By Julie Houth
Cryptocurrency has recently caught the attention of the public and government regulators. Since then, most people have heard the term cryptocurrency and more specifically, Bitcoin. There are some people who believe it is a form of currency. Other people don’t know enough about it to have an opinion. Attorneys as legal advocates and advisers are confronted with the fact that some of their clients may own or would like to invest in cryptocurrency. This article is intended to provide a brief summary about cryptocurrency and the tax consequences that should be considered.
What Are Cryptocurrencies and Where Do They Come From?
Blockchain technology is the use of a decentralized, publicly distributed ledger that is replicated and hosted on various computers that create many digital carbon copies. Blockchain technology is utilized by cryptocurrencies, which are virtual or digital assets. Cryptocurrencies use decentralized control instead of central banking systems. This gives the system credibility in the way transactions are recorded. This essentially means that the data in a blockchain cannot be modified. This also means that transactions are made with no middleman so there are no banks involved.
Bitcoin is by far the most popular and famous cryptocurrency. Bitcoin was first created in 2009 by an unknown person using the alias, Satoshi Nakamoto. Since Bitcoin’s debut, other cryptocurrencies have emerged such as Ethereum, Litecoin and Ripple. There are different methods of obtaining virtual assets. The methods include, but are not limited to, mining, exchanging cryptocurrency for sovereign (fiat) currency, exchanging cryptocurrencies for other cryptocurrencies or initial coin offerings (ICOs). Investors should note that no regulator has defined cryptocurrency as fiat currency, the money minted by governments.
Initial Public Offerings vs. Initial Coin Offerings
After a private company has an initial public offering (IPO), that company transitions into a publicly traded, owned entity. There are many reasons a private company goes public, which could include raising capital and plans of growing and expanding the company. Companies that hope to go public negotiate and contract with investment banks in regard to the number and the prices of shares issued. The reason negotiations on the number and prices of shares issued is complex in this process is because the ultimate goal is to sell shares to the public for more than what was paid to the original owners of the company. IPOs are generally seen in companies that have high capital and aren’t typically seen in small businesses.
Since the emergence of cryptocurrencies, ICOs, a new fundraising instrument, permit smaller businesses to reel in investors. ICOs allow accredited investors to fund the creation of a blockchain that will compensate them in coins. These coins can be used on the network or traded for other cryptocurrencies. A big difference between an IPO and an ICO is that an ICO does not provide equity in the company. As a business owner, ICOs could be a good approach to retaining equity, while seeking out investors to bankroll the company’s capital needs among other things.
Where Can You Invest and Exchange Cryptocurrencies?
There are several ways to exchange cryptocurrencies. Gemini, Kraken and Robinhood are some exchange vehicles for cryptocurrency. The most popular and well-known is Coinbase. These exchange vehicles provide a way to buy and sell virtual assets. Some of these companies only allow an investor to buy and sell certain types of cryptocurrencies so investors should be aware of these restrictions. For example, Coinbase only allows an investor to buy or sell Bitcoin, Bitcoin Cash, Ethereum and Litecoin. The popularity of Bitcoin and other virtual assets not only drew in investors but also government regulators.
IRS Tax Reporting Requirements
Since Bitcoin’s debut in 2009, many people made a lot of money over the years without any type of government regulation. In 2014, the Internal Revenue Service (IRS) issued Notice 2014-21, which describes how existing tax principles apply to transactions involving virtual currencies like Bitcoin. In this Notice, the IRS indicates that virtual currencies that can be converted into traditional currency are considered property for tax purposes and that a taxpayer can have gain or loss on the sale or exchange of a virtual currency.
There are a few key things to take away from IRS Notice 2014-21. Firstly, income from exchanging cryptocurrency for goods or services is the fair market value of the virtual currency in the date the property was received in U.S. Dollars. Secondly, the basis is equal to the fair market value on the date the currency was received in U.S. Dollars. Next, the character of gain or loss depends on whether the cryptocurrency is a capital asset. Those gains or losses could be reported as either capital gains or ordinary income, depending on the transaction. An example would be if the virtual currency was held as an investment property. In that case, the gain or loss on the sale would be considered capital gain or loss. Lastly, IRS Notice 2014-21 is the only IRS position on tax reporting requirements as of present.
The IRS and State Regulators on Cryptocurrencies
Although the IRS has taken a step toward regulating transactions involving cryptocurrencies, the laws around this topic are still very novel. However, now that the IRS has cryptocurrenices on their radar, other government regulators are sure to follow. By way of illustration, in 2015, the New York Department of Financial Services created something called the BitLicense regulation. BitLicense was created to regulate the administering, buying, exchanging, issuing, selling, storing and transmitting of virtual currency. In January 2017, Coinbase became only the third entity to receive a BitLicense. There have been speculations that California is seeking to impose a similar license that would require any business interested in transactions involving cryptocurrencies to hold a license, but this rule has yet to be enacted. Attorneys, tax professionals and investors should stay tuned.
Julie Houth is a graduate from Thomas Jefferson School of Law, received her LL.M. from the University of San Diego School of Law, and is licensed to practice in New York.