How is Bitcoin taxed? And other key questions about cryptocurrency

On October 21, 2020, PayPal announced it would be entering the cryptocurrency market. By hosting a “wallet” on the PayPal app, the company instantly provided access to cryptocurrency to more than 300 million people. Most of these users don’t (and won’t) own cryptocurrency, but they now have access to trade, manage, and in the near future, use cryptocurrency, including Bitcoin, as a form of payment for goods and services purchased through PayPal.

By allowing the use of cryptocurrency, PayPal is leading its users into an uncharted territory of tax policy. In this article, we’ll mainly focus on Bitcoin, as it is the most common type of cryptocurrency. We’ll start with a brief explainer of how cryptocurrency works, walk you through where we are with the related tax issues, and leave you with some key things that we believe must be addressed before investors should start down the path of cryptocurrency.

What is Bitcoin? Where did Bitcoin come from?

In 2008, Satoshi Nakamoto published Bitcoin’s whitepaper. While Satoshi Nakamoto is a pseudonym and the author of the paper remains anonymous, it is a fact that this person or persons began “mining” the first Bitcoin and sent the first Bitcoin to another person.

In 2010, someone paid 10,000 Bitcoin for two pizzas. By the end of 2017 and in early 2018, that amount of Bitcoin would have become equivalent to about $200 million as Bitcoin’s market price peaked at just over $20,000. Since then, the cryptocurrency ecosystem has moved beyond food purchases. Terms like blockchain, airdrops, and mining have been vaulted from obscurity as big corporations move into the cryptocurrency market, with PayPal, Cash App, and soon Venmo bringing cryptocurrency mainstream.

As it becomes easier and easier to own these digital assets, accountants will start getting more and more questions about how crytpocurrency might be taxed.

How does Bitcoin work?

Alice sends Bob some Bitcoin. From Alice’s “wallet” of choice, she enters Bob’s public address as the recipient of this transaction. The public address is Bitcoin’s equivalent of a secure public bank account number and looks something like this: A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa.

Once Alice hits send, the entire Bitcoin network is notified of this transaction. At no time does this transaction move through any central location. Not a bank, not any one server. Instead, Bob will receive the Bitcoin once all “nodes” in the network agree that Alice did not send Bob any more Bitcoin than she owned. This is the verification process.

A “node” is someone’s hardware running the Bitcoin protocol, and each of these nodes stores a copy of the distributed ledger, or the blockchain. The ledger contains all transactions since 2009, when the first Bitcoin was mined.

While all transactions are accessible for anyone to review through a “block explorer,” Alice does not need to trust Bob or even know him at all. All transactions are encrypted, and only the important metadata of each transaction is accessible online. When all nodes in the network reach consensus, the transaction will be verified, and Bob’s wallet will show that the Bitcoin has been received.

Lost already? The explanation is tough to understand for a reason – it’s almost impossible to imagine an alternative to a bank, let alone an alternative that is automated. It’s no easier to imagine accountants choosing to theorize on these subjects, either. Computer scientists, however, don’t mind uprooting centuries-old institutions by inventing technology that disrupts them.

Bitcoin is a solution to what was a long-standing computer science problem of how you prevent someone from spending more cryptocurrency than they have, deleting transactions, or modifying their accounts to add currency they haven’t earned, also known as the double-spending problem.

The distributed ledger solves the problem, and Bitcoin is just one application of this underlying technology, which allows for “trustless” verification and documentation. The same technology is being used by major corporations in shipping networks and food distribution networks, including Walmart.

The technology underpinning cryptocurrency is important and interesting, but it’s the value of Bitcoin that has made headlines. Imagine a single Bitcoin either mined or purchased for pennies in 2010 selling for more than $20,000 seven years later. Bitcoin has been notoriously volatile, but hedge funds and banks, including J.P. Morgan, are entering the cryptocurrency market. Major companies are showing Bitcoin on their balance sheets. Confidence in this market is growing, and the accountant’s understanding of cryptocurrency must grow with it.

What does the IRS say about cryptocurrency?

(Not much.) In 2014, the IRS issued its first formal guidance on how to deal with cryptocurrency transactions, Notice 2014-21.

Takeaways from Notice 2014-21 are:

• cryptocurrency should be treated as property;
• mining rewards are income;
• income and expenses should be recognized for tax purposes at full market value when cryptocurrency is received or paid in the course of business.
  • The payer would report the gain or loss associated with the cryptocurrency spent and record the expense at fair market value. This could include payments made by customers or vendors as well as wages paid by employers.
  • Example: Alice buys Bitcoin for $100. The $100 of Bitcoin appreciates to $150 at the time Alice pays Bob for services rendered. Alice will record a capital gain of $50 and record a $150 expense for the services.

After Notice 2014-21, the IRS sought more expertise and began sending out notices to many taxpayers who likely skipped reporting their cryptocurrency. For example, the 2020 draft Form 1040 shows that the IRS has moved the question about cryptocurrency to the first page, asking each taxpayer whether they have traded cryptocurrency. This is different from the 2019 1040 version of this question, where you had to respond affirmatively if you owned cryptocurrency but never took part in a taxable event.

In 2019, the IRS issued Rev Ruling 2019-24, which answered some questions about which cryptocurrency transactions should be included in gross income. New tax events like “airdrops” are now considered income and valued at the full market value when the cryptocurrency is received. Additionally, a “soft fork” and “hard fork” might constitute taxable events, the latter being more probable. All of these new terms represent scenarios where a taxpayer might come into what seems like free cryptocurrency. Just getting a handle on these terms is hard enough, and we use them just to illustrate how difficult it is to properly reference a taxable event.

What do accountants do about Bitcoin?

Aside from FAQs on the IRS website, there has been no further guidance. So, we operate from the assumption that our clients are unaware of taxable events if they own and trade cryptocurrency. Because there is so little guidance, our clients (and even most accountants) can’t know.

Why should anyone care? Well, remember PayPal. Using Bitcoin and other cryptocurrency is more accessible than ever, and it will become more accessible in ways that are truly novel. Imagine logging in and out of a website with only a wallet, or public address, while never giving up your personal information. That technology already exists, and it’s essential that firms develop practical solutions to identify and account for tax events from a client’s “web wallet.”

For example, purchasing goods and services with cryptocurrency could result in capital gains. Imagine having a reporting requirement every time you purchased groceries because appreciated property was used as payment.

We don’t doubt PayPal’s ability to develop a cryptocurrency payment method, considering other companies already have the technology, but it’s easy to imagine why they might not want to, at least in terms of dealing with potential tax implications.

What is and is not a taxable event won’t be a concern until a taxpayer has already triggered a reporting requirement. If a taxpayer purchases those groceries with Bitcoin, hopefully there are good reports to inform this taxpayer of their gains and losses. At this point, unless the transaction happened on a major exchange, like Coinbase, decent reporting is not easy to come by.

Spoor Bunch Franz has identified areas where IRS guidance is needed while acknowledging that the tax system may be catching up (slowly). There are aspects of these new financial models that are completely incompatible with the conventional understanding of a taxable event. These models were developed from code, not legal contracts. The lack of clarity surrounding how tax law should apply to cryptocurrency shows how the IRS’ glacial pace is incompatible with the warp speed of cryptocurrency developers.

These developers are fueling decentralized computing innovation, and in turn, accountants need to find a way to be innovative while recognizing the slow evolution of our tax law.