Business models change. When that happens, so should the systems that were built around them. As of now, some of the major systems in place that effect cryptocurrencies, like the legal and tax systems, are stifling new businesses and if they don’t catch up, the North American economy will suffer accordingly.
Working at Tendermint, I have realized how difficult it is to work within paradigm changing technology yet be forced to work within the confines of systems of a previous paradigm.
In the spirit of the open source ethos, and sharing of ideas, I want to share some of the things I’ve learned to help founders, operators, and those new or experienced in crypto, learn the ins and outs of crypto company operations, but faster and with more guidance. 2017 was the year when companies tried to figure out how to raise money in tokens legally, 2019 and beyond will be about learning how to operate businesses, powered by tokens, in a compliant and tax efficient manner. In this series, I’ll cover some basic operating functions that are wildly different in crypto than your typical start up. These differences will show up in crypto taxes and accounting, decentralized teams and global regulation, and treasury management, to name a few. Part I (where you have landed today), will focus on taxes.
Over 200 years ago, the railway industry (one of my favourite historical bubbles) caused a massive shift in how companies operate, moving businesses from sole proprietorship to corporations, allowing for massive economic scale. Companies became much greater than the sum of their parts.
For the past few centuries, the corporate structure has fuelled economies worldwide. It has proven to be the most successful playbook and model by which people can profit, remove personal liability, and hire employees. As a result, the business systems of the world have been shaped around the corporate structure. In turn, the tax and legal systems, two major systems that support corporations, have molded and learned how to regulate corporations since the 1800’s.
However, as corporate structures change, as people interact and do business differently, the tax and legal structures that support the “how to start a corporation” playbook, are not changing concurrently. As a result, the systems are left to try and catch up to changing times by using “closest metaphors” and “best proxies” to value things they don’t understand.
The Complexity of the World’s Tax Systems
I often joke that in the months I have been with Tendermint, I have received a fast-tracked Master’s Degree in International Tax Law. We have 3 offices in different countries (US, Canada and Germany), all which have different rules and regulations. I have learned more over the past months, than I could have imagined about different countries’ tax rules. But, what really stands out is that the legal and tax systems are somewhat misaligned with the reality in which we work. I will focus this post mostly on the tax system (more on legal in future posts). In the U.S., the IRS dictates how you should track crypto transactions, but for anyone who has gone through this process, they know that reconciling business expenses incurred in USD and repaid in crypto is not an effortless task and there is not a lot of software that provides help with this. So, a lot of manual entries happen.
Tendermint maintains good records to ensure we are as accurate and up to date as possible, following IRS guidance of tracking pools. But the guidance from the IRS is misaligned, it consistently uses “closest metaphors” that don’t fit the nature of the system we are experiencing.
Taxing crypto as ‘property’ as the best proxy isn’t a strong comparable nor is it representative of crypto use. By trying to maintain this complex system — which is nearly an impossible task to get perfectly right — I question the IRS’ ability to manage their own suggested path.
Germany has made a strong movement toward crypto tax efficiency by treating crypto as a free flow, similar to fiat, and removing the need to track pools like inventory. So, when you use crypto to pay for expenses, no capital gains need to be tracked and recorded. This removes a massive layer of complexity which bogs down the North American system. If we implemented something like this in North American it would move us one step closer to connecting the paradigm of the current tax system and a potential future system.
If I pay an expense with BTC, does it make sense that I have to pay capital gains on that? No, why do I have to pay more to spend money?
If I sell crypto for cash and make a profit, does it make sense that I pay capital gains on that? YES!
If I transfer a small amount of fair market value (FMV) of BTC to FMV of ETH does it make sense that I have to pay taxes on that? No, I transacted FMV to FMV, there should not be a cost basis.
Here are my thoughts: only where the word Cash appears should the exchange result in a tax.
If BTC → Business Expense → No tax
If FMV BTC → FMV ETH → No tax (section 1031 like-like right?!)
If BTC → Cash → Tax
If BTC → ETH → Cash → Tax
The current tax treatment of crypto assets puts crypto companies in a position of massive asset misalignment. Companies have to pay taxes on anything they transact in crypto, but they don’t necessarily have the liquid fiat dollars to pay the taxes on the transaction in the first place.
It is complicated and adds a lot of friction for companies to have these tax consequences. Say you pay a business expense with 0.0005BTC and it’s a taxable event, you have to make a journal entry to record the transaction and note the proper gain or loss recognition. This overhead makes people less likely to transact in crypto, it stifles innovation in jurisdictions with this kind of tax treatment. Ultimately, legitimate and innovative tech companies will be incentivized to relocate to more crypto-friendly jurisdictions other than the US and Canada to develop their paradigm changing technologies. In turn, this will leave North America out of the fold as these new technologies develop.
There are ways that the government and policy makers could take a closer look at how new technologies fit operationally into the old paradigm. They can ask what small changes they can make to help align the past and the present.
Some simple solutions would be:
- Remove the need for capital gains tax on small expense payments and like-for-like token transactions to remove the logistical overhead from everyday transactions.
- Allow companies to pay taxes directly in crypto, so a company is not bankrupted in fiat tax liability by holding and transacting in crypto.
Uber and Lyft didn’t fit into the legal and operational paradigms when they first launched; cities and states put up fights. But, these companies knowingly kept breaking the law, and they won, forcing a new legal and regulatory paradigm to adjust around them.
Instead of attempting to overhaul the old systems all at once, let’s reinvent things one step at a time and examine these new assets with forward looking eyes. Let’s evaluate how we can make small changes that help bridge the systems of old and new and allow new paradigm-shifting companies to work within the established systems more efficiently and effectively.