FINANCIAL SERVICES TRENDS

DECRYPTING THE TAXATION OF BY: GREGORY KASTNER

Issue X – October 2018

INTRODUCTION Mazars USA LLP is an independent member firm of Mazars Group.

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Financial Services Trends

Limited guidance on taxation sold directly to another person at a price you set that is accepted Despite the billions of dollars (which is projected to be trillions in on sites such as LocalBitCoins or BitQuick. They can even be 2018 according to a September 2018 Satis Group report) flowing in converted to a local currency and withdrawn from an ATM at and out of the various such as , places found on Coinatmradar. and Litecoin, the United States taxation of these products is governed mostly by Internal Revenue Service (IRS) Notice 2014- For investors not wanting to own cryptocurrencies directly or 21 issued back on March 25, 2014. With regards to the nuances wanting to use a manager to invest in them, options have begun to and uncertainties not covered by the notice, the IRS has chosen to open up. Privately traded partnerships such as hedge funds or remain mostly silent. private equity funds have begun to trade in cryptocurrencies and offer investors access to their appreciation (or depreciation) What is cryptocurrency through the private placement of these partnership interests. What is a cryptocurrency? Unlike United States Dollars, British Pounds or Euros, cryptocurrencies only exist in the virtual ’s institutional arm has been approved as a qualified universe, meaning there is no tangible paper bill or metal coin that custodian by the state of New York and BitGo by South Dakota. can be physically touched. Nor are they considered legal tender. This license allows them to securely hold deposits of Instead the Internet and only the Internet is used to transfer Bitcoin cryptocurrencies much like a bank account. or Ethereum tokens from their originators to every subsequent owner. Origins Fluctuations in cryptocurrency value depend mostly on people’s A price is set at an Initial Coin Offering (ICO) or Initial Public Coin perception of the value and are not necessarily tied to anything – Offering (IPCO) and then trading begins in the virtual universe. such as earnings of a company, the value of gold or what your dog This is done through a secure Internet portal account sometimes wants for breakfast that morning. Their creation came from a called a coin wallet. A register, accessible to all owners desire to allow fast, better secured, less costly transfers of value extemporaneously, tracks everyone’s ownership and is called a between consumers and producers without the use of bank . This register is updated every time ownership accounts or credit cards. Ability to avoid use of trusted changes. The details of your ownership represented in this intermediaries while retaining anonymity was also coveted. Ideally, blockchain that all others can see is sometimes called your public they would be immune to fluctuations in just one country’s currency key. and to counterfeiting or theft. Obviously, as the market has grown and speculators have stepped in, cryptocurrency’s utility has Access to spend any of your cryptocurrency in your coin wallet is increased from a way to pay for goods or services to also an provided by a private key. This private key is a long list of avenue for speculative investment. Because of the sometimes numbers and letters which needs to be kept secure to prevent extreme volatility in values created by these speculative losing access. investments, some merchants or individuals won’t accept these highly fluctuating cryptocurrencies in lieu of more traditional forms There are three types of cryptocurrency tokens generally – utility, of payment. security and payment: Cryptocurrencies are generally taxed in one of two ways, • Utility or user tokens enable the holder access to a depending on how they were acquired. One area the IRS has not future service being developed – Filecoin, Flipcoin and addressed is whether their use affects their taxation as well. Storj are examples. • Equity security tokens are similar to stock shares in that Mining classified as a U.S. trade or business they carry an ownership element, may have voting When involved in the “mining” or creating of cryptocurrencies, the rights and can earn “dividends.” Digix is an example. taxpayer could be considered as engaged in a trade or business. Debt security tokens act as short-term loans to a The implications of such can be significant. Income generated company and earn the equivalent of interest – Steem from a United States (U.S.) based trade or business is generally utilizes such a scheme. Effectively Connected Income (ECI) – that is, U.S. sourced and subject to federal tax withholding if any profits flow through a • Currency or payment tokens are used as their name partnership or joint venture to a foreign entity or individual. If a implies – Bitcoin, Litecoin, ZCash and Monero are partnership interest involved in producing such income is sold, the examples. proceeds would also be subject to withholding under the new Tax How cryptocurrency is exchanged Cuts and Jobs Act (TCJA) changes to Internal Revenue Code Cryptocurrencies can be exchanged in a few ways. They can be (IRC) §864 and §1446 taking effect in 2018. Such income will sold for cash on certain websites that act as exchanges such as presumably also be treated as subject to self-employment tax Coinbase, or . They can be exchanged for other under IRC §1401 if not received by an incorporated entity. If any types of cryptocurrency on sites such as Shapeshift. They can be of the income flows to a pension plan, charity or IRA account, it

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Financial Services Trends

could also create an unexpected tax liability as this income will years, dissimilar to the rules for individuals. Under the TCJA, also be classified as Unrelated Business Taxable Income (UBTI) however, corporations are subject to a maximum federal tax rate of under IRC §512. only 21%. In the past, long-term investments were probably held at the individual level because of the tax rate differential providing For amounts flowing to an individual, such income would be a more beneficial answer. Now, if long-term investments’ treated as ordinary income and not receive any preferential tax appreciation help fund a business, it may make more sense to rate such as those available to long term capital gains or qualifying leave them in a corporation. Most states do not have a different dividends. A limited partner would classify such income as passive rate for capital versus other types of income. under IRC §469 and generally avoid paying self-employment tax on any profits. General partners and limited liability company Such capital gains or losses on sales of cryptocurrency are (LLC) managing members would receive non-passive income presumably portfolio and not passive for purposes of limited subject to the self-employment tax. If the self-employment tax partners in a fund that invests in cryptocurrency. As such, income element is a concern, structuring the entity as a limited partnership would not be able to be offset against other passive losses such as (LP) instead of as an LLC might be preferable. By statute, limited from a real estate limited partnership interest. partners in an LP are not subject to the self-employment tax. LLC members are not distinctly protected by that same statute. Presumably, if one were to buy and sell cryptocurrency continually Another possible unexpected consequence of “mining” is that such throughout the year, losses would be subject to the wash sale income could also be classified as state-sourced and have state rules under IRC §1091. Different types of cryptocurrency probably income taxes and withholdings due. If where customers reside would not be treated as “substantially identical” for this section but and where the “mining” is done differ, different states’ sourcing if such a trading strategy were employed, these rules need to be rules could possibly subject more than 100% of the income to state considered. To avoid having to analyze the historical trading for income tax as there is not universal uniformity across states with purposes of such tracking, could the Bitcoin or Ethereum be regards to such rules. treated as a security and be eligible for the mark-to-market rules of IRC §475(f) if a timely election is made? Since cryptocurrencies Cryptocurrency is not tangible personal property nor is it services are not traded on what is defined as a qualified exchange at this and so its sale would not incur sales or use tax as would be due in time, presumably they would not be eligible for IRC §1256 mark-to- other retail businesses. market treatment as 60% long term capital gains/losses and 40% short term capital gains/losses. Cryptocurrency does not create Mining classified as a hobby foreign currency gains or losses as defined by IRC §988. If the “mining” of a cryptocurrency does not rise to the level of a trade or business, the IRS could argue any losses incurred should Shorting a cryptocurrency (borrowing with the promise to be classified as hobby losses under IRC §183 and not be allowed. repurchase in the future in the hopes the value will drop) would Generally, a good faith expectation of profit governs such also require looking at the straddle rules of IRC §1092. classification. Usually, a single occurrence does not rise to the Debt tokens, presumably, would be subject to the market discount level of trade or business. and original issue discount rules of IRC §1276 and §1272. Some of the gains might need to be reclassed as ordinary income or a Held for investment current inclusion of income might be required depending on the If the taxpayer is not “mining” and only involved in buying and interest actually paid. selling cryptocurrency created by others, it is treated as an investment in property. As such, gain or loss is treated as capital After the TCJA took effect at the beginning of 2018, only in character. For individuals, if it is held one year or less, it is exchanges of real property are eligible for a tax-free exchange treated as short term capital gain or loss and long term if held under IRC §1031. Prior to the new tax law, this was uncertain as longer. Under the TCJA, long term capital gains carry a maximum the law did not specify real property, but only property. federal rate of 20% and short-term capital gains carry a maximum Expenses attributable to the trading or investing in Bitcoin as an federal tax rate of 37%. Only $3,000 of capital losses in excess of investment would be subject to the same rules as investing in other capital gains are allowed to an individual per year and any of these securities, i.e. either being classified as an “above-the-line” unused losses can be carried forward indefinitely. Such income is ordinary deduction or as a miscellaneous itemized deduction also net investment income for purposes of the 3.8% tax on whose benefit was eliminated for individuals by the TCJA. For individuals with modified adjusted gross income over $200,000 corporations and PFICs, there is no such limit on these expenses ($250,000 for married couples filing jointly). and they are essentially treated as deductible expenses.

For corporations, no capital losses in excess of capital gains are Assignment of basis for sales and forks allowed and there is not a different federal income tax rate for long In terms of which layer is sold and how to assign a tax basis to term versus short term. With some restrictions, capital losses may such layer held for investment, the default method for sales of be carried back three years for corporations and forward only 5 stock under Treasury Regulation §1.1012-1 would be first in, first

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Financial Services Trends

out (FIFO). However, the option to identify the highest priced layer assess additional tax to 6 years if the excess is substantial. as being sold first is allowed. Such identification must be made at Substantial is defined in this context as over 25% of gross income the time of the sale. Despite the regulation referring to sales of for the year. Some states extend the statute even longer than the stock, many practitioners are applying these rules to federal government. If the omission is deemed fraudulent, cryptocurrency because of the similarities and not the average cost however, there is no time limit. method available to holders of mutual fund (Regulated Investment Company) shares. No Form 1099s are currently issued from If cryptocurrency is received for services as an employee, income cryptocurrency operators, so the taxpayer would have to track the still needs to be recognized for income tax purposes and all various layers and tax basis of each layer. required payroll taxes paid by the employee and employer.

Another area of uncertainty with regards to tax treatment is that of Required disclosures forks of cryptocurrency (such as for holders of Besides properly reporting the income tax consequences of any Bitcoin). Forks generally occur when there is a change in the cryptocurrency transaction, any direct or indirect holdings of software that cryptocurrency miners use, sometimes because of a cryptocurrency could potentially be subject to information reporting dispute, and owners of the current cryptocurrency receive new as well. The filing requirements of Form 114, Report of Foreign keys that give them value on a new blockchain. Should this Bank and Financial Accounts or the so-called FBAR, and Form transaction be treated the same as a stock split and just some of 8938, Statement of Specified Foreign Financial Assets should both the cost basis assigned proportionately to it? Is no basis assigned be considered if the cryptocurrencies are held by an offshore under the argument that no ascertainable value exists for the new vehicle or held in an offshore coin wallet. Failure to file these cryptocurrency? Is income recognized to the extent that the new forms in some cases can be argued as willful and the penalties fork has a market value? If the old cryptocurrency is eliminated, is severe. this some sort of tax-free exchange similar to those offered for stock under IRC §368, even if this does not all happen all at once? Owners of cryptocurrency also need to comply with the Anti-Money On these questions, the IRS has so far remained silent. However, Laundering rules initiated by the Bank Secrecy Act of 1970 and there is a Supreme Court case from 1955, Commission vs. possibly file Currency Transaction Reports or Suspicious Activity Glenshaw Glass Co. that many practitioners site as perhaps the Reports. All carry stringent recordkeeping requirements. governing doctrine. Conclusion According to the case, when a taxpayer receives undeniable While there is a lack of specific guidance on the taxability of accessions to wealth, clearly realized, and over which the taxpayer cryptocurrencies, the proper treatment and consequences can be has complete dominion, a recognition of income must occur. If the extrapolated from other sources in most examples. Proper new cryptocurrency, the fork, has value and can be traded without disclosures should be considered to prevent possibly severe hindrance immediately, it appears there could be a taxable event penalties for non-compliance. upon the fork. Unlike a stock split where the price has just been altered per share, something new has been created: a new For questions on the article above or for other help with any other cryptocurrency. If, however, a value cannot be placed on the fork tax or accounting issues, please contact me or any member of our or it cannot be traded now or with any definite timeframe in the team of seasoned professionals at Mazarsusa.com. future, it may not have to be recognized as income today. The IRS, however, is generally not too keen of deferrals of what they deem to be income and so these restrictions would have to have FOR MORE INFORMATION CONTACT: merit. Regardless, forks have not been directly addressed by the GREGORY KASTNER, CPA

IRS and so either approach is not definitively correct and each case should be analyzed individually. DIRECTOR FINANCIAL SERVICES GROUP Used to pay personal expenses +1 212.375.6583 What if cryptocurrency is directly used to pay for personal [email protected] expenses? A gain or loss might be incurred. If it’s a loss, the taxpayer would have to argue that the cryptocurrency was held for investment and then a capital loss could be recognized. Personal- VISIT US AT www.mazarsusa.com use asset losses are not deductible – such as losses on sale of a car or a personal residence like a house or boat. Disclaimer of Liability Our firm provides the information in this e-newsletter for general guidance only, and does not constitute If it’s a gain, the taxpayer would be required to recognize the gain the provision of legal advice, tax advice, accounting services, investment advice, or professional under IRC §61. Failure to report such a gain could extend the consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any statute of limitations from the normal three years the IRS has to decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation.

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Financial Services Trends

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