Currently, the Internal Revenue Service (IRS) does not have an internal policy on the taxation of all cryptocurrencies per se, but rather on the so-called virtual currencies, which, according to the definition of IRS itself, are any representation of a value through a digital medium, which works as a real exchange currency, unit of account and/or store of value.
In some environments, virtual currency operates with “real” currency, that is, currency such as US paper money, or any other country designated as the base. This type of currency uses cryptography to validate and protect transactions that are digitally recorded in a kind of ledger.
A virtual currency that has an equivalent value in “real” currency or that acts as a substitute for “real” currency, is called a convertible virtual currency. A good example is Bitcoin, as it can be traded digitally between users and can be purchased or exchanged for US dollars, euros, and other “real” or virtual currencies.
The sale or exchange of virtual currencies used to pay for goods or services, and even the maintenance of these currencies as an investment, often have tax consequences.
With this in mind, in 2014, the IRS issued Notice 2014-21, IRB 2014-6 as a guide for individuals and companies on the applicable tax treatment to transactions involving virtual currencies. To date, this Notice is the only “formal” guidance issued by the IRS.
Notice 2014-21 treat virtual currencies as “property” (not foreign currency) for federal tax purposes, and it has been established that general tax principles relating to transactions in capital assets (such as stocks traded on a stock exchange, for example) will govern the transactions involving convertible virtual currencies. Below we highlight the most important points provided in Notice 2014-21:
Transactions with Virtual Currencies
Taxpayers who receive virtual currency as payment for services rendered or goods sold must pay US Federal Income Tax at a rate of 10% to 37%. In the calculation of taxable income, the basis to be considered is the fair market value, in US dollars, of the virtual currency on the date it was received.
In the event that the virtual currency is listed on an exchange and the conversion rate is set by market supply and demand, the fair market value of the currency is determined by converting the virtual currency into US dollars at the exchange rate, in a reasonable manner and that it is applied consistently.
For those who sell or exchange virtual currencies, taxation on capital gain is applicable (up to 20% for a period longer than 1 year and up to 37% for a period shorter than 1 year). However, if the virtual coins are kept in stock or for the sole purpose of sale to third parties in a business, the applicable taxation is that of ordinary income, subject to the relevant rates of the business.
Specifically, with regards to those who carry out the mining of virtual currencies, it is important to highlight that this activity is considered a taxable event. Therefore, the fair market value of the currency on the date the mining is completed must be included in the individual’s taxable gross income, under which ordinary income rates apply (10% to 37%).
Additionally, if the mining activity is considered to be a business belonging to the taxpayer, whether it is a formal company or an autonomously developed business, US taxation pertaining to social security matters will apply.
Furthermore, the payment of virtual currency by an employer to its employees may be considered salary, an opportunity in which the fair market value of the currency will act as the basis for the employee’s taxation (withholding tax from 10% to 37%).
The positive variation of this virtual currency after receipt as remuneration is subject to taxation as short or long-term capital gain in the event of exchange or sale.
Exchange Variation
Under applicable law, virtual currency is not treated as currency that may generate foreign exchange gain or loss for US Federal Income Tax purposes.
Obligation to report
Payment made through virtual currencies must be reported, in the same way as a payment made through the delivery of goods.
In 2019, the IRS started to include in the Federal Income Tax form (Form 1040) a field intended to question whether the taxpayer carried out any transaction with virtual currencies during the calendar year.
Penalties
If an individual performs a transaction with virtual currencies that is not in compliance with current US tax legislation, they may be subject to penalties such as fines.
In the US Congress, lawmakers have begun discussions about the tax implications of cryptocurrencies and, on August 10th, 2021, approved part of a Senate bipartisan infrastructure package plan that enforces the same reporting obligations assigned to securities transactions to cryptocurrency transactions, in addition to other compliance implications.
As for such compliance implications, the need to report virtual currencies held on platforms located outside the US in the Foreign Bank Account Report (“FBAR”)/Foreign Account Tax Compliance Act (“FATCA”) forms is highlighted.
Basically, in transactions with securities (stocks on the stock exchange, for example), the price paid for the share and the fees involved are reported to the IRS by stockbrokers. In the aforementioned infrastructure legislation, these same transaction reporting obligations would be assigned to digital asset brokers. In the tax universe, this is known as the “whistleblower” who forces the taxpayer to declare the transactions and collects the taxes due.
Furthermore, although the IRS has already been developing regulations regarding cryptocurrencies, there is some debate about this tax authority’s perview to impose new rules. The vote now goes to the House.
Written by Camila Cabral, Drummond Advisors tax consultant