No Taxation Without Decentralization: The IRS Closes in on Crypto

2017 was a manic year for Bitcoin and Cryptocurrencies all across the globe. The world suddenly began to take cryptocurrency seriously as hundreds of thousands—or perhaps millions—of new traders entered the cryptosphere for the first time.

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2017 was also the year that cryptocurrency caught the eyes of the world’s governments in a serious way. The global fever to regulate cryptocurrency has certainly not passed through the West without affecting none other than the Internal Revenue Service (IRS), the United States government’s department of taxation.

In addition to the exponential rise of the crypto markets at large, the IRS has certainly taken notice that a relatively low number of tax returns reporting crypto capital gains have been filed despite the fact that so many new investors came into the space.

While no large-scale action has been taken quite yet, the IRS demanded that the popular Coinbase app hand over 480,000 of its users’ personal information and account records in November of 2017.

Initially, Coinbase attempted to stave off the probe, but a federal judge in California eventually ruled that the company was required to turn over 14,000 accounts of users who had profited by $20,000 or more in 2017. Coinbase declared the ruling a “partial victory.”

To prevent any further trouble, Coinbase now displays a quaint reminder to its users:

(Coinbase also added a “Taxes FAQ” page to the support section of its website.)

So far, there has been no direct implication that the United States government is taking steps to seize information from other centralized crypto wallets and exchanges. However, the fact that it has happened at all is certainly some indication of the future.

One thing is clear--the IRS has a vested interest in collecting on funds gained from trading and holding cryptocurrency.

Closing in on Crypto: Controversial Tax Bill of Late 2017 Closed Loophole

The United States federal government has never considered cryptocurrency to be legal tender. Rather, Bitcoin and other kinds of cryptocurrency have traditionally been legally classified as property for federal tax purposes. Practically, this has the effect of “imposing extensive record-keeping rules and significant taxes on [their] use”, according to a Forbes report.

The recent controversial tax bill that was signed into effect at the end of 2017 closed a long-standing loophole for crypto traders. Previously, crypto investors could avoid having to pay short-term capital gains taxes by using '1031 exchanges'.

This kind of exchange supports what’s known as a 'like-kind' trade in which a qualified third-party intermediary must declare that the properties being exchanged are the same kind of asset (i.e. a business for a business, or one piece of investment real estate for another). The beauty of 1031 exchanges, of course, is that they are tax-exempt.

In the past, the law regulating 1031 exchanges made no specific mention of whether or not cryptocurrencies could be traded through this medium. Now, the law explicitly states that cryptocurrencies cannot be traded on a 1031 exchange.

Under the new tax bill, any profitable trade of one cryptocurrency for another is subject to federal and state capital gains taxes. According to a report from Quartz, gains made from the sale of digital assets can be subject to a federal tax of as much as 37% as well as a state tax from 3-13%.

Long-term gains (profits from assets held for at least 366 days) will be taxed at a lower rate, somewhere between 0-20%. A single person whose income surpasses $200,000 a year could be subject to an addition 3.8% Net Investment Income Tax (NIIT).

Reporting gains can be a particularly complicated task due to the unique technical nature of some crypto gains (i.e. currencies distributed through hard forks). Additionally, crypto holders who have assets based abroad must report their holdings to both the IRS and the US Treasury using form 8938 and FinCen form 114, respectively.

Quartz also reported that funds raised through cryptocurrency cleverly could be used for charitable donations, and then claimed as tax deductions. However, the cryptocurrency must be donated as is, without converting it into fiat first, as such a conversion would “trigger a tax on the gains.”

Tax on Crypto in the United States for Business Owners, Employees, and Freelancers

As Bitcoin and other cryptocurrencies have become more popular, the practice of paying employees or freelancers in cryptocurrency has risen in popularity as well. While no cryptocurrency has been classified as legal tender in the United States, the IRS taxes income earned or paid in cryptocurrency just the same as fiat income.

If you are a business that is planning on paying a freelance or independent contractor using Bitcoin or another cryptocurrency, you must convert the amount paid into USD and then report the payment on an IRS Form 1099 (just as you would with fiat). Businesses paying their employees with cryptocurrency must follow the same process with W2 forms.

Extra Benefits for Long-Long-Term Crypto Holders?

Before and after the passage of the most recent large-scale tax bill in the US, taxation policies on cryptocurrencies have favored retirement account investors.

In a report for Forbes, IRA Financial Trust Company President Adam Bergman wrote that if funds from a retirement account are used to generate capital gains from the purchase and sale of a capital asset, the funds generated will not be taxed until the account holder receives a distribution from the account. In the case of Roth IRA or Roth 401k, qualifying distributions may not be taxed at all.

The Beast Charges Ahead

Given the largely anonymous nature of most cryptocurrencies, It’s not entirely clear how the IRS and the US government’s various other financial institutions will be able to track the trading and ownership of cryptocurrencies outside of centralized platforms and apps (like Coinbase). With the imminent advent of decentralized exchanges, this task may only become more difficult.

However, the US government--while rather slow moving, in this case--has a lot of crypto tax revenue to collect. It seems somewhat clear that the US government does want to regulate with too heavy a hand, and thereby stifle the growth of the Blockchain startup industry in the United States. That being said, the US government will not drop the effort to collect what it views as rightfully its own.