the blockchain can still run. Think of the blockchain as a very large conference room with quite a few people sitting at the table, if one or more of them for one reason or another should leave the room, the conference can still continue. Further, all data transmitted on the blockchain is public, meaning every computer connected as a node has a record of every transaction that has taken place since 2009. This data is still anonymous, even though it is public because it is nearly impossible to discern the identity of the parties making the transactions. The data, once agreed upon by all nodes, adds to the chain and becomes a permanent and immovable part of the blockchain and stored on what’s referred to as the distributed Ledger, the record of all transactions and events in the chain.

The blockchain also has a reward system in place to encourage miners, or tech-savvy users, to uncover the solutions to the equations that unlock more coins and more of the blockchain. Miners who help solve the equations receive coins as rewards for their hard work. At certain junctures, however, when enough coins have been mined, an event called the halving takes place, which reduces the reward by half, giving fewer rewards for solving the equations over time and forcing the utility of the coin by having miners offload some of their holdings to pay for their expenses. That’s why so many crypto investors often wait for the halving to happen before they begin buying and selling. This sudden supply shock drives up demand over the following months and allows investors to take a large profit.

What separates a cryptocurrency from most other currencies is the fact that it is decentralized, meaning no single source has full control of the currency, which creates a secure network that cannot be hacked or tampered with. In the network or blockchain, all nodes must agree on any transaction that takes place within it. If there is a contradiction, such as a coin being spent twice, the blockchain will roll back both transactions and only recognize the earliest occurrence and the node used to create the fraudulent transaction would be identified by all other nodes. What this means is it’s nearly impossible to steal or confiscate another person’s coins, let alone counterfeit a coin.

But there is a caveat: How can you recover funds from a crypto wallet you’ve lost the password to? Sadly, there is no known method or computer capable of breaking into a digital wallet and restoring those coins to the blockchain for the owner to redeposit into another wallet. This is the case not only because the code is secure, but because the nodes in the blockchain would reject the unauthorized movement of the coins.

The blockchain runs on a hexadecimal code, meaning it incorporates both letters and numbers to enhance the security and uniqueness of each individual transaction to limit the possibility of ever having a repeated code run and cause the nodes to disagree. The complexity of the hexadecimal code makes it the most secure medium for the blockchain to run on at the cost of taking a very long time compared to cash or credit to make a single transaction take place. What may take less than a minute for cash to transact between two parties may take up to 20 when using cryptocurrency.

For example, what if we look at it visually? How complex does the code make something simple turn into? If I were to put my name into hexadecimal, it would look something like this: 427261646c657920446542656c.

What Gives Cryptocurrency Value?

There are a few terms that go along with the idea of value that we’ll unpack in this section: scarcity, divisibility, utility, counterfeit ability and transferability.

You’ve heard of the economic concept of supply versus demand. The more of something there is, the less demand for it there is for it, and vice versa. With certain cryptocurrencies, having a fixed supply, or a limit on the number of coins that can be found on the entire network leaves room for demand to skyrocket since there can never be the issuance of more coins. Ultimately, that alone can be a major factor that drives up the value in a market where more and more investors are buying and holding these currencies.

The ability to break down a single coin or token of value into smaller increments is a staple to any economy, as any medium of exchange should be sufficiently divisible to accurately reflect the value of all goods and services available throughout the market. Think of cents versus dollars. There are some items that we pay less than a dollar for simply because we view it as less valuable than a dollar and to accurately apportion a price to that good or service. Imagine paying a whole dollar for a gumball versus 25 cents.

The utility is where the most recent events are coming into focus. For a currency to be effective, it must be able to trade hands between parties as a payment for goods and services and it must be readily available. A major highlight in the U.S. market that drove a lot of crypto value was Tesla accepting Bitcoin as a method of payment for its vehicles. The more widely accepted and utilized these coins are by more market participants, the greater the value of these currencies will become. Not to mention what doors the technology of the blockchain itself could potentially provide for secure transacting and data storage in the years to come.

Counterfeiting has been one of the oldest plagues of currency since its inception. There will always be someone who wants to have more of a currency without having to put the work in to earn it honestly. Crypto shines in this section, as it is nearly impossible to forge a counterfeit token. To pull this off, the fakers would have to convince every computer on the network that their new fake coin is valid and then convince them again that this coin can be used in a valid transaction.

Transportability is the easiest to conceptualize. Currencies should be easily transferred between one party and another. It’s the main reason the world stopped transporting gold bars from one place to another to pay for transactions and shifted to notes backed by a gold standard. While crypto is the easiest transport physically, only requiring a thumbstick-sized wallet to hold all of your coins, it takes the most time to transact due to the highly secure nature of the blockchain.

What’s the IRS’s take on crypto?

The Internal Revenue Service treats cryptocurrencies as property, meaning that the disposition of a coin would be subject to short- or long-term capital gains taxes depending on how long it has been held. For long-term investors, this is quite advantageous. They could likely save a lot on taxes using the capital gains rates rather than ordinary income rates for holding and waiting for it to increase in value.

However, it’s not all sunshine and rainbows, as the dispositions of a coin take place whenever it’s sold or used to pay for a transaction. If you were to buy a Bitcoin at $10 and it appreciated in value up to $100, then you use it to pay your accountant for $100 worth of work, you’d pay capital gains taxes on $90. Essentially what that ultimately means is that you’re taxed for using the cryptocurrency for an ordinary transaction. What if you’re the one receiving the crypto? What tax implications would that have? Using the example above, the accountant would record taxable earned income of $100 taxed at ordinary rates. The same would apply if you were a miner who had received cryptocurrency as a reward for your mining activities. If they then sold their earned coins, they could pay tax again at the appropriate capital gains rate if it appreciated in value.

If that weren’t complicated enough, the IRS has issued new revenue rulings in regard to what is referred to as a hard fork and an airdrop. Let’s define what we’re talking about before we get into the tax section.

Like all technology, updates and protocol changes are a normal part of everyday life, but in crypto, this creates a whole new event known as a hard fork. When a protocol change takes place on a blockchain ledger, it creates a diversion from the legacy ledger and the new distributed ledger, potentially creating a whole new currency in the process. Following a hard fork, transactions involving the legacy currency are recorded on the legacy ledger and transactions on the new or updated currency are to be recorded on the new distributed ledger. An airdrop is a means of distributing units of a cryptocurrency to the ledger addresses of multiple taxpayers. A hard fork followed by airdrop results in sending units of the new currency to addresses with the legacy ledger, but a hard fork is not always followed by an airdrop.

Before we go any further, let’s discuss constructive receipt. Constructive receipt means that you as a taxpayer have received or have unrestricted control to withdrawal funds that you have earned. Typically, this is a concept for cash-basis taxpayers to determine income. For example, you have a check from a customer for payment for services rendered, but you haven’t yet deposited the money. Did you have constructive receipt of those revenues? The answer to that question is yes because you can exercise control over withdrawing those funds. Physical possession of the cash isn’t required, just the ability for it to be withdrawn without restriction.

Cryptocurrency from an airdrop is generally received on the date and time it is recorded on the distributed ledger. However, a taxpayer may constructively receive the currency prior to record on the distributed ledger. A taxpayer does not have a constructive receipt when the airdrop is recorded if the taxpayer is unable to exercise control over the cryptocurrency. A good example of this is if the currency is airdropped into a wallet managed by an exchange that does not yet support the newly created currency. If the taxpayer later on gains the ability to transfer, sell, exchange or dispose of the currency, at that time the currency will be treated as constructively received. As for the hard fork, if a new currency is created in connection with a hard fork and a taxpayer receives this new currency, whether by airdropping or directly from the hard fork, the taxpayer has gross ordinary income.

How Can PCO Bookkeepers Help?

Here at PCO Bookkeepers, our clients are our first priority. Whether that’s strategizing for crypto-related tax situations like these or even getting ready to sell your business, we have you covered. Schedule an appointment with us today.