How Do I Win the 'Game' of Income Tax in the USA?

Photo by Emily Schultz on Unsplash

For Index Coop contributors in the United States, INDEX rewards are considered taxable income because they are received in exchange for services rendered.

Income is taxed differently than investment proceeds, which are subject to capital gains tax, so it is important to know the differences between each tax type.

For U.S. contributors, INDEX received in exchange for work performed is subject to Federal Income Tax, State Income Tax, and Self Employment Tax.

1. Federal Income Tax

Federal Income Tax rates vary by filing status and tax bracket. Your total taxable income (not just your INDEX rewards) is used to determine the tax bracket that you land in, and the implicit rate that you pay increases as you move up tax brackets.

You can find 2020–2021 rates and guidance here.

2. State Income Tax

State Income Tax varies from one state to the next. For example:

There is no state income tax in Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming
Meanwhile, Colorado, Illinois, Indiana, Kentucky, Massachusetts, Michigan, New Hampshire, North Carolina, Pennsylvania, and Utah have a flat (or a fixed percentage) state income tax.
The rest of the states have a progressive state income tax that varies based on total income.

You can find State Income Tax rates and guidance for 2021 here.

3. Self Employment Tax

Self Employment Tax applies to individuals running their own business (like an LLC or Partnership), working as freelancers (as a Sole Proprietor), or working as independent contractors (often Sole Proprietors or Single-member LLCs).

Self Employment Taxes — also known as FICA taxes — account for Social Security and Medicare contributions that employers typically deduct from W-2 workers’ paychecks.

Self Employment Tax rates are the same for all U.S. taxpayers; You can find rates and guidance here.

Self-employed individuals can generally deduct half of the Self Employment Tax when determining taxable income, essentially offsetting the portion of FICA taxes that an employer would typically pay on your behalf.

How to Calculate Taxable Income From Contributor Rewards

The amount of taxable income from contributor rewards that you ought to report is determined by the price and quantity of INDEX at the time of receipt, or when the rewards are officially held by your wallet.

It is important to note that monthly rewards use a 20-day rolling average to determine the INDEX price for the previous period; however, this is NOT the price that you should use to calculate your taxable income.

The INDEX price that you should use is the market price when your rewards are claimed or distributed to your web3 wallet.

Simply stated, your taxable income on a monthly basis is:

# of INDEX Tokens * Current Market Price = Monthly Taxable Income

For example, if the 20-day rolling average price of INDEX for June is $25.00 and the Treasury WG decides that you are due $1,000.00 worth of INDEX tokens for your contributions, then 40 INDEX tokens ($1,000.00 / $25.00 rolling average price) are allocated to you.

However, if the market price of INDEX is $28.50 when you claim your rewards and receive them in your wallet, then your taxable income for the month is actually $1,140.00 (40 INDEX x $28.50 per token).

The same reasoning applies if the market price of INDEX is lower than the 20-day rolling average, meaning that your monthly taxable income could be lower than the nominal amount allocated to you when rewards are published.

Please note that this equation does not factor in Self Employment Tax deductions when determining Taxable Income.

Additionally, because U.S. citizens pay taxes on an annual basis, you will need to add each month’s taxable income to arrive at total taxable income from Index Coop activities for the year.

Capital Gains Taxes

The calculation for monthly taxable income also yields your cost basis in the tokens, which is a starting point for calculating any capital gains (or losses) whenever you sell your INDEX tokens.

Proceeds From Sale — Cost Basis = Capital Gain / Loss

For example, if you claim 40 INDEX tokens when the market price is $25.00 then your basis in the tokens is $1,000.

If you sell those tokens when the market price is $30.00, then you’ve earned a $200 capital gain ($1,200 proceeds from sale — $1,000 cost basis) on a per token basis.

This profit of $200 is subject to capital gains tax, and you may pay a higher capital gains tax rate if you have held the tokens for less than 1 year (long-term capital gains taxes tend to be more favorable).

In the same way, if your cost basis is $1,000 (40 INDEX * $25.00 Mkt Price @ Time of Receipt) but you sell all your tokens for $750 (40 INDEX * $18.75 Mkt Price @ Time of Sale), then you would recognize a capital loss of $250.

You can find more information regarding capital gains taxes on crypto here.

Tax Strategies

For Income Taxes: Wait to claim your INDEX rewards until you’re ready to realize the taxable income.

If you think that the price of INDEX will fall, it may make sense to wait and claim your rewards when the market is down so that you realize less taxable income.

However, this approach renders a lower basis in your tokens which will increase the capital gains tax that you pay in the future if the INDEX price appreciates and you decide to sell.

You may also want to wait until a certain period, say a new tax year, to claim your rewards if you’re trying to spread out taxable income across periods.

For Capital Gains Taxes: Keep detailed records of the monthly rewards that you claim as well as your basis in each batch of tokens.

This will allow you to employ the HIFO (Highest-In First-Out) accounting method which means that the INDEX tokens with the highest basis are sold first, minimizing the amount of capital gain that you must recognize and pay taxes on immediately.

The concept of earning income in the form of governance tokens is foreign to most outside of crypto, but many federal governments around the world are ahead of the curve.

Many countries across every continent have already insisted that tokens received as compensation for work are considered taxable income, so it is important for Index Coop contributors to understand the tax implications of their rewards.

To learn more about paying taxes on cryptocurrency, we recommend the following resources:

Disclaimer: Please note that this piece is for educational purposes only and that it does not constitute financial advice. The tax information shared in this article is not comprehensive and it is the responsibility of each individual to assure that they comply with all federal, state, and local mandates.