Understanding Cryptocurrency Tax Rules

Question:        I deal in cryptocurrency through my business. Customers sometimes pay me in Bitcoin and I sometimes use Bitcoin to pay suppliers. Will these transactions be treated as if payment was made in cash?

Answer:          Cryptocurrency is not the same as cash. That being said, as exotic as the world of cryptocurrency may be, the tax rules are relatively simplistic for Bitcoin and other forms of digital currency, generally known as cryptoassets or cryptocurrency.  The IRS has announced that cryptocurrency should be treated as property, not cash.  Accordingly, the general rules of property will apply in determining the tax treatment of the receipt of and payment with cryptocurrency.  This means that any Bitcoin you receive will be taxed based on the fair market value of the cryptoasset at the time payment is received and payments in Bitcoin will be treated as if you sold property at the time and in conjunction with the payment made.

In some cases, in return for services rendered, payment is made to the service provider in a form other than cash.  Assume, for example, you perform services and issue an invoice to a customer who pays your bill with Microsoft stock worth $10,000. For tax purposes, you will be treated as if you received a payment of $10,000. Since cryptocurrency is treated as property, not cash, the income you report will be based on the fair market value of the cryptoasset on the date of receipt.

Any cryptocurrency payment you receive in the ordinary course of business for services rendered or products sold will be treated as ordinary income. If on the other hand you are receiving payment in Bitcoin or some other cryptoasset in return for the sale of a capital asset, you will report a capital gain or capital loss from the sale based on the market value of the property received in connection with the sale.

On the payment side, the tax treatment is similar but with a slightly different twist.  If you make a payment in cryptocurrency, you are deemed to have made a payment based on the value of the cryptoasset at the time payment is made. But with cryptocurrency, as with any other payment with non-cash property, you will have to report income based on the difference between the market value of the cryptoasset at the time of payment and your tax basis in the cryptoasset. 

Assume Leo owns Bitcoin which he initially acquired for $8,000.  If Leo receives a $10,000 bill and pays the bill with the Bitcoin he bought for $8,000, Leo must report the $2,000 of appreciation as income.  Whether the $10,000 is deductible depends on the nature of the payment.  If the payment is made in the ordinary course of business, the payment will yield a deduction for Leo.

With the treatment of cryptocurrency as property, a taxpayer must be mindful of other general tax rules.  If a taxpayer owns or holds cryptocurrency for a period of greater than one year and then sells the cryptoasset at a gain, the tax on the sale gain will be determined as if the taxpayer sold a capital asset for a period held more than one year.  Of course, if the cryptoasset is held for a period of not more than one year, then the gain will be taxed less favorably as a short-term capital gain.   

Other general tax rules apply to payments made in cryptocurrency.  For example, if you are a consultant and you receive payment for services in cryptocurrency, in addition to income tax on the payment received, self-employment tax will be imposed on the amount you receive.   Similarly, any wages paid to an employee in the form of cryptocurrency will be subject to withholding and payroll taxes based on the market value of the cryptocurrency paid. 

As the use of digital currency increases, one can expect more guidance on specific situations.  That being said, if you follow the general rules for property treatment, you will generally be in compliance with how the IRS currently treats these types of transactions.

 

The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfbbg.com.

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