Income, from Whatever Exchange, Mine, or Fork Derived: The Basics of U.S. Cryptocurrency Taxation1

By Kathleen R. Semanski2

n this article, intended as an introduction to the inter- taxable under current law at marginal rates up to 37 Iesting and myriad tax issues arising in the world of percent (or 40.8 percent, factoring in the net invest- cryptocurrency and blockchain technology, we focus on ment income tax3). In contrast, gain or loss on the sale certain U.S. federal income tax consequences of crypto- of property can constitute either ordinary income or currency transactions. The following is a very high-level capital gain, depending on whether the property sold discussion of the consequences generally applicable to is or is not a capital asset. If a capital asset, the reduced U.S. individual holders of cryptocurrencies and will long-term capital gains rate (up to 23.8 percent under not be applicable to all taxpayers depending on their current law, including the net investment income tax) particular situation. Moreover, as there is limited of- could apply if the asset sold was held for more than 1 cial guidance addressed to cryptocurrency transactions, year. this article relies largely on predictions of how gen- eral tax principles may be applied to cryptocurrency There are compelling arguments for treating cryp- transactions. tocurrency as money or, alternatively, as property, the theoretical merits of which are beyond the scope of 1. Is It Property or Is It Currency? this article. For present purposes, the opinion that A “cryptocurrency,” generally, is a digital or virtual matters is that of the U.S. Internal Revenue Service currency that functions as a medium of exchange by (the IRS), and fortunately the IRS has given us some using encryption in lieu of a centralized issuing or reg- guidance. In Notice 2014-21,4 the IRS declared that ulatory authority to verify transactions and to manage “convertible virtual currency,” that is, virtual cur- the issuance of new coins. A “coin” is a unit of value rency having an equivalent value in “real currency” associated with a cryptocurrency—the crypto equiva- (such as the U.S. dollar) is “property” for U.S. federal lent of a U.S. dollar. income tax purposes.5 Therefore, the tax treatment of cryptocurrency transactions will generally follow Although it might seem an academic question, the the rules applicable to transactions involving noncash distinction between property and currency is critical to property. understanding U.S. federal income taxation of crypto- currencies. Generally, when a U.S. individual or business Whether income realized on an exchange of prop- uses cash to purchase property, the holder of the cash is erty is ordinary or capital will generally depend on not taxable on any gain or loss inherent in the cash used whether the property exchanged is a “capital asset” in for the purchase (i.e., changes in the value of the U.S. the hands of the seller, which depends on the taxpay- dollar between the time the cash was earned or other- er’s purpose in holding the property. Property held for wise acquired by the holder and the time of the sale). investment purposes (i.e., in anticipation of the prop- Gain on nonfunctional foreign currency exchanges (i.e., erty’s appreciation over time) generally will be treated currencies other than the main currency used by a trade as a capital asset. The same type of property, if held as or business) is generally ordinary income and, therefore, “inventory” of the taxpayer (i.e., for sale to customers in the ordinary course of the taxpayer’s trade or business), would not qualify as a capital asset. In other words, coins purchased and held by an investor would generally be Kathleen Semanski is an associate in the Tax Department at a capital asset, whereas coins held for sale by a dealer in Proskauer Rose LLP. cryptocurrencies would not.

8 • Banking & Financial Services Policy Report Volume 37 • Number 6 • June 2018 2. How Is Income (or Loss) Calculated more than 1 year before using it to buy donuts, John’s in a Coin Exchange? gain would be taxed at the long-term capital gains rate. In a transaction for cash The donut shop would have gross receipts of $5.00 When cryptocurrency is purchased with U.S. dollars, from the sale to John and would take a $5.00 tax basis in the purchaser generally will take a tax basis in the coins the Bitcoin received. equal to the amount of cash paid. Later, when the coins are sold to another party for U.S. dollars, the amount of In an exchange of coins for coins taxable gain (or loss) on the sale is the diference between Under Notice 2014-21, an exchange of coins of one the original purchase price (i.e., the holder’s “tax basis” ) cryptocurrency for another type of cryptocurrency will, and the later sale price. As explained above, whether the in most cases, be treated as a taxable sale. Similar to the taxpayer’s gain or loss is capital or ordinary depends on treatment of the exchange of cryptocurrency for prop- whether the coin was a capital asset in the hands of the erty, the amount of gain or loss realized on the sale is taxpayer (i.e., whether the property was held for invest- the diference between the taxpayer’s basis in the cryp- ment). If a capital asset, the applicable tax rate will depend tocurrency exchanged (usually the U.S. dollar value of on whether the coin was held for longer than a year. whatever “real” currency was used by the taxpayer to purchase the cryptocurrency) and the fair market value In a transaction for property and/or services of the cryptocurrency received as of the date of the Cryptocurrencies are considered a type of property exchange. other than money. Therefore, when coins are used to purchase other (noncash) property and/or services, the Prior to January 1, 2018, some taxpayers and prac- exchange is a property-for-property exchange (i.e., a titioners took the position that cryptocurrency-for- “barter” exchange). Generally speaking, when a tax- cryptocurrency exchanges qualifed as “like-kind payer exchanges property for other property in a tax- exchanges” under section 1031 of the Code. In a like- able sale, the amount “realized” by the taxpayer is the kind exchange, tax on any unrealized appreciation in fair market value of the property received (measured as the currency relinquished in the exchange is deferred; of the sale date). The amount of gain or loss realized by the tax basis in the relinquished currency carries over to the seller is the diference between the amount realized the replacement currency and the untaxed gain is pre- and the seller’s basis in the cryptocurrency used to make served until a later disposition of the replacement cur- the purchase. The buyer would acquire a tax basis in the rency for cash or other (non-like-kind) property. This cryptocurrency received equal to its fair market value question has been mooted for tax years beginning after on the date of exchange.6 December 31, 2017, as changes to the tax law enacted at the end of 2017 limit like-kind exchange treatment To illustrate by way of example, imagine that John, a to real property transactions.7 However, taxpayers enter- U.S. individual taxpayer, purchased Bitcoin as an invest- ing into cryptocurrency-for-cryptocurrency exchanges ment for its fair market value in cash in a single transac- prior to January 1, 2018, may want to consult their tax tion dated November 8, 2015 (closing price reported on advisors as to the viability of the like-kind exchange CoinDesk: $373.49). If exactly 2 years later, on November reporting position. 8, 2017, John uses Bitcoin (closing price reported on CoinDesk: $7,458.79) to purchase a bag of mini-do- Determining basis in coins exchanged nuts for $5.00 from a donut shop in Austin, Texas, John In order to calculate the amount of taxable gain would have taxable gain on the diference between the or loss realized in a sale or exchange, a taxpayer must fair market value of the donuts ($5.00) and John’s basis know its basis in the coins exchanged. Where a tax- in the Bitcoin used in the exchange. Assuming that the payer acquires all of its coins in a single transaction, CoinDesk closing price for Bitcoin represents fair mar- this should not be too hard to determine. Generally, ket for the date of the transaction, in addition to empty the taxpayer’s basis in each coin should equal the price calories, John would have taxable gain on his purchase paid for each coin—either the amount of cash received of the donuts equal to approximately $4.75 [$5.00 × or the fair market value of the property relinquished ($7,458.79 − $373.49)/$7,458.79 = $4.749]. Because in the exchange. If the taxpayer acquires several coins John acquired the Bitcoin for investment and held it for at the same time and later disposes of only a portion of

Volume 37 • Number 6 • June 2018 Banking & Financial Services Policy Report • 9 them, the taxpayer’s aggregate basis in the coins would be eligible for average cost basis reporting (which be distributed proportionately to each individual coin. essentially spreads aggregate basis evenly among the For example, assume a taxpayer purchased 10 coins of taxpayer’s shares).11 currency X (X coins) for $10.00 in March 2015, and in March 2017 disposed of fve coins for $25.00. The tax- If cryptocurrencies are treated for tax purposes as payer’s basis in the X coins exchanged would be $5.00, commodities rather than securities, the regulations gov- or $10.00 × 5/10. Its gain on sale would be $20.00, or erning tax basis in stock dispositions may apply to com- the excess of $25.00 over its basis of $5.00. The taxpay- modities by analogy.12 The Commodity Futures Trading er’s remaining $5.00 basis would be allocated among the Commission (CFTC) has determined that Bitcoin fve X coins retained. and other cryptocurrencies are commodities.13 While the CFTC’s conclusion is not binding on the IRS, the The determination of basis becomes more compli- IRS has looked to the fnancial world to determine the cated (and less certain) where the taxpayer has acquired meaning of the word “commodity” as used in other pro- its coins in multiple transactions and at varying prices.8 visions of the Code.14 An alternative approach would be Returning to the previous paragraph’s example, assume to apply the rules for determining basis in nonfunctional that the taxpayer does not dispose of its fve X coins currency transaction. Regulations generally provide that in March 2017 but rather acquires fve additional X the basis of nonfunctional currency withdrawn from a coins in August 2017 for $100.00 (or $20.00 each). In bank account may be determined using “any reasonable December 2017, when the market price of one X coin method that is consistently applied from year to year.” has decreased to $10.00 per coin, the taxpayer decides Specifc examples given are frst-in, frst-out, last-in, to sell fve of its coins for $50.00 (or $10.00 each). If frst-out, and pro rata. Although the IRS declined to the taxpayer is treated as disposing of fve of the X coins classify cryptocurrency as currency in Notice 2014-21, acquired in 2015, the taxpayer will have a gain of $45.00, and so the nonfunctional currency regulations do not or $50.00 less its basis of $5.00. If instead the taxpayer apply to cryptocurrencies by defnition, the IRS may is treated as disposing of the fve X coins acquired in apply similar rules by analogy. August 2017, the taxpayer would have a loss of $50.00. Clearly, if the choice is left up to the taxpayer, it would Applying the stock rule to the X coin example above, prefer the latter outcome. if the taxpayer were able to adequately identify the X coins delivered to the buyer in the December 2017 Under section 1012 of the Code, a taxpayer’s basis exchange as those acquired in August 2017, the taxpayer in property sold is generally the cost of that prop- would be treated as having sold the higher basis coins and erty to the taxpayer, subject to certain adjustments. would be able to claim a loss for tax purposes. Because all By default, this requires specifc identifcation unless transactions are stored on the blockchain, adequate iden- another basis accounting method is allowed by the tifcation is theoretically possible if a taxpayer has direct Code or regulations.9 Although Notice 2014-21 does control over the keys to its coin wallet and is sophisticated not address basis accounting for cryptocurrencies, enough to select (and establish to the satisfaction of the analogies can be drawn to other areas of the tax law. IRS) what coins are transferred to the buyer. Adequate For example, Treasury regulations provide that a tax- identifcation may be difcult if not impossible for a tax- payer disposing of stocks or bonds will be treated for payer holding its coins on a cryptocurrency exchange, as tax purposes as disposing of its high-basis stocks or the exchange may not give users the option to select the bonds frst only if it is able to “adequately identify” particular coins transferred or provide the required evi- the particular stocks or bonds delivered to the buyer dentiary support. Another way to manage identifcation (i.e., by showing delivery to the buyer of certifcates may be to hold each “lot” of coins (i.e., group of coins representing shares that were acquired on a partic- acquired at the same time and at the same price) in a ular date for a particular price).10 If the taxpayer is separate wallet or on a separate exchange. not able to adequately identify the shares delivered, the taxpayer is treated as having sold the earliest- If the stock rules do not apply, taxpayers arguably acquired shares frst, known as the “frst-in, frst- should be able to use FIFO or another reasonable method out” or “FIFO” method, or in some instances may to determine basis in their coins exchanged by analogy

10 • Banking & Financial Services Policy Report Volume 37 • Number 6 • June 2018 to the regulations applicable to nonfunctional currencies, produces two separate versions of the cryptocurrency’s provided that the method used is consistently applied blockchain sharing a common history.17 The Bitcoin/ and does not consistently result in high-basis units being Bitcoin Cash hard fork resulted in each holder (i) receiv- disposed of frst.15 If the taxpayer in the example above ing an amount of Bitcoin Cash nominally equivalent to were permitted to use the last-in, frst-out method to its holdings of Bitcoin immediately before the fork and determine its basis in the X coins sold in December 2017, (ii) retaining its pre-fork Bitcoin. Although most peo- it would presumably be required to apply this method ple would agree that Bitcoin Cash has value (the trad- to all of its cryptocurrency transactions.16 Nevertheless, ing price of a single coin topped $4,000 in December given the lack of IRS guidance on the subject, the saf- 2017), it is unclear when this value is “income” for tax est approach may be to use specifc identifcation, if this purposes, the amount of income realized, and the tax method is feasible (and if identifcation is supported by character of this income. the user’s cryptocurrency exchange). Accession to wealth: the Glenshaw Glass A note on valuation approach Assuming the cryptocurrency is both acquired and The most straightforward treatment, arguably, would sold for cash, and adequate records are kept, the deter- be to treat the new coins received in a cryptocurrency mination of any taxable gain or loss should be fairly fork as a taxable windfall (similar to lottery winnings) straightforward. In contrast, if a taxpayer acquires coins under the basic test for income set forth in Commissioner v. by mining, or receives coins as payment for goods or Glenshaw Glass:18 it is an undeniable accession to wealth, services (or in exchange for other coins), determining clearly realized, over which the recipient has complete the coins’ fair market value as of the relevant testing dominion and control (assuming that the recipient has date can be a signifcant challenge. In addition to vol- access to the new cryptocurrency, discussed below). The atile day-to-day trading prices (over the course of less result would be ordinary income to the recipient equal than 3 weeks in November, the trading price of Bitcoin to the fair market value of the property received as of dropped as low as $5,857.32 before rebounding to a the date of receipt and without any reduction for the price over $10,000 on some Korean exchanges), crypto- return of capital (i.e., the recipient’s basis in the crypto- currencies generally lack a centralized trading platform currency immediately before the split). (or, initially, any formalized trading platform), making it difcult to identify a single, U.S. dollar-denominated While sound as a matter of general tax principles, market price. Notice 2014-21 does not give further this approach presents signifcant practical challenges. insight into how fair market value is determined, noting Staying with Bitcoin Cash as an example, it is unclear only that the taxpayer’s determination must be made “in when the initial recipients of Bitcoin Cash actually a reasonable manner that is consistently applied.” “realized” this income. Depending on where Bitcoin holders stored their Bitcoin, some recipients did not 3. Are Forks Taxable? have (and could not get) the digital keys necessary to immediately access the Bitcoin Cash (and/or convert Coin “splits” and “hard forks” the Bitcoin Cash into actual cash), raising a question As explained above, exchanges of property for other of “dominion and control” under the Glenshaw Glass valuable property generally results in taxable gain (or test. Just as signifcant is the valuation difculty. There loss) equal to the diference between the fair mar- was no readily available market for Bitcoin Cash until ket value of the property received and the taxpayer’s sometime after the split and, even then, trading prices basis in the property exchanged. Although this general varied considerably among the diferent exchange plat- principle also applies to exchanges of one cryptocur- forms. Although the initial value of the Bitcoin Cash rency for another (e.g., Bitcoin for Ethereum), it is not distributed to Bitcoin holders was, nominally, equal to clear whether (or how) this principle applies where an the value of the recipients’ Bitcoin holdings, the values entirely new cryptocurrency splits of from an existing of the two cryptocurrency products quickly diverged cryptocurrency (e.g., Bitcoin Cash and Bitcoin), also as a separate market for Bitcoin Cash emerged. The known as a “hard fork.” A hard fork generally results uncertainty surrounding the moment of realization fur- from a change to the cryptocurrency’s software, which ther complicates matters: given the market volatility of

Volume 37 • Number 6 • June 2018 Banking & Financial Services Policy Report • 11 cryptocurrencies, shifting the testing date for fair market after as immediately before the split. It is, however, dif- value even a day or two can have a signifcant efect on cult to maintain this argument in the case of the Bitcoin the amount of gain realized. Cash hard fork, given that it actually resulted in the cre- ation of a new cryptocurrency having unique character- No realization event: the stock istics, its own blockchain, and ultimately an independent dividend approach trading value. There is also potential for value redistribu- Another approach would be to look at coin forks as tion in a hard fork that would not be present in a pure analogous to dividends paid with respect to stock. Stock split. Although all holders of Bitcoin nominally received dividends and stock splits that do not result in a change an equivalent amount of Bitcoin Cash in that fork, not in the recipient’s proportionate ownership of the issuer all holders had the digital keys to access the new coins are generally not taxable events under the Code.19 Any and not all storage platforms supported the new cur- built-in gain is deferred until the stockholder sells or rency. If the two currencies are viewed as sharing in the otherwise disposes of its stock for money or other prop- same underlying market capitalization, this means that erty. In contrast, the receipt of a cash distribution, or a some of the value of original Bitcoin shifted to Bitcoin distribution of other property (for example, securities of Cash in the fork, resulting in a disproportionate gain another corporation), is a taxable event and can result to those with access and a corresponding loss to those in ordinary income, return of basis, and/or capital gain without. In a decision subsequent to Eisner v. Macomber, to the recipient, depending on the particular circum- the Supreme Court noted that while a proportionate stances. Although analogies can be drawn to coin splits, distribution of new common shares conferring no new the current tax treatment of stock dividends is deter- rights or interest in the issuer was not taxable, “where a mined under statutory rules specifc to distributions to stock dividend gives the stockholder an interest diferent stockholders; although cryptocurrencies are property, from that which his former stock holdings represented, they are not currently treated as “stock” for tax pur- he receives income.”21 Under this test, the receipt of poses. Applying these statutory provisions to cryptocur- Bitcoin Cash appears to be income. rency distributions would probably require action from Congress, although IRS guidance may be able to apply Taxability without liability: the zero similar treatment to cryptocurrencies by analogy. value approach The American Bar Association tax section, in an open Alternatively, the IRS could treat a cryptocurrency letter (the ABA Letter), recommended that cryptocur- split as not a taxable event at all, if the converted cur- rency received in a hard fork during the 2017 tax year rency is substantially identical to the property previously be treated as a taxable event at the moment it is received, held by the taxpayer. Rather than recognizing gain at reasoning that a taxpayer’s ability to use both the origi- the time of the split, the unrealized gain inherent in the nal currency and its “forked” progeny is an accession to additional coins issued would be taxed when the coins wealth under Glenshaw Glass principles.22 However, the are converted into cash or used to purchase property or ABA Letter also proposes that the value realized in the services. Before the adoption of sections 305 and 306 of taxable event could be zero, which would result in no the Code (which today govern stock distributions), the immediate tax liability (although the taxpayer’s basis in Supreme Court in Eisner v. Macomber20 considered the the coin would be zero). Instead, when the forked coin tax consequences of pro rata stock dividends, concluding was subsequently disposed of, the taxpayer would pay that their receipt was not taxable because not a proper tax on the entire value of the cash property received in “realization” event. The payment of stock dividends did the exchange. If the taxpayer held its cryptocurrency as not mark a change in the value of the corporation or a capital asset, the gain on this subsequent disposition the shareholder’s entitlement to or participation in the would be capital. The argument for treating the fork corporation’s assets or profts. as a realization event, despite some taxpayers’ limited access to either the new coins (e.g., because the coins This approach might make sense for a traditional are hosted on an exchange that has not enabled access), split—for example, if each holder received additional is that a taxpayer could take afrmative steps to claim coins of the same cryptocurrency but the aggregate the new coins and is, therefore, in constructive receipt. exchange value remained exactly the same immediately The amount realized, however, is zero, because at the

12 • Banking & Financial Services Policy Report Volume 37 • Number 6 • June 2018 moment the new coin is received it is not yet known if the intentions of the parties engineering the fork and the new protocol will be adopted, whether a market for the response by the community of stakeholders. If we the coin will develop, or what the market price will be. follow the technical approach, it appears the taxpayer would have a new capital asset, a new basis (of zero), Treating the fork as a zero basis, taxable event has and a new holding period in its post-fork Ethereum. A several advantages for taxpayers. First, having a taxable disposition of Ethereum on the next day would result event bolsters the argument that the later gain on the in short-term capital gain equal to the entire amount disposition of the coin is capital: when a taxpayer hold- of cash or the value of other property received in the ing the original coin as a capital asset acquires a forked exchange. Even if the taxpayer could claim a capital loss coin, it acquires a new capital asset (albeit one with zero on its legacy Ethereum Classic, depending on the tax- value). Second, a taxable event starts the clock on the payer’s holding period, this could be a long-term capital 1-year holding period for long-term capital gain on the loss, resulting in a character mismatch (the long-term subsequent disposition of the forked coin. Last, the zero capital loss not fully ofsetting the tax on short-term value, zero basis premise allows the taxpayer to defer any capital gain). On the other hand, if the taxpayer decides tax liability until a subsequent disposition of the coin. to retain its post-fork Ethereum and is able to claim an immediate capital loss on its Ethereum Classic, it could Although the zero basis approach resolves the logis- potentially receive a tax beneft without having realized tical problems of timing of realization and valuation of an economic loss. amount received, it leaves some questions unanswered as to general application. What happens in the case of a Although the Ethereum example underscores the hard fork where only the forked coin survives and orig- weaknesses of a too-technical approach, the qualitative inal coin falls into obsolescence? The expectation often approach is problematic in its own way. It seems clear in hard forks is that only one of the two resulting cryp- in hindsight that the Ethereum fork would result in tocurrencies will survive. For example, in 2016, the core the wide adoption of the new protocol, but this result developers of Ethereum decided to implement a hard was not inevitable or uniform. A small but signifcant fork to correct a weakness in the existing Ethereum minority maintained the original protocol, continuing protocol23 that had left it vulnerable to hacker attack. to hold and to mine Ethereum Classic. It seems reason- While the developers consulted the Ethereum commu- able for these users to retain their basis in legacy (i.e., nity24 in hopes of reaching a general consensus on the pre-fork) Ethereum in their Ethereum Classic. As of desirability of the hard fork, because of the decentralized this writing, there has been no IRS guidance published nature of the Ethereum platform, the decision whether, specifcally addressing this issue, leaving considerable post-fork, to participate in the original or the new ver- uncertainty for those recipients of the estimated $5 bil- sion of Ethereum would ultimately be left to the partic- lion worth of Bitcoin Cash who have yet to fle their ular stakeholders (e.g., the miner, exchange, or platform). 2017 tax returns. Ultimately, the majority of Ethereum users moved to the new Ethereum blockchain (which retained the name 4. Other Taxable Cryptocurrency “Ethereum”), while approximately 15 percent stayed on Transactions the original blockchain (redubbed “Ethereum Classic). Within hours of the fork, Ethereum Classic was valued Cryptocurrency-denominated compensation at 1/10 the value of Ethereum; while the disparity has An employee who receives compensation denom- grown, Ethereum Classic, nevertheless, currently trades inated in cryptocurrency is subject to tax at ordi- at a higher price than pre-fork Ethereum.25 nary income rates on the fair market value of the coins received. Additionally, cryptocurrency paid to Should a taxpayer’s basis in its pre-fork Ethereum an employee as compensation is generally treated as carry over to the post-fork Ethereum, or has the tax- “wages” for employment tax purposes and is there- payer acquired a new capital asset with a zero basis? fore subject to federal income tax withholding The answer depends on whether we regard the post- as well as unemployment and FICA taxes.26 As the fork coin as a new capital asset simply because it exists U.S. government does not currently accept tax pay- on a new blockchain protocol, or whether we look to ments in the form of cryptocurrency, a portion of

Volume 37 • Number 6 • June 2018 Banking & Financial Services Policy Report • 13 the cryptocurrency would have to be liquidated into recognized to any particular individual except through cash before being remitted by the employer.27 The ownership of one’s keys. For persons who store their employee would take a basis in the cryptocurrency private keys on physical hard drives or in “paper wal- received equal to the amount of income recognized lets,” losing the hard drive or wallet can mean the loss upon its receipt. The employer would also have tax- of an entire fortune without any hope of recovery. In able gain to the extent of any appreciation in the 2013, a Welsh man, James Howells, famously claimed to cryptocurrency used to pay the employee’s compen- have lost his private keys to 7,500 Bitcoin after acci- sation (which would be ofset by the employer’s com- dentally throwing away the hard drive on which they pensation deduction). were stored. When the trading price of Bitcoin sur- passed $17,000 per Bitcoin in December 2017, Howells Currency “mining” activities sought (and was denied) permission from his local city A taxpayer who acquires cryptocurrency as a result council to dig up a local landfll in hopes of recover- of “mining” activities (i.e., the consumption of com- ing the lost drive.31 Had Howells been a U.S. taxpayer, puter resources to verify and record cryptocurrency he arguably would not have been able to claim a loss transactions on a blockchain ledger) will generally real- for the lost Bitcoin in 2013 or at any time prior to ize ordinary income for U.S. federal income tax pur- December 2017 (and then, only once appeals before poses upon receipt of the mined coin equal to their fair the city council were abandoned and all rights in the market value on the date of receipt.28 A miner can be coins relinquished).32 A taxpayer generally must show an viewed as performing a service for all other holders of intent to abandon in order to claim a loss deduction for the cryptocurrency; the service is compensated by a pro abandoned property, which requires, at a minimum, that rata dilution of all other holders when a new coin is the taxpayer cease efort to recover the lost coins and issued to the miner. Therefore, the miner’s income will show additional afrmative steps to irrevocably relin- generally be ordinary. The miner’s basis in the newly quish ownership.33 Because loss deductions are limited mined coin will equal the amount of income realized to the taxpayer’s adjusted basis in the lost property (in upon its receipt. Howells case, the amount of income reported by him in connection with his mining of the lost coins), the actual An individual taxpayer engaged in cryptocurrency amount of any permitted deduction may be negligible. mining as a trade or business (and not as an employee) will have to pay self-employment taxes on the fair mar- An investor may also claim a loss deduction if its ket value of any cryptocurrency received but may be coins are stolen in a hacking attack or following phys- able to deduct or capitalize certain expenses (e.g., the ical theft of its private keys in the year when the theft cost of electricity, computer equipment). is discovered.34 While worthlessness may theoretically occur where a cryptocurrency is valued so low that that Worthless and abandoned coins miners cease to expend the energy to verify transactions Taxpayers generally are able to deduct losses where on the cryptocurrency’s blockchain, it is not clear that investment property is lost or is permanently abandoned a taxpayer would be able to claim a loss without an by the taxpayer.29 The amount of the deduction would afrmative abandonment or some other taxable event.35 be the taxpayer’s adjusted basis in the lost or abandoned Section 165(g), which allows taxpayers deductions for coin (generally, its cost basis); if the taxpayer held the losses on worthless securities, adopts a narrow defni- coin as a capital asset, the character of the loss would be tion of “security” and is therefore unlikely to apply to capital.30 cryptocurrencies.36

The worthless and abandoned property rules raise 5. How Is Income from Cryptocurrency interesting timing questions when applied in the cryp- Transactions Reported to the IRS? tocurrency context. For example, the loss or abandon- ment of a coin may occur where the taxpayer loses Gain (or loss) on cryptocurrency exchanges its private keys. Losing one’s private keys is similar to As the IRS recently reminded taxpayers, U.S. taxpayers losing cash; because of the anonymous and encrypted must report their gain and loss from Bitcoin transactions nature of the blockchain protocol, ownership cannot be just as they would gain and loss from any other property

14 • Banking & Financial Services Policy Report Volume 37 • Number 6 • June 2018 transaction.37 Until the IRS designates cryptocurrencies minimis rule for reporting gain on cryptocurrency as “specifed securities” for U.S. federal income tax pur- transactions along the lines of the exemption currently poses, coin exchanges should not be required to issue available for certain nonfunctional foreign currency Form 1099-B informing taxpayers of their gain or loss transactions under section 988 of the Code.44 The Polis on brokered coin transactions.38 Taxpayers who do not and Schweikert bill was not included as part of the receive a Form 1099-B are, therefore, required to deter- comprehensive tax legislation45 passed in December of mine their tax basis in the coins they acquire and to last year. It is unclear whether or when this bill will be keep track of this basis in order to calculate gain or loss considered by Congress in the future. upon later sale. Some coin exchanges may allow users to download a fle of their account history so that they Income received as payment for goods can track gains and losses for tax purposes. This amount or services is then reported to the IRS on Form 8949 and attached Employees or independent contractors that receive to the individual’s tax return. cryptocurrency as payment for services should receive a W-2 or 1099-MISC, as applicable, indicating the fair Some exchange platforms, such as Coinbase, have market value of the cryptocurrency paid as of the date begun providing their users tax basis reporting infor- of payment.46 Notice 2014–21 imposes specifc infor- mation.39 Third-party providers such as CoinTracking mation reporting requirements both on employers and calculate taxable gain and loss for users based on infor- on persons who purchase services from independent mation from past cryptocurrency transactions uploaded contractor for use in their trade or business. Third-party by users.40 While the Coinbase tax basis report applies settlement organizations (TPSOs) such as Coinbase the frst-in, frst-out method to calculate gains and losses are also subject to reporting requirements if the num- from cryptocurrency transactions, CoinTracking allows ber and the dollar value of the transactions they settle users to calculate taxable gain using a variety of basis exceed certain thresholds.47 accounting methods, including frst-in frst-out, last-in frst-out, highest cost frst-out, and lowest cost frst-out. The IRS Coinbase summonses On November 29, 2017, a U.S. federal district court De minimis exception ordered Coinbase to turn over to the IRS personal As a result of the IRS’s decision to treat cryptocurrency identifcation and fnancial information on as many as as property, generally every exchange of cryptocurrency 14,355 account holders and 8.9 million transactions is taxable, even something as seemingly inconsequential (according to estimates provided by Coinbase). 48 The for tax purposes as buying a cup of cofee with crypto- IRS had brought the “John Doe” summons against currency or withdrawing cash from a Bitcoin ATM. In Coinbase after an investigation had revealed evidence of contrast, section 988 of the Code (governing exchanges mass underreporting of bitcoin-related gains. (According of nonfunctional foreign currency) exempts up to $200 to the IRS summons, cited in the court’s order, between of exchange rate gain on personal use transactions con- 800 and 900 taxpayers reported Bitcoin-related gains ducted in foreign currency.41 There have been eforts to on an electronically fled Form 8949 during the years introduce a de minimis exception to the tax reporting covered by the order, a number vastly lower than the requirements for cryptocurrency transactions, appar- estimated number of users engaging in taxable crypto- ently motivated by a concern that Notice 2014-21 currency transactions.) Although the order was limited has inhibited the development of cryptocurrency as a to account holders having bought, sold, sent, or received day-to-day medium of exchange.42 In 2017, Rep. Jared cryptocurrency worth $20,000 or more in a single year, Polis (D-Colo.) and Rep. David Schweikert (R-Ariz.) it is probable that the IRS will continue to pursue sim- introduced a bill, The Cryptocurrency Tax Fairness Act, ilar orders against Coinbase and other exchanges until which would exclude the frst $600 (adjusted for infa- legislation implementing uniform third-party reporting tion) of gain from a single cryptocurrency transaction procedures are adopted. (or a series of related transactions) from gross income for U.S. federal income tax purposes.43 Both the American Financial crimes and tax evasion Bar Association Section of Taxation and the American Notwithstanding the general characterization of Institute of CPAs have previously recommended a de cryptocurrencies as property for U.S. tax purposes, the

Volume 37 • Number 6 • June 2018 Banking & Financial Services Policy Report • 15 U.S. Treasury’s Financial Crimes Enforcement Network www.blockchainandthelaw.com/2017/11/income-from-whatever- (FinCEN) regards “exchangers” (i.e., cryptocurrency exchange-mine-or-fork-derived-the-basics-of-u-s-cryptocurrency- exchanges such as Coinbase) as “money service busi- taxation/. 2. The author would like to thank Michael Fernhof, Jeremy 49 nesses,” or MSBs. Therefore, although a cryptocur- Naylor, and Eftychios Pnevmatikakis for their thoughtful com- rency is not itself “money,” cryptocurrency exchanges ments to this article. Any errors are solely those of the author. are required to report when Bitcoin is exchanged for 3. Section 1411 of the U.S. Internal Revenue Code of 1986, as large amounts of actual money under rules intended amended (the Code). All references to section numbers are to to prevent money laundering. While not all crypto- sections of the Code or to the Treasury Regulations promul- gated thereunder except as otherwise provided. currency exchanges have complied and registered with 4. IRS Notice 2014-21, 2014-16 I.R.B. 938. FinCEN as MSBs, the penalties for failure to comply 5. Although the Notice only applies expressly to convertible vir- can be steep.50 tual currencies, we assume the same rationale would apply to cryptocurrencies generally. U.S. taxpayers that hold foreign bank accounts 6. Commission fees paid to acquire cryptocurrency may be added to tax basis under section 1016 of the Code. denominated in cryptocurrency may be required to 7. See Section 13303 of Pub. L. 115-97 (passed December 22, report these accounts on FinCEN Form 114, Report 2017). of Foreign Bank Account (FBAR) if the aggregate 8. As of April 29, 2018, each of the 34 largest Bitcoin addresses had value exceeds $10,000 at any point in the calendar acquired Bitcoin in multiple transactions, ranging from nine to year.51 Although the IRS has not issued ofcial guid- more than 150,000. Nearly 2/3 of these addresses had engaged ance on the subject, it is possible that accounts covered in sale as well as acquisition transactions. See https://bitinfocharts. com/top-100-richest-bitcoin-addresses.html (last accessed April 29, by the FBAR would include cryptocurrency held on a 2018). foreign exchange (although the requirement does not 9. See Treas. Reg. § 1.1012-1(a). appear to apply to cryptocurrency held in one’s per- 10. Treas. Reg. § 1.1012-1(c)(2). sonal wallet).52 11. Treas. Reg. § 1.1012-1(c)(1), -1(e). 12. See, for example, Perlin v. Comm’r, 86 T.C. 388 (1986). 13. CFTC Grants DCO Registration to LedgerX LLC, U.S. U.S. individual taxpayers are also required under the Commodity Futures Trading Commissioner (July 24, 2017), Foreign Account Tax Compliance Act (FATCA) to https://www.cftc.gov/PressRoom/PressReleases/pr7592-17 (last report to the IRS any “foreign fnancial assets” valued accessed May 5, 2018). at $50,000 or more on IRS Form 8938. Although not 14. See, for example, Rev. Rul. 73-158, 1973-1 C.B. 337. entirely clear, because cryptocurrency is “property” for 15. See Treas. Reg. § 1.988-2(a)(2)(iii)(B) (a method that consis- tax purposes, it is arguably a foreign fnancial asset sub- tently results in high-basis units being withdrawn frst is not “reasonable”). ject to this reporting rule. 16. While an argument might be made that a taxpayer need only use a consistent method for transactions in the same cryptocur- 6. Conclusion rency, or from the same digital wallet, this approach appears to Although intended as an introduction of the exist- be inconsistent with the nonfunctional currency regulations. ing tax laws applicable to cryptocurrency transactions, See Treas. Reg. § 1.988-2(a)(2)(iii)(B)(1) (requiring that a basis determination method be consistently applied “to all accounts this introduction raises as many questions as it provides denominated in a nonfunctional currency”). answers. As cryptocurrencies continue to gain in popu- 17. See, for example, David Far mer, What is a Bitcoin fork?, The larity and are used in a wider variety of settings, the tax Coinbase Blog (July 27, 2017), https://blog.coinbase.com/what-is-a- issues implicated in these transactions are likely to grow bitcoin-fork-cba07fe73ef1 (last accessed May 5, 2018). ever more complex. Additional guidance from Congress 18. 348 U.S. 426 (1955). or the IRS is sorely needed to resolve the uncertainty 19. Section 305(d)(1). 20. 252 U.S. 189 (1920). surrounding tax treatment of cryptocurrency trans- 21. Koshland v. Helvering, 298 U.S. 441 (1936), rev’g 81 F.2d 641 (9th actions and to give taxpayers a clearer roadmap for Cir. 1936). compliance. 22. American Bar Association Section of Taxation, Letter to David Kautter, Acting Commissioner of the IRS re: Tax Treatment of Notes Cryptocurrency Hard Forks for Taxable Year 2017 (March 19, 1. This article is based, in part, on an earlier blog post of the same 2018) (the “ABA Letter”). Note that the guidance requested title. See Kathleen R. Semanski, Income, from Whatever Exchange, in the ABA Letter was specifc to tax year 2017; the Section of Mine, or Fork Derived: The Basics of U.S. Cryptocurrency Taxation, Taxation has not yet concluded on the proper U.S. federal income Blockchain and the Law (November 29, 2017), https:// tax treatment of Hard Forks as general matter. ABA Letter at 12.

16 • Banking & Financial Services Policy Report Volume 37 • Number 6 • June 2018 23. A “protocol” is basically a set of rules that governs operations the cryptocurrency exchange where the coins are stored and so and communications between network participants and the indicating. See Jon P. Brose & Brett R. Cotler, Hand Over Your blockchain ledger. Digital Wallet. Yes, Cryptocurrency Transactions are Taxable at 24. Holders of Ether were given the opportunity to vote on the 14, available at https://bit.ly/2s0k7mI (last accessed May 23, hard fork via an ad hoc polling mechanism at carbonvote.com. 2018). Users voted by sending nominal amount of Ethereum to either 34. Section 165(e). a “Vote-No” or “Vote-Yes” address. The votes were weighted 35. Worthlessness might also occur following a hard fork, if a tax- based on the number of coins recorded to that holder’s account payer includes the value of the forked currency in income, and and the transferred Ether returned via smart contract. A record the new protocol is ultimately not adopted by participants. The of the historical vote can be found at http://v1.carbonvote.com/ ABA has suggested that a taxpayer in this situation may be able (last accessed April 28, 2018). to claim a loss equal to its adjusted basis in the forked coins (i.e., 25. Ethereum Classic was trading at $23.55 as of May 7, 2018. the amount of income originally included). ABA Letter, supra, Ethereum Classic, CoinMarketCap (May 7, 2018), https://coin- n.19, at n.20; see also section 165(c)(2). marketcap.com/currencies/ethereum-classic/. Immediately before 36. Section 165(g)(2) (defning a “security” as a share of stock in the hard fork in July 2016, legacy Ethereum was trading at a corporation, a right to subscribe for or to receive a share approximately $11.11; the trading price of Ethereum as of of stock in a corporation, or a bond, debenture, note, certif- May 6, 2018, was $731.87. Ethereum, CoinMarketCap (May 7, cate, or other evidence of indebtedness issued by a corpora- 2018), https://coinmarketcap.com/currencies/ethereum/. tion or a government with interest coupons or in registered 26. Notice 2014-21, supra, n.4. form). 27. A number of states are considering accepting state tax pay- 37. IRS, IRS reminds taxpayers to report virtual currency transac- ments made in cryptocurrency, including Arizona, Georgia, tions, IR-2018-71 (March 23, 2018), available at https://www. and Illinois. An Arizona bill that would have provided for irs.gov/newsroom/irs-reminds-taxpayers-to-report-virtual-curren- taxes on transactions conducted in cryptocurrency to be paid cy-transactions (last accessed April 29, 2018). directly at the point-of-sale using blockchain technology 38. See section 6045(g)(3)(B); Treas. Reg. § 1.6045-1(a)(14). was vetoed by Governor Doug Ducey on May 16, 2018. Bill Cryptocurrency derivative sales may nevertheless be subject to History for S.B. 1091, Arizona State Legislature, https://apps. Form 1099-B reporting. See, for example, Stevie D. Conlon et al., azleg.gov/BillStatus/BillOverview/69854 (last accessed May 21, Taxation of Bitcoin, Its Progeny, and Derivatives: Coin Ex-Machina, 2018). Tax Notes (February 19, 2018). 28. Notice 2014-21, supra, n.4. 39. See, for example, Coinbase Support, Taxes FAQ, coinbase.com, 29. Section 165(a), (c)(1)-(2). https://support.coinbase.com/customer/en/portal/articles/1496488- 30. Section 165(b), (e); Treas. Reg. § 1.165-1(c). taxes-faq (last accessed May 4, 2018). 31. Nicole Kobie, This man’s lost bitcoin are now worth $75m – 40. CoinTracking, https://cointracking.info/ (last accessed May 5, and under 200,000 tonnes of garbage, Wired (December 1. 2018). 2017), http://www.wired.co.uk/article/bitcoin-lost-newport-land- 41. Section 988(e)(2). fll. For a lost wallet story with a happier outcome, see Mark 42. See, for example, Press Release, Creating tax parity for cryptocurren- Frauenfelder, ‘I Forgot My Pin’: An Epic Tale of Losing $30,000 cies, U.S. Representative Jared Polis (September 7, 2017), https:// in Bitcoin, Wired (October 29, 2017), https://www.wired.com/ polis.house.gov/news/documentsingle.aspx?DocumentID=398438 story/i-forgot-my-pin-an-epic-tale-of-losing-dollar30000-in-bit- (last accessed May 5, 2018). coin/. 43. See H.R. 3708, To amend the Internal Revenue Code of 1986 32. However, as the loss deduction must be taken in the tax year in to exclude from gross income de minimis gains from certain which the loss actually occurred (even if not the same tax year sales or exchanges of virtual currency, and for other pur- as the act of overt abandonment), the taxpayer may be required poses (September 7, 2017), Congress.gov, https://www.congress. to fle an amended tax return for the earlier loss year to claim gov/115/bills/hr3708/BILLS-115hr3708ih.pdf (last accessed the deduction. Treas. Reg. § 1.165-2(a). Prior to January 1, May 5, 2018). 2018, individual taxpayers were permitted to take deductions 44. See AICPA, Comments on Notice 2014-21: Virtual Currency for unexpected casualty losses over $100 to the extent in excess Guidance (June 10, 2016), https://www.aicpa.org/Advocacy/ of 10 percent of adjusted gross income. Tax/DownloadableDocuments/AICPA-Comment-Letter-on- 33. Treas. Reg. § 1.165-1(b) (generally requiring that section 165 Notice-2014-21-Virtual-Currency-6-10-16.pdf (last accessed losses be fxed by “identifable events”); see also United Dairy May 5, 2018); American Bar Association Section of Taxation, Farmers, Inc. v. U.S., 267 F.3d 519 (6th Cir. 2001) (identifable Comments on Notice 2014-21, available at https://www. events “must be observable to outsiders and constitute some americanbar.org/content/dam/aba/administrative/taxation/pol- step which irrevocably cuts ties to the asset”) (internal quo- icy/032415comments.authcheckdam.pdf (last accessed May 5, tation marks omitted); Rev. Rul. 2004-58 (describing section 2018) (recommending a de minimis exception for cryptocur- 165 losses as “abandonment losses”); Gulf Oil v. Commissioner, rency gain reporting consistent with guidance for foreign cur- 914 F.2d 396 (“[m]erely abandoning” leases on paper “because rency transactions). they are deemed worthless” was insufcient to demonstrate 45. See supra, n.6. abandonment for purposes of a section 165 loss deduction). A 46. Form 1099-MISC is generally required for payments of $600 taxpayer may be able to establish abandonment by writing to or more to an independent contractor.

Volume 37 • Number 6 • June 2018 Banking & Financial Services Policy Report • 17 47. Coinbase provides a Form 1099-K to business users that have 50. See, for example, Assessment of Civil Money Penalty, In re received $20,000 or more from virtual currency sales over a BTC-E a/k/a/ Canton Business Corporation and Alexander Vinnik, minimum of 200 transactions. See Coinbase Support, Taxes FinCEN No. 2017-03 (imposing civil penalties of $110,003,314 FAQ, coinbase.com, https://support.coinbase.com/customer/en/ on an ofshore cryptocurrency exchange, BTC-e, for willful portal/articles/1496488-taxes-faq (last accessed May 4, 2018). violation of MSB registration requirements and other willful 48. Order re: Petition to Enforce IRS Summons, U.S. v. Coinbase, failure to comply with anti-money laundering laws). Inc., et al, Case No. 17-cv-01431-JSC (N.D. Cal. November 28, 51. 31 C.F.R. 1010.350. 2017). 52. An IRS webcast previously reported that virtual currency would 49. An “exchanger” is defned as “a person engaged as a business not be reportable on the FBAR for the 2014 fling season (the in the exchange of virtual currency for real currency, funds, video has since been removed from the IRS Web site). The or other virtual currency.” FinCEN, Application of FinCEN’s AICPA has requested ofcial guidance on the foreign reporting Regulations to Persons Administering, Exchanging, or Using requirements for virtual currency. AICPA, Comments on Notice Virtual Currencies, FIN-2013-G001 (March 18, 2013), 2014-21: Virtual Currency Guidance (June 10, 2016), https:// available at https://www.fncen.gov/sites/default/fles/shared/ www.aicpa.org/Advocacy/Tax/DownloadableDocuments/AICPA- FIN-2013-G001.pdf (last accessed May 5, 2018); see also Comment-Letter-on-Notice-2014-21-Virtual-Currency-6-10-16. FinCEN, Request for Administrative Ruling on the Application of pdf (last accessed May 5, 2018); see also Andrew Velarde, FinCEN FinCEN’s Regulations to a Virtual Currency Trading Platform, FIN- Not Expecting FBARs for Virtual Currency, Tax Notes (November 2014-R011 (October 27, 2014), available at https://www.fncen. 8, 2017) (quoting a FinCEN ofcial stating that “[a]s the regula- gov/sites/default/fles/shared/FIN-2014-R011.pdf (last accessed tions are currently written, a virtual currency wallet would not May 5, 2018). fall under our defnition of an account”).

18 • Banking & Financial Services Policy Report Volume 37 • Number 6 • June 2018