The main tax myths about cryptocurrency debunked
Crypto and taxes may not be a heavenly match, but taxes seem inevitable, and the United States’ Internal Revenue Service (IRS) has made it clear that it is up to people who don’t come forward. With subpoenas from the IRS on Coinbase, Kraken, Circle, and Poloniex, as well as other enforcement efforts, the IRS is on the hunt. The IRS sent 10,000 letters of various versions asking for compliance, but all of them encouraged taxpayers to comply.
The IRS hunt for crypto has often been compared to the IRS hunt for overseas accounts more than a decade ago. Unfortunately, it’s not clear if there will ever be a crypto amnesty program that mimics the offshore clearance programs the IRS has formulated for offshore accounts.
Related: More IRS crypto coverage, more risk
The IRS made its first major announcement about crypto in the 2014-21 notice, classifying it as property. This has major tax consequences, accentuated by wild price fluctuations. Selling crypto can generate profits or losses and be taxable. But buying something with crypto can also trigger taxes. Paying employees or contractors is also possible. Even paying taxes in crypto can raise more taxes.
We are already seeing crypto audits by the IRS and some states (especially the California Franchise Tax Board) and more are sure to follow. At least now there are alternatives to tracking and filing tax returns that can make the process easier than it was in the early days. Everyone tries to minimize taxable crypto profits and defer taxes where legally possible.
Still, it is easy to get confused about tax treatment and to take tax positions that are difficult to defend when caught. With that in mind, I’ve heard a few things here that I call crypto tax myths.
You cannot owe taxes on cryptocurrency transactions unless you are given an IRS Form 1099. If you did not receive a Form 1099, you can check the box on your tax return that says you have not made any cryptocurrency transactions.
Strictly speaking: Taxes can still be owed even if the payer or broker does not submit a Form 1099. A Form 1099 will not collect tax if no previous tax was due, and Form 1099 does not report much taxable income. A Form 1099 could be wrong in this case, explain it on your tax return. But if you’re under scrutiny and your best defense is not to report your transactions because you didn’t receive a Form 1099, that’s weak.
If you hold your crypto in a private wallet instead of an exchange, you don’t have to report the crypto in your tax return.
Strictly speaking: Private wallet or exchange, the tax rules are the same. The impulse to hide property by moving assets into anonymous holding structures is not new. When Swiss banks began disclosing their US account holders to the IRS and the US Department of Justice, many US taxpayers tried pretty much anything, but in the end almost all of them paid, mostly with heavy fines. The cryptocurrency question on the IRS Form 1040 is not limited to cryptocurrencies held through exchanges. If you say “no” while holding crypto in a private wallet, you may be providing false information on a tax return signed under penalty of perjury. You might bet you never get caught, but thousands of US taxpayers with Swiss bank accounts can testify to how bad this bet can turn out.
If you hold your crypto through a trust, LLC, or other entity, you do not owe any taxes on the crypto transactions and you do not need to report. Also (the myth continues) LLC income is tax free.
Strictly speaking: Owning crypto through a legal entity can keep income off your tax return. However, unless the company is qualified (and registered) as a tax-exempt company, the company itself is likely to have tax reporting requirements and may owe taxes. For tax purposes, LLCs are taxed as corporations or partnerships, depending on the circumstances and tax choice. Individual member GmbHs are not counted so the LLC income ends up on the sole owner’s return. If your company is an overseas company, there are complex US tax rules that make you directly liable for certain income generated within the overseas company.
If I structure the sale of my cryptocurrency as a loan (or any other non-sale transaction), I don’t need to report the proceeds.
Strictly speaking: Consider whether to borrow or sell the crypto. The IRS and the courts have solid doctrines for ignoring bogus transactions. Are you getting back the same crypto that you borrow? Do you charge interest on the loan and pay tax on the interest when you receive it? Some loans may not hold up. And when you sell crypto and get a promissory note, it can make your taxes even more difficult with installment sale calculations.
A crypto exchange is a type of trust in that you cannot unilaterally change the policies of the exchange. So you do not have the crypto in your account for tax reasons and you do not have to report any transactions via an exchange.
Strictly speaking: The IRS didn’t say anything about it. The IRS guidelines suggest that the IRS regards taxpayers as the owners of the cryptocurrency held through their stock exchange accounts. It seems highly unlikely that the IRS would view crypto held through an exchange account as property of the exchange itself (as a trustee) rather than the property of the account holder. Taxpayers often own their assets through accounts held by institutions such as bank accounts, investment accounts, 401 (k) s, IRAs, etc.
In most cases, tax law treats the taxpayer as the owner of the funds and assets held through these accounts. Some special accounts like 401 (k) s and IRAs have special tax rules. And an account that is treated as an escrow account isn’t necessarily a good tax return. Trust beneficiaries, especially foreign trusts, have burdensome reporting obligations. So before considering crypto exchanges as trusts, be careful what you want. The designation of a trust does not mean that the income generated within the trust is exempt from income tax.
The amendment by Congress to Section 1031 of the Tax Code, which restricts exchanges of like types to real estate, makes crypto-to-crypto exchanges non-taxable.
Strictly speaking: Section 1001 of the Tax Code provides that a taxable profit results from the “sale or other sale of assets”. Selling real estate of any kind for cash or other real estate can result in a taxable profit. The IRS says crypto is owned, so trading crypto for other crypto is selling crypto for the value of the new crypto.
Before the amendment to Section 1031 came into effect in 2018, a crypto-for-crypto swap as a similar exchange under Section 1031 could have been OK. But the IRS is pushing back this position on tax audits and has issued guidelines on tax deny-free treatment for certain cryptocurrency swaps. That’s not a precedent and doesn’t cover the waterfront, but it does tell you what the IRS thinks. In any case, now that Section 1031 has restricted the treatment of like exchanges to real estate, crypto-to-crypto swaps are taxable unless they qualify for another exemption.
Every taxpayer has the right to plan his affairs and transactions in such a way that he seeks 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 are not complying with tax laws and it pays to be careful in the future and clean up the past. Be careful out there.
This article is for general informational purposes and is not intended and should not be construed as legal advice.
The views, thoughts, and opinions expressed herein are solely those of the author and do not necessarily reflect the views and opinions of Cointelegraph.
Robert W. Wood is a tax attorney serving clients worldwide from Wood LLP’s San Francisco office, where he is a managing partner. He is the author of numerous tax books and frequently writes about taxes for Forbes, Tax Notes, and other publications.