Have you been searching for a comprehensive summary of all the recent and not so recent IRS actions regarding virtual currencies? You have arrived! But before we begin, if you are interested in some background on the early days of cryptocurrency reporting, visit my previous article, Navigating the Perilous Waters of Cryptocurrency Reporting.
Cryptocurrencies have presented taxpayers with a contentious atmosphere for some time. In years past, tax accountants had little direction regarding the appropriate way of disclosing income from cryptocurrency transactions on Form 1040. IRS Notice 2014-21, issued in April of 2014, provided some guidance about virtual currencies. However, IRS's definition of virtual currency encompassed all conceivable forms of computer-generated value, ranging from virtual gambling tokens to any digital assets of worth. This proved to be a somewhat confusing description for cryptocurrency enthusiasts.
Additional help arrived in 2018, when the court granted to the IRS the now famous John Doe summons against Coinbase, the largest U.S. cryptocurrency exchange. This landmark ruling also marks the beginning of decisive IRS action on the subject of cryptocurrency reporting requirements. As part of its Virtual Currency Compliance campaign, the IRS is making a focused effort to educate taxpayers, guide tax practitioners and investigate criminal activity that aims to abuse the semi-anonymous and borderless nature of cryptocurrency transactions.
In July of 2019, the IRS mailed educational letters to taxpayers suspected of failure to fully and correctly report income and pay the resulting taxes from virtual currency transactions. By the end of August, over 10,000 taxpayers received such letters. Three types of letters were mailed: Letter 6173, Letter 6174, and Letter 6174-A. While all three versions intended to educate the recipients regarding their reporting obligations as a consequence of having cryptocurrency accounts or engaging in cryptocurrency transactions, only Letter 6173 required immediate action and response.
Just a few short months later, the IRS issued two additional pieces of guidance: Revenue Ruling 2019-24 and Frequently Asked Questions on Virtual Currency Transactions (FAQs). The revenue ruling discusses the creation of ordinary income from a hard fork that is followed by an airdrop. In this situation, the taxpayer receives units of a newly created cryptocurrency. These new units are reportable on the taxpayer's tax return as ordinary income measured at fair market value as determined at the time and date of the receipt. Also discussed is a second scenario when the hard fork is not followed by an airdrop. Since new units are not created in the absence of airdrop, there is no reportable income. Therefore, ordinary income does not occur when the hard fork is not followed by an airdrop, because the owner of the original cryptocurrencies does not receive new units of any kind.
While the IRS admits that FAQs are not authoritative sources of guidance taxpayers and tax professionals should not rely solely on FAQs published on the IRS website, such tools have been helpful in answering the most commonly asked questions about various topics, as is the case with the virtual currency transactions FAQ. In more than 40 questions and answers, the IRS provides clear explanations on various cryptocurrency issues such as:
For tax year 2020, there is a virtual currency question on page 1 of Form 1040. The position is a strong indication of the IRS’ intent to move from educating taxpayers towards enforcement. Answering the question is mandatory and will help the IRS identify taxpayers who are subject to reporting income and paying the resulting taxes from cryptocurrency transactions. Much requested guidance has also arrived. The instructions for the 2020 Form 1040 now include specific directions. Virtual currency is defined as a digital representation of value, a unit of account, a store of value, and a medium of exchange. Furthermore, the instructions state that convertible virtual currencies have an equivalent value determinable in real currency, they are convertible to USD or property, and can be used as a substitute for real currency. The IRS uses the term “virtual currency” broadly. Virtual currency treatment will apply to all digital assets possessing characteristic of a convertible virtual currency regardless of what they are called. Other references in the instructions include reportable transactions, capital gains and losses from virtual currency transactions, and reporting obligations due to virtual currency related activities carried out in a trade or business.
Despite the recent IRS actions to clear the confusion, tax filing requirements of cryptocurrencies are still challenging, even for the most educated virtual currency enthusiasts. The Kerkering Barberio International Tax Team in Sarasota, Florida has the expertise and the experience to help taxpayers with both their U.S. tax return and foreign informational filings.