Key cryptocurrency tax myths debunked
Crypto and taxes may not be a perfect match, but taxes seem inevitable, and the U.S. Internal Revenue Service (IRS) has made it clear that it is going after people who don’t report. . With IRS summons to Coinbase, Kraken, Circle, and Poloniex, along with other enforcement efforts, the IRS is looking. The IRS sent out 10,000 letters in different versions asking for compliance, but all of them were nudges to encourage taxpayers to comply.
The IRS hunt for crypto has often been compared to the IRS hunt for foreign accounts over a decade ago. Unfortunately, it is not clear whether there will ever be a crypto amnesty program mimicking the offshore voluntary disclosure programs the IRS has formulated for offshore accounts.
Related: No more IRS crypto reports, no more danger
The IRS made its first major crypto announcement in Notice 2014-21, classifying it as a property. This has significant tax consequences, accentuated by sudden price fluctuations. Selling crypto can trigger a gain or loss and be taxable. But even buying something with crypto can trigger taxes. Pay employees or contractors too. Even paying taxes in crypto can trigger more taxes.
We’re already seeing crypto audits from the IRS and some states (most notably the Franchise Tax Board of California), and more will certainly follow. At least now there are tax tracking and preparation alternatives that can make the process easier than it was in the beginning. Everyone tries to minimize taxable crypto gains and defer taxes when legally possible.
Still, it’s easy to get lost on tax treatment and take tax positions that can be difficult to defend if you get caught. With that in mind, here are some things I have heard, which I will call crypto tax myths.
You cannot pay tax on cryptocurrency transactions unless you receive an IRS Form 1099. If you did not receive a Form 1099, you can check the box on your tax return indicating that you have not made any transaction with the cryptocurrency.
Really: A tax may still be due, even if the payer or the broker does not file a Form 1099. A Form 1099 does not create tax where no tax was previously due, and many taxable income is not reported on 1099 forms. A 1099 form can be wrong in which case explain it on your tax return. But if you are audited and your best defense is that you have chosen not to report your transactions because you did not receive a Form 1099, that is low.
If you hold your crypto through a private wallet instead of an exchange, you don’t need to report the crypto on your tax returns.
Really: Private wallet or exchange, the tax rules are the same. The impulse to hide ownership by moving wealth to anonymous holding structures is not new. When Swiss banks started disclosing their U.S. account holders to the IRS and the U.S. Department of Justice, many U.S. taxpayers tried just about anything, but almost everyone ended up paying, usually with hefty penalties. The cryptocurrency question on IRS Form 1040 is not limited to cryptocurrency held through exchanges. If you say ‘no’ even though you hold cryptos through a private wallet, you are potentially making false statements on a signed tax return under penalty of perjury. You might be making the bet that you will never get caught, but thousands of American taxpayers who have bank accounts in Switzerland can attest to how badly this bet can be played.
If you hold your crypto through a trust, LLC, or other entity, you do not owe tax on crypto transactions and do not have to report. In addition (the myth continues), the income generated by LLCs is tax exempt.
Really: Owning crypto through an entity can reduce your income tax return. But unless the entity qualifies (and is registered) as a tax-exempt entity, the entity itself will likely have tax reporting obligations and may owe taxes. For tax purposes, LLCs are taxed as corporations or partnerships, depending on their facts and their tax choices. Single Member LLCs are not counted, so the LLC’s income ends up on the sole proprietor’s return. If your entity is a foreign entity, there are complex US tax rules that may make you directly responsible for certain income generated within the foreign entity.
If I structure the sale of my crypto as a loan (or other transaction without a sale), I don’t have to report the proceeds.
Really: Consider whether you are lending or selling the crypto. The IRS and the courts have strong doctrines for ignoring fictitious transactions. Do you get back the same crypto that you lend? Do you charge interest on the loan and pay interest tax as you receive it? Some loans may not hold up. And if you sell crypto and receive a promissory note, it can further complicate your taxes with installment sales calculations.
A crypto exchange is a type of trust because you cannot unilaterally change the policies of the exchange. Thus, you do not have the crypto in your account for tax purposes and do not have to report transactions through an exchange.
Really: The IRS hasn’t said any of this. IRS guidelines suggest that the IRS considers taxpayers to own the cryptocurrency held through their exchange accounts. It seems highly unlikely that the IRS will consider cryptos held through an exchange account to be owned by the exchange itself (as an administrator), rather than owned by the account holder. Taxpayers often own their assets through accounts held by institutions, such as bank accounts, investment accounts, 401 (k), IRAs, etc.
In most cases, tax law considers taxpayers to be the owners of the money and assets held through these accounts. Some special accounts like 401 (k) and IRAs have special tax rules. And having an account treated like a trust is not necessarily a good tax result. Beneficiaries of trusts, and in particular foreign trusts, have onerous reporting obligations. So, before you think of crypto exchanges as trusts, be careful about what you want. Calling something a trust does not mean that the income generated within the trust is exempt from income tax.
The Congress amendment to Section 1031 of the Tax Code which restricts similar exchanges to real estate does not make crypto-to-crypto exchanges taxable.
Really: Article 1001 of the Tax Code provides that a taxable gain results from the “sale or other disposal of property”. The sale of any type of property for money or other property can create a taxable gain. The IRS says crypto is property, so trading one crypto for another crypto is a sale of crypto for the value of the new crypto.
Before the Section 1031 Amendment came into effect in 2018, a crypto-to-crypto exchange might have been acceptable as a like-for-like exchange under Section 1031. But the IRS rejects that position. in tax audits and has issued guidelines that deny tax. -free processing for some cryptocurrency swaps. It’s not a precedent and it doesn’t cover the waterfront, but it does tell you what the IRS thinks. In any case, now that Section 1031 limits the treatment of like-for-like exchanges to real estate, crypto-crypto swaps are taxable, unless they qualify for another exception.
Take away food
Every taxpayer has the right to plan their affairs and transactions to try to minimize taxes. But they should be wary of quick fixes and theories that sound too good to be true. The IRS seems to believe that many crypto taxpayers do not comply with tax law, and that it is worth being careful in the future and doing a bit of cleaning up for the past. Be careful there.
This article is for general information purposes and is not intended to be and should not be construed as legal advice.
The views, thoughts and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Robert W. Wood is a tax lawyer representing clients worldwide from Wood LLP’s San Francisco office, where he is a managing partner. He is the author of numerous tax books and writes frequently on taxes for Forbes, Tax Notes and other publications.