Here’s How to Avoid a Potential Battle With the IRS Come Tax Time

The Cryptocurrency Landscape

With the release of Bitcoin in 2009, cryptocurrency quickly became the new ‘hot thing’ in technology and financial markets. Since that initial launch, some 4,000 different cryptocurrencies have been released, with more on the horizon every day. While the cryptocurrency market can be measured in many ways, all methodologies point to its rapid increase in size and activity.

From a market cap perspective, the total capitalization for all cryptocurrencies totals more than $215 billion, with a 3,083% increase in the number of cryptocurrencies released from 40 available in December 2013 to 1,273 available at the end of 2017. And, as of early October 2018, there has been an additional 60% increase in the end-of-2017 number, with 2,042 cryptocurrencies now available to investors. Incidentally, the top ten cryptocurrencies account for 85% of the overall market cap for this space.

Growth for this market space is expected by industry and financial experts to continue its strong growth, even with the recent significant price fluctuations and volatility. An October 2018 survey of fintech leaders estimated that the top ten cryptocurrencies will increase by 52% by year-end 2018, and by 148% by year-end 2019.

Another recently released study conducted by the Satis Group showed that even though 2018 has been a bear market for cryptocurrency, the market will likely still experience significant growth in trading volumes, estimated at approximately 50% in 2019. The growth prediction is driven in no small measure by both growing corporate/institutional interest and by increased market accessibility for all participants.

Bitcoin
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Image credit: geralt / Pixabay

Crypto is Here to Stay

We’ve all seen tech ‘trends’ that simply didn’t stand the test of time (think Betamax). That’s not the case with cryptocurrency. Cryptocurrency is gaining in acceptance and buy-in from major fund managers, signaling a high level of recognition in financial markets of its long-term value. The unique attributes of cryptocurrency and blockchain technology tell the story behind its growth and acceptance:

    • Security – because prior transactions (blocks) cannot be altered, and each transaction generates its own private encryption key, a global cryptocurrency blockchain is arguably one of the most secure information sets in the world
    • Privacy – because parties involved in a transaction do not necessarily know the identity of others involved, investors are able to maintain anonymity
    • Traceability – think of this as a dollar bill (as an example) that arrived in your wallet with a complete ledger of every person through whose hands it passed, as well as when it arrived and departed.
    • Adaptability – most cryptocurrency blockchains also can encrypt and secure many forms of data, making the network valuable for processing transactions and information that is not necessarily related to that specific cryptocurrency.
    • Immutability – because it is impossible for alter or even amend past transactions in a blockchain, investors are protected from fraud and theft. At least in theory.
    • Trustless – because cryptocurrency transactions do not require trust in an intermediary such as a bank, transactions can be completed without worrying about the safety or security of such institutions.
    • Foundational – blockchain technology can be used by a broad array of other functionalities, like information processing and affiliate transaction networks.

Another indication that crypto is here to stay is that the U.S. government’s combined total investment in blockchain analysis companies has more than tripled since early 2018, as evidenced by research conducted and published by Diar. So far, that number adds up to $5.7 million, with the IRS leading in blockchain investment. And, globally, the investment in cryptocurrency and blockchain technology has grown by leaps and bounds.

The Accounting Challenge for Crypto Investors

With more and more individuals and institutions entering the cryptocurrency market, along with the geometric growth of the market, a critical problem has arisen. As crypto participants buy and sell a wide range of coins, they are confronted with the need to track their ‘in’ and ‘out’ prices to accurately calculate their taxes – similar to standard taxation requirements to maintain an accurate cost basis for any investments, and transactions with those investments.

Backing up for a moment:

The last significant guidance from the Internal Revenue Service as it relates to cryptocurrency was issued in 2014, at a point in time well before the massive growth of crypto took over (and continues). However, the IRS has stated that cryptocurrency is property, much like land, and is thus subject to both income and capital gains taxes upon the sale of an investor’s holdings.

The U.S. House of Representative Ways & Means committee has gone so far as to issue a letter to the IRS requesting more explicit guidance so that taxpayers will be able to compute and then pay their taxes correctly; the committee also is unhappy that the IRS is focusing more on enforcement than on providing appropriate and timely guidance for taxpayers. Unfortunately, the IRS is still entirely tied up in dealing with the consequences and changes resulting from the recent tax overhaul, so it may well take some time for these cryptocurrency issues to be addressed by the IRS.

It’s a large, and growing problem for crypto investors – consider this quote from a recent article:

“In 2015, just 800 Americans reported their crypto earning to the IRS. But with last year’s seemingly endless stream of new ICOs and the now almost mythical bull run of the market, the IRS is aware of the popularity of cryptocurrency and will be on the lookout for anyone who doesn’t report their gains. Tax evasion is a serious offense that can lead to a prison sentence and hundreds of thousands of dollars in fines.”

“Because the IRS treats your cryptocurrency assets like property, they’re subject to capital gains taxes.  This means that you pay taxes on the increase in the value of your cryptocurrency holdings. Yet, it’s also possible for someone to receive cryptocurrency as a payment or wage from an employer or contractor. In that case, these cryptocurrency earnings are subject to standard income taxes.”

The vast majority of investors are at least somewhat familiar with tax rules, particularly about capital gains tax. For crypto participants, there are three events (comprised of buying, selling or trading cryptocurrency) that are considered taxable events under the capital gains rules. These taxable events include:

  • Exchanging or trading a cryptocurrency for another cryptocurrency
  • Selling cryptocurrency for fiat money (American dollars, Euros, etc.)
  • Using cryptocurrency to purchase goods or services

Another significant problem for crypto investors is that as people invest in more and more different cryptocurrencies, it has become increasingly difficult to maintain records that provide the going-in and coming-out basis for each different coin. And as the number of transactions per investor increases, the importance of impeccable records becomes paramount.

It boils down to a cascade of issues, ending with a significant problem. First, transaction data is not standardized and thus nearly impossible to correlate, cryptocurrency to cryptocurrency. The cascade goes like this:

    • Because there are many cryptos bought and sold across many exchanges with high-speed trading, rapid price fluctuations and little to no transparency; AND
    • Because exchanges report trades differently (and often inaccurately); AND
    • Because many ‘wallet to wallet’ transaction do not pass through an exchange; AND
    • Because no crypto transactions are currently recorded with any metadata; AND
    • Because no industry standards exist for how trades are accounted for and reported:
      • There is no correlation within the crypto market
      • Without correlation, there is essentially no way to track accurate cost basis data
  • Without accurate cost basis data, there is no simple way to track tax liability

It’s clear that the ongoing – and growing – challenge for cryptocurrency investors will only increase as more exchanges, transactions and cryptocurrencies come into play. For the investor, it’s doubly frustrating because the majority of taxpayers want to do what’s right.

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Image credit: Crypto360/Flickr

What’s the Solution?

As noted above, the last significant guidance released by the IRS occurred nearly four years ago, in Notice 2014-21, which addressed the taxation of virtual currency transactions being treated as property for federal tax calculation. This means that the general tax principles that apply to property transactions also apply to any exchange of cryptocurrencies. So, with the IRS, the country’s most visible regulatory body, seemingly in absentia, other state and federal agencies are attempting to step into the void – for example, the New York State Attorney General (NYAG) issued a 32-page report detailing its concerns about the lack of consumer protections currently in place within the cryptocurrency market. A recent Investopedia article further details the concerns and findings of the NYAG’s report.

Regarding regulation and standards establishment, a March 2018 proposal from the Winklevoss brothers to create a Virtual Commodities Association (VCA) became a reality in August 2018, with the intention to ‘work toward the goal of establishing an industry-sponsored, self-regulatory organization of the U.S. virtual currency industry, specifically virtual commodity marketplaces.’ However, it is likely to take significant time to have an impact, especially since there is no legal requirement for exchanges to join the VCA.

While such industry-driven resources are valuable, they don’t necessarily fully answer the needs of investors, who are required to provide accurate and timely reporting of all cryptocurrency transactions for tax purposes.

A recent Forbes article gives a ‘primer’ statement about the issue:

“The details of all cryptocurrency transactions in a network are stored in a public ledger called a “Blockchain,” which permanently records all transactions to and from online wallet addresses, including date and time. Taxpayers can use this information to determine their basis and holding period. Technology to assist taxpayers in this process is being developed currently, and some helpful online tools are now available.” The question to which crypto participants must find an answer is what tools exist for record-keeping and accounting that can be depended on to protect them.

It is likely that the IRS will issue updated guidance in the near future, and some of the direction will probably include additional regulatory reporting for exchanges and wallets, so that the IRS will have knowledge of everyone who is investing in, trading and using cryptocurrency. The purpose of this guidance will be to make clear to all participants how to correctly calculate gains and losses, similar to what traditional brokerages are required to provide to both the IRS and the taxpayer using 1099-B forms.

However, this reporting will likely not be entirely accurate, because calculating cost basis does not necessarily occur when cryptocurrency is transferred from one exchange to another. And backtracking to the original cost basis – after trades and transfers may have occurred – is very difficult.

The crux of solving the problem of crypto participants having complete, fully correlated data from which their tax liability can be accurately figured lies in creating a solution that includes tools to assist taxpayers in reporting taxable income accurately.

An Emerging Solution: Creating a Platform for Crypto Investors

Recording-keeping and accounting for tax purposes has moved to the virtual world, in the form of organizations that provide support to people who are now – and increasingly – working with virtual currencies as well as fiat currencies. As transaction numbers continue to rise, it is important to find a ‘place’ to bring together the data from all transactions into one secure location.

In this vacuum, others are working to create a framework for crypto investors to maintain the record-keeping, accounting and reporting requirements. For example, Coinbase says it has launched a ‘cost basis for taxes’ report to help its customers file their taxes; however, it is useful only if a crypto participant is working exclusively with the exchanges with which it partners.

Another potential solution, ZenLedger is a tax software product for cryptocurrency investors that allows users to import their cryptocurrency transactions, calculate gains and income and autofill tax forms used to report capital gains. However, a key functionality – correlation of trades, transfers and sales across all exchanges and wallets – is not available, so crypto participants must gather all of their transaction data to use the software.

ProfitStance is an emerging software-as-a-service company, the first to offer its subscribers a fully developed cryptocurrency record-keeping and accounting solution. The company has created its software with a twofold mission: to ease the burden on accountants and accounting firms, and to protect investors by bringing together all of the transaction data, across wallets and exchanges, to avoid errors in taxation calculations.

Unlike other ‘solutions,’ ProfitStance has built its software for crypto investors rather than crypto companies – a solution that was created by a group of crypto investors who understand and solve the most critical issue in cryptocurrency investing today: how to accurately and efficiently track every transaction, whether it is an investment, a purchase using cryptocurrency, or moving cryptocurrency between exchanges.

Because the company is continuously building bridges with all of the exchanges and wallets, ProfitStance can track each individual crypto from purchase to trade, transfer or sale in a fraction of a second. When a cryptocurrency investor buys/sells/transfers assets across multiple wallets and exchanges, each move can distort the cost basis when looked at solely by wallet or exchange.  ProfitStance has developed a holistic solution that correlates activities across all wallets and exchanges which allows accurate tracking of cost basis and ultimately accurate tax reporting.  And the software continually tracks all subscriber crypto activity, allowing participants to track their tax liability on a daily basis.

On the institutional end, Libra, a company based in New York City, seeks to provide the tools to simplify the complicated series of circumstances that companies dealing with crypto uniquely face. According to the company’s site, their product, Libra Crypto Office, “…enables funds, fund administrators, exchanges, trading operations, and crypto enterprises to automate and optimize middle and back-office processes and reporting, while improving operational and financial analysis and control.”

In an interview with BlockTelegraph, Jake Benson, CEO, and founder of Libra said, “We want to be the de facto solution for back-office operations in the crypto ecosystem.” To that end, the company is developing a suite of products to simplify interaction for companies operating in the space. This includes financial institutions as well as mining operations and other entities in the space. Benson continued, “Our long-term objective is to bring maturity to this asset class. Success, for me, is allowing any fund, anywhere in the world (and there’s 11,000 of them) to have the right software and processes in place to comfortably invest in this asset class.”

The future of cryptocurrency will rely on the implementation of services such as those outlined above. Clear processes will allow for the space to continue growing without fear of potentially debilitating clashes with the IRS in the future.

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