Tax Season is Here! If You Own Bitcoin, The IRS Wants To Know.

Blog Post | 110 KY. L. J. ONLINE | March 07, 2022

Tax Season Is Here! If You Own Bitcoin, The IRS Wants To Know.

By: Amanda Guillen, Staff Editor, Vol. 110

$2,035,918,948,953. Do you know what that number is? As of February 20, 2022, there are almost 20 thousand different cryptocurrencies with a market capitalization of $2 trillion.[1]  To put this number into perspective, two trillion is about 7% of America’s national debt.[2] $2 trillion is equivalent to two times the market capitalization of Tesla, the sixth-largest company in the world.[3] Two trillion dollars in $100 bills stretch 5.44 times around the Earth’s equator.[4] This growth did not occur overnight.[5] So, why has the IRS just decided to ask this question on our beloved 1040 U.S. Individual Income Tax Return “…did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?”[6] Well, because the technical architecture of various cryptocurrencies makes it difficult to bring it within existing tax rules.[7]

History of the IRS and Cryptocurrency

The most well-known cryptocurrency is Bitcoin. Bitcoin officially made its first appearance in 2009, widely attributed to Satoshi Nakamoto, believed to be a pseudonymous hacker or hackers.[8] As with most things new and foreign, cryptocurrency was viewed distrustfully by many governmental bodies.[9] Bitcoin was seen as an underground creation, one which many could not define. It was as if the Bitcoin founders held hands around a fire pit and claimed that this paperclip (Bitcoin) was worth $10 million.  It would be strange to assume that this imaginary agreement would be taxed, but the government has always been more interested in the substance of the transaction. The waterlike form of cryptocurrency would not slip through the taxman’s fingers.

What Is the IRS Guidance on Virtual Currency?

In the United States, the Taxing and Spending Clause of the Constitution gives Congress the power to collect taxes.[10] From there, the IRS defines the overarching definition of gross income in § 61(a)(3), which provides that, except as otherwise provided by law, gross income means all income from whatever source derived, including gains from dealings in property.[11] Under § 61, all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion, are included in gross income. [12] In general, income is ordinary unless it is gained from the sale or exchange of a capital asset or a special rule applies.[13]

Within § 61 is the definition of virtual currency, which the IRS views as property, like stocks.[14]  Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account and a store of value other than a representation of the United States dollar or a foreign currency.[15] Cryptocurrency is treated like a stock, but is it?

Issues of Treating Cryptocurrency Like a Stock  

With 16% of U.S. adults who have dabbled in cryptocurrency, there is a long list of remaining issues that have not been vetted by the IRS.[16] Regulators should be providing clear guidance that offers safeguards for investors without destroying the investment and innovation already ported into cryptocurrencies and blockchain as a whole.[17]

For example, it is debatable where some crypto transactions occur, which leads to more significant issues of determining which jurisdiction has primary taxing authority.[18] Other realization issues stem from the lack of cryptocurrency guidance, such as hard fork cryptocurrency[19]. Additionally, there is an anonymous nature of cryptocurrency which is subject to little government oversight.[20] Should cryptocurrency users be taxed on using Bitcoin to buy a cup of coffee? Instead of fitting a circle in a square peg, it may be ideal for the IRS to create a new square peg to clearly define the unique aspects of cryptocurrency. 

Enforcement By The IRS

Regardless of the issues that need to be ironed out, in 2018, the IRS launched a compliance campaign on virtual currency whose goal was to search out taxpayers who weren’t following the rules.[21] In 2019, the IRS sent letters to 10,000 taxpayers who owed back taxes on unreported virtual currency transactions[22]. Today, the IRS, realizing the magnitude of this growing problem, has offered grants up to $625,000 for software to trace cryptocurrency traders and has hired independent consultants to track down tax evaders. [23] Additionally, the IRS is seeking help from technology companies to systematically obtain transaction information as to the gains and losses from the use of cryptocurrencies.[24] As virtual currency has a market capitalization of $2 trillion[25], the efforts by the IRS are bound to increase revenue for the government.

Regardless of how murky cryptocurrency may seem, Americans will continue to invest in Bitcoin. But, if you do[26], make sure to let the IRS know.

[1] Global Cryptocurrency Charts, Coin Mkt. Cap, (Feb. 20, 2022), https://coinmarketcap.com/charts/.

[2] Allen Rappeport, U.S. National Debt Tops $30 Trillion as Borrowing Surged Pandemic, N.Y. Times (Feb. 1, 2022), https://www.nytimes.com/2022/02/01/us/politics/national-debt-30-trillion.html; Christ Morris, Crypto Market Cap Is Once Again Above $2 Trillion, Fortune, (Mar. 2, 2022), https://fortune.com/2022/03/02/crypto-market-cap-2-trillion/ (in December 2021, crypto market value topped $3 trillion).

[3] Kirsten Korosec, Tesla Surpasses $1 Trillion Market Value, Tech Crunch (Oct. 25, 2021), https://techcrunch.com/2021/10/25/tesla-1-trillion-market-cap/.

[4] Paul Toscano, What Does $1 Trillion Look Like?, CNBC (Sep. 13, 2013), https://www.cnbc.com/2009/04/08/What-Does-$1-Trillion-Look-Like.html.

[5] Megan DeMatteo, Bitcoin Doubles Its Value in 2021, Then Nearly Lost It All in the First Month of 2022. Here’s A Look at Its Price Over The Years, Time (Jan 1. 2022), https://time.com/nextadvisor/investing/cryptocurrency/bitcoin-price-history/.

[6] U.S. Individual Income Tax Return, Form 1040, IRS (2021), https://www.irs.gov/pub/irs-pdf/f1040.pdf

[7] James Anderson, David Berke, Christopher Bowers & Nathan Giesselman, Tax Law Struggles To Keep Pace With the Proliferation of Cryptocurrency, JD Supra (Jan. 20, 2022), https://www.jdsupra.com/legalnews/tax-law-struggles-to-keep-pace-with-the-6709809/.

[8] Lawrence J. Trautman, Is Disruptive Blockchain Technology the Future of Financial Services?, Consumer Fin. L.Q. Rep. 232, 2334 (2016).

[9] David C. McDonald, Coining New Tax Guidance: How the IRS is Falling Behind in Crypto, 28 U. Mia In’t & Comp. L. Rev. 152, 154

[10] U.S. Const. art. I, § 8.

[11] I.R.C. § 61(a)(3).

[12] See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955); Rev. Rul. 2019-24, I.R.B. 1004, https://www.irs.gov/pub/irs-drop/rr-19-24.pdf.

[13] See, e.g.., §§ 1222, 1231, 1234A. 

[14] Publication 544, Sales and Other Disposition of Assets, IRS (2019), https://www.irs.gov/publications/p544#en_US_2019_publink100072274.

[15] See 31 C.F.R. § 1010.100 (m).

[16] Andrew Perrin, 16% of Americans say they have ever invested in, traded or used cryptocurrency, Pew Rsch. Ctr. (Nov. 11, 2021), https://www.pewresearch.org/fact-tank/2021/11/11/16-of-americans-say-they-have-ever-invested-in-traded-or-used-cryptocurrency/.

[17] See generally David C. McDonald, Coining New Tax Guidance: How the IRS is Falling Behind in Crypto, 28 U. Mia In’t & Comp. L. Rev. 152, 171 (2021) (discussing deeper issues tied into complexities of cryptocurrencies and their inability to conform to an existing framework, and that today’s guidance is a “hot mess”).

[18] James Anderson, David Berke, Christopher Bowers & Nathan Giesselman, Tax Law Struggles To Keep Pace With The Proliferation of Cryptocurrency, JD Supra (Jan. 20, 2022), https://www.jdsupra.com/legalnews/tax-law-struggles-to-keep-pace-with-the-6709809/.

[19] See generally Danhui Xu, Free Money: But Not Tax-Free: A Proposal for the Tax Treatment of Cryptocurrency Hard Forks, 87 Fordham L. Rev. 2693, 2695 (2019) (discussing the application of treating hard forks as property per the IRS and the distinctions of hard forks from anything similar that we know today such as stock splits, treasure troves, corporate spin-offs, and dividends).

[20] McDonald, supra note 17, at 155.

[21] See IRS Announces the Identification and Selection of Five Large Business and International Compliance Campaigns, IRS (Jul. 2, 2018), https://www.irs.gov/businesses/irs-lbi-compliance-campaigns-july-2-2018.

[22] See IRS has begun sending letters to virtual currency owners advising them to pay back taxes, file amended returns; part of agency’s larger efforts, IRS (Jul. 26, 2019), https://www.irs.gov/newsroom/irs-has-begun-sending-letters-to-virtual-currency-owners-advising-them-to-pay-back-taxes-file-amended-returns-part-of-agencys-larger-efforts.

[23]  1 Robert S. Fink, Recent Compliance Initiatives in Criminal Tax Prosecutions, Blockchain, Tax Controversies—Audit, Investigations, Trials § 16.07, 278.6 (2021).

[24] Id.

[25] Supra note 1.

[26] Supra note 6,  referring to the 1040 Tax Form question “Did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?”.