It is tax season in the U.S. as this is being written (the tax filing date for 2020 federal taxes has been moved from its typical April 15 date to May 17, 2021) and, for the first time this year, the very first question on the standard 1040 Form is whether “at any time during 2020 did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency.”
In other words, it is the very first piece of information the IRS wants to know, right after a person’s name and address. The subtlety of the placement of this question is not lost on anyone. The IRS obviously believes that there is significant under-reporting (and under-paying) of tax obligations relating to cryptocurrency transactions and it is seeking to increase the revenue stream to the government from those transactions.
In 2019, the cryptocurrency question was on Schedule 1 of the tax form. That schedule is used for reporting certain adjustments or additional income; thus, many filers do not use it. The prominent placement on the 2020 1040 Form means that the 150 million people who use that form will have to answer the question. Moreover, while the question itself does not in any way change the obligation to pay taxes on cryptocurrency transactions, there is a difference to a filer between overlooking that obligation on the one hand, and answering a question untruthfully on the other. The existence of the question will likely compel tax preparers to affirmatively ask the question of their clients. And, an inaccurate answer could be used against the filer by the IRS.
How does the U.S. government treat cryptocurrency? The answer depends on which government agency one is talking about. To the Securities and Exchange Commission, cryptocurrency can be a security. The SEC has brought numerous cases (civil and criminal) against parties who sold cryptocurrency tokens without filing a registration statement for the offering and without the offering satisfying any exemption from registration. The SEC position is that the offerings for such tokens qualify as securities under the Commission’s longstanding Howey test.
To the Commodity Futures Trading Commission, cryptocurrencies are commodities. On Sept. 17, 2015, the CFTC brought its first cryptocurrency action against an unregistered Bitcoin trading platform. The CFTC charged Coinflip Inc. and its chief executive officer with operating a facility for the trading or processing of commodity options (offering to connect buyers and sellers of Bitcoin option contracts) without complying with the Commodity Exchange Act or CFTC Regulations otherwise applicable to swaps. The most significant part of the CFTC’s Order was the following unambiguous statement about cryptocurrencies: “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities.”
But there is still more confusion among the alphabet soup of agencies of the U.S. government. The Financial Crimes Enforcement Network (FinCEN) is a bureau of the U.S. Department of Treasury that, among other things, collects and analyzes information about financial transactions in order to combat domestic and international money laundering, terrorist financing, and other financial crimes. As far back as 2013, it considered virtual currencies to be money. And, finally, the U.S. Office of Government Ethics takes the position that virtual currency qualifies as “property held … for investment or the production of income” under the Ethics in Government Act, meaning that executive branch employees are required to report their holdings of virtual currency on their public or confidential financial disclosure report, subject to applicable reporting thresholds for property held for investment or the production of income.
For purposes of this article, it is of course the position of the IRS that is relevant. The IRS focus on cryptocurrency is relevant to both taxpayers who buy and sell cryptocurrency, as well as businesses or individuals that transact with such taxpayers. Taxpayers need to be familiar with the IRS positions on the tax treatment of cryptocurrency transactions. Third parties can find themselves contending with IRS requests for information about taxpayers and their cryptocurrency transactions. In some circumstances, third-party record keepers can incur financial or regulatory obligations such as having to keep records or report transactions.
Taxpayers should be aware that the IRS first introduced its guidance regarding the tax treatment of virtual currencies in 2014, in IRS Notice 2014-21. The IRS said that, for federal tax purposes, virtual currency is treated as property—not as money—and that general tax principles applicable to property transactions apply to transactions using virtual currency. Thus, a taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. Furthermore, if virtual currency is used to pay for an item or otherwise exchanged for property, the taxpayer has a taxable gain if the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis for the virtual currency.
Notice 2014-21 further provides that (1) virtual currency received by an independent contractor for performing services constitutes self-employment income, (2) a payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property, and (3) payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. In other words, there are many ways that taxpayers can run afoul of tax laws when it comes to cryptocurrency and the IRS has brought the issue into sharper focus by placing the cryptocurrency question at the top of the Form 1040.
But taxpayers and third parties should know that this is only one of the steps the IRS has taken to beef up its enforcement efforts. The IRS labeled one initiative “Operation Hidden Treasure,” which, as first reported by Forbes, was announced during a March 5, 2021, Federal Bar Association presentation on fraud enforcement priorities by Damon Rowe, the Director of the Office of Fraud Enforcement at the IRS. As Forbes reported, Operation Hidden Treasure is comprised of agents who are trained in cryptocurrency and virtual currency tracking, and who are focused on taxpayers who omit cryptocurrency income from their tax returns. It is a partnership between the civil office of fraud enforcement and the criminal investigation unit and seeks to root out tax evasion from cryptocurrency owners.
In Part 2 of this article, we will look at other enforcement efforts by the IRS, as well as reporting and withholding obligations that might come to the fore based on past IRS enforcement activity.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
David Zaslowsky is a partner in the disputes practice in the New York office of Baker McKenzie and is editor of the firm’s blockchain blog. Scott Frewing is a partner in the tax practice in the Palo Alto office of Baker McKenzie. They can be reached at email@example.com and firstname.lastname@example.org , respectively.
Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.