Navigating the Cryptocurrency Market
As cryptocurrency becomes more used and accepted, interest in this ever-evolving market continues to grow. Business owners may have questions about the potential benefits and risks of investing and/or transacting in it. Here is a look at how cryptocurrency works, its tax implications, and the government’s role in its management.
How Cryptocurrency Works
Cryptocurrency is a digital representation of value that functions as a medium of exchange, payment, and a measure and store of value. Unlike fiat currencies, cryptocurrencies are not backed by any government entity, which can make it difficult to assess their value.
Cryptocurrency uses cryptography to secure transactions that are digitally recorded on a distributed ledger each time they travel from one owner to the next, utilizing blockchain technology. Blockchain is immutable, meaning it cannot be altered and remains unchanged. This makes it nearly impossible to counterfeit. A node or computer can verify each transaction on the blockchain. In return for verifying and securing transactions on the blockchain, these nodes are rewarded by receiving cryptocurrency, such as Bitcoin. Each cryptocurrency system is separate and not interchangeable.
Cryptocurrency is commonly referred to as tokens or coins, depending on how they are used. Coins are cryptocurrencies that have a standalone blockchain, such as Bitcoin, Ethereum, and Ripple. This coin is what you use for paying transaction fees and participating in the network. Tokens are currencies supported by a specific blockchain rather than powering their own. They are not the native coin of the network.
Income Tax Consequences
For your federal taxes, the IRS treats cryptocurrency as property, and it should be reported in U.S. dollars. That means a taxpayer who provides goods or services and receives payment in virtual currency has a gross income equal to the fair market value of that virtual currency, as measured in U.S. dollars. A taxpayer who exchanges virtual currency for property has gain or loss on the transaction. The amount of gain or loss is based on whether the fair market value of the property received differs from the taxpayer’s adjusted basis in the virtual currency.
Employers can pay employee wages in cryptocurrency. If one chooses to do so, those wages are subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax. Employers must report these withheld amounts on Form W-2, Wage and Tax Statement. Employees who receive virtual currency as payment from their employer must include the fair market value of the virtual currency in their gross income. This becomes an employee’s tax basis. Any subsequent appreciation or depreciation becomes capital gain or loss upon disposition of the cryptocurrency.
Suppose you receive virtual currency for performing services as an independent contractor. In that case, your self-employment income is equal to the fair market value of the virtual currency measured in U.S. dollars on the date of receipt, and those virtual currency payments are subject to self-employment tax.
For most popular virtual currencies, it’s easy to determine the fair market value because they are generally listed on an exchange, and the exchange rate is established by market supply and demand. The taxpayer can convert the virtual currency into U.S. dollars at the exchange rate as of the date of the virtual currency transaction.
However, the IRS still needs to provide guidance on determining the fair market value of the hundreds of virtual currencies not listed on an exchange and on harmonizing different values for the same currency on different exchanges.
Government Regulation
U.S. policymakers have indicated they are slowly moving toward regulating cryptocurrency. To limit illicit activity, authorities have targeted the exchanges that allow users to convert cryptocurrency into U.S. dollars or other national currencies. This issue is ongoing, and no definitive solution or answer has yet been determined.
Proposed regulations were recently issued by the IRS regarding information reporting for digital asset sales and exchanges. These proposed regulations, if finalized as proposed, would require information reporting similar to what is currently required of traditional brokers who issue 1099-B’s to those individuals and entities who sell or exchange stocks, mutual funds, etc. The proposed regulations would be effective for sales or exchanges of digital assets occurring on or after January 1, 2025. The intent of the proposed regulations is to better police those individuals and/or entities transacting in digital assets.
Meanwhile, the U.S. Securities and Exchange Commission has been aggressively targeting crypto firms. The SEC considers a range of widely traded digital assets to be securities—like stocks, bonds, and exchange-traded funds. A security is generally anything that represents a value and can be traded. The SEC’s position that many cryptocurrencies are securities could impose strict regulatory requirements and require detailed disclosures to inform investors of potential risks. The SEC has brought over a hundred enforcement actions in the past decade, claiming various cryptocurrencies are securities. It is an important distinction because if considered securities, the government would regulate cryptocurrencies, undermining their decentralized nature.
Specific cryptocurrencies, such as Bitcoin, are not considered securities. U.S. regulators agree that Bitcoin is not a security because it was started by an anonymous person going by a pseudonym and does not exist to raise money for a specific project.
In short, there is no uniform policy regulating cryptocurrency, and business owners should expect the landscape to continue to evolve.
To help determine if cryptocurrency makes sense for your business and how to report virtual currencies accurately, contact RDG+Partners at 585-673-2600.