How cryptocurrency is challenging CPAs, the government
October 2018 Footnote
As cryptocurrency, blockchain and the like become words seeing more regular use around the office, Geno Fragnito asked Judith Herron, an expert on virtual currency, to provide readers with a view of the issue from the regulatory side.
CPAs who do tax work typically devote significant time to fully understanding the tax code and all the rules surrounding its enforcement. The CPA's goal is to guide clients through the regulatory maze, so clients pay the least amount of tax while remaining compliant with the law.
A new dimension has been added to this equation with the introduction of virtual currencies.
This is problematic because the current Internal Revenue Code was designed for coins you can touch. It is not clear how to apply those same rules to digital coins like Bitcoin.
It used to be that Bitcoin was the only virtual currency, but that was all the way back in 2009. Now, less than 10 years later, there are literally thousands of these coins. While many do not represent much value, there are more than 60 different digital coins that, if converted to dollars, would have a market value of more than $100 million each. Bitcoin valued that way represents more than $100 billion.
Breaking down Bitcoin, other coins
If you stopped paying attention to Bitcoin when the hysteria surrounding the topic confirmed it must be a bubble, here's a Bitcoin 101 refresher course.
Bitcoin is a digital token that can be sent electronically from one user to another. This electronic transmission requires cryptography (in this case solving a mathematical code) to be authenticated and completed. Both the initiation and authentication of the transactions are done on a decentralized network of computers. Once the transaction is authenticated, it is recorded on a public blockchain ledger.
The different coins that have emerged since Bitcoin use similar technology. The difference from Bitcoin is those transactions are recorded on a different blockchain ledger. The need for some cryptography in all the transactions is why you often hear the word cryptocurrency used to describe it.
There is no central bank or regulator for any virtual coin. Proponents say the complexity of the algorithm and the use of the blockchain technology offer fraud protection that makes regulators unnecessary. Regulators are not aligned with this position, as the one number not required to use cryptocurrency is a U.S. tax ID number. Anonymous ways to move currency offer utility for people in the money laundering business.
FinCEN, the U.S. Treasury's division that focuses on trying to stop money laundering, is working on how to effectively enforce regulations on this subject. One challenge is that the agency does not treat digital currencies as money. They point out cryptocurrency lacks an essential ingredient that all other currencies have: acceptance as legal tender in a specific jurisdiction. Absent that quality, FinCEN says it is more a payment system than a currency.
The IRS agrees the coins do not meet the definition of currency. However, there is plenty of real currency involved in these digital transactions. Often, when currency is exchanged for anything, a taxable event occurs. The IRS is always looking to find more taxable events. In 2014, the agency issued guidance in the form of IRS Notice 2014-21, which says digital transactions will be treated as property transactions. When you purchase virtual currency, you establish basis and, when there is redemption, the difference between basis and sale proceeds is taxable income.
This is theoretically straightforward, but the reality is more complex. There is no stock exchange setting basis, nor a 1099-B at the end of the year listing all the transactions done under a set tax ID number. Many people became first-time owners of digital currencies as their run-up in value became headline news in 2017. Also, people who had purchased earlier suddenly had more in their virtual wallets than expected. As prices headed in the opposite direction in 2018, it is safe to assume that this was a consequence of people exiting their positions. There may be more taxpayers in 2018 who need to report the actual difference between virtual basis and the real currency in their bank account.
Individuals doing transactions in digital currency typically set up a virtual wallet through an Exchange that enables the execution and settlement of the transaction. The IRS notice suggests these Exchanges can provide a third-party validation of the fiat currency value of the virtual currency at redemption. Unfortunately, there is no consistent, accepted conversion method. Presumably, a taxpayer with good screen-shot documentation can use the Exchange information to establish the tax liability. It is not clear, though, how the IRS will react to the same exchange in the same timeframe, resulting in a different value. The only other guidance available is fair market value should be calculated in a "reasonable manner that is consistently applied." When it comes to tax, often the IRS definition and the taxpayer definition of reasonable vary considerably.
There are some Exchanges in the U.S., but most virtual currency transactions occur offshore. In 2014, an IRS analyst publicly stated that virtual currency accounts were not subject to FBAR reporting requirements for that year. Since then, there is no guidance regarding assets in virtual currency outside of U.S. jurisdiction, including possible application of reporting obligations under FATCA.
Further complicating potential offshore reporting is the different ways of using a virtual currency Exchange. Some people have a virtual wallet that accesses their account at the Exchange to engage in transactions. There are other people who hold the virtual currency on a hard drive or flash drive. If your flash drive full of Bitcoin is under your bed in Minnesota, does the fact that you engage in transactions through an Exchange offshore matter?
The AICPA released a letter to the IRS in May detailing their recommendations for expanding on the guidance offered in 2014. A few of the areas the AICPA requested to be addressed included the expenses of obtaining virtual currency, acceptable valuation and documentation, and holding virtual currency in a retirement account.
Given the size of the IRS to-do list related to the new tax law, it's not likely this request will get timely attention. However, absent further guidance, it is recommended reading to help a practitioner think through how best to advise taxpayers who decided to engage in digital currency transactions in 2018.
Judith Herron is a CPA at Markovitz Dugan & Associates. She provides accounting services to privately held companies and their principals. You may reach her at email@example.com or 412-571-0500.
Read the AICPA letter
Read the letter the AICPA sent to the IRS detailing recommendations.