A couple of weeks ago, a friend of mine who is an active crypto trader told me he’d wrapped up his personal taxes. He’s a die-hard, anti-system kind of a guy, but he made sure to do everything to a tee because you never know what broke governments are willing to do.
After recording every single transaction, his supporting documents came out to more than 10,000 sheets. More sheets than the IRS will even allow you to submit. I have to say, that made me very glad to be in the HODL camp.
If you are a US citizen or resident, the hard truth is that you’re dealing with one of the most complex tax systems in the world. On top of that, if you’ve actively traded crypto or used it to buy and sell goods over the last year, your life just got far more complicated.
Hopefully, by now, you’ve already enlisted professional help to prepare your taxes. But just in case, read on in today’s article as I cover how investments in crypto fare in the hands of an archaic tax system.
In 2014, the IRS officially classified cryptocurrencies as ‘property’ which effectively means that all cryptocurrency investments are subject to capital gains tax.
Though this may not seem like much of a big deal, the reality is that this classification makes life extremely cumbersome and complicated for crypto investors since each and every transaction must be treated as a taxable event.
Everything from tiny transactions to large investments must be recorded, including the date of each transaction and its value in US dollars. Yes, this includes the cup of coffee you bought with Bitcoin last September.
It’s a thankless and time-consuming task, not to mention intrusive. Imagine if you had to report every single purchase you made with your credit card to the government each year. And then convert all of those purchase prices into a different currency at the fair market value at the time of the purchase. You would need to know the exact time of each transaction and the exact price of the crypto at that precise moment! That’s the practical result of having crypto classified as ‘property.’
And it doesn’t stop there. Having recorded this data on a spreadsheet, you must determine your capital gains or losses within the parameters of short and long-term investments and report that information in your tax return.
And that’s just for ‘normal’ transactions.
Imagine if you want to use crypto in lieu of fiat to make a loan. Let’s say you want to lend 100 Bitcoin at 10 percent interest. Theoretically, your transaction should result in a capital gain of 10 Bitcoin, and you should be liable for taxation on that amount.
However, since all transactions must be recorded in US dollars, if the price of Bitcoin rose (or fell) during that time, that simple transaction could render you with a much higher (or lower) capital gains liability, whether or not you ever realized that gain in dollars.
Applying archaic asset classification to this new asset class has created a significant disconnect between what’s happening on paper versus what’s happening in reality.
While conventional cryptocurrencies like Bitcoin are treated as property for federal tax purposes, the treatment of initial coin offerings (ICOs) and security token offerings (STOs) isn’t so clear cut.
Since the IRS has not yet released an official tax statement on token sales, there is some general confusion on how ICOs and STOs should be taxed. However, just as the SEC tries to apply 80-year-old securities law to crypto, the IRS will also likely attempt to apply traditional tax law to the taxation of ICOs and STOs.
In the case of STOs, it’s clear that the tokens are sold as part of a securities offering. As a result, these tokens can be classified in the same way as traditional securities. If the STO represents equity, its tokens will be taxed like equity. If the STO represents debt, its tokens will be taxed like debt. The fact that the offering is handled through an STO as opposed to a traditional security offering does not garner it special tax treatment.
Until very recently, the SEC had made it clear that it considered all ICOs to be security token offerings as well. However, last month, the SEC chairman said that some ICOs may have initially been securities offerings, but over time they could have become something else. Even more recently, the SEC indicated that not all ICOs will be securities offerings.
These leaves purchasers of ICOs in a complicated situation. Are the tokens securities or property? And if they are securities, which type?
The SEC’s case-by-case treatment of individual ICOs and tokens will continue to make it a difficult and daunting task for those looking to stay on the good side of the IRS.
Another key area of debate is the tax liability faced by projects that have raised money via token offerings. Again, the distinction between whether the token offering qualifies as a security offering is critical.
According to existing tax law, capital raised when a company engages in a security offering is not considered taxable income under US accounting standards. With STOs, this means that issuers don’t face any tax liability from the initial sale of tokens. Only when those tokens are bought or sold thereafter are traders liable for taxes on the capital gains.
For ICOs that do not qualify as securities offerings, on the other hand, since their tokens are considered ‘goods,’ issuers may be liable for income tax from the moment the initial sale of tokens takes place.
Not surprisingly, how a project handles its tax liability when launching a token offering, is becoming a significant matter of debate.
A few months ago, Kik, the Canadian instant messaging app, was notified by the SEC that its token offering was an unlawful securities offering. Unwilling to back down, Kik responded with a comprehensive letter that outlined why it’s offering should not be considered a securities offering. One of the many arguments Kik made in its defense was that it had paid taxes on its token offering, thus demonstrating that Kik did not treat its token offering like a securities offering.
If the tokens were securities, Kik would not have had to pay taxes. Essentially, if the SEC wins then the IRS loses, as Kik would then be entitled to a major tax refund. (Side note: Is it bad if I root for both the SEC and IRS to lose?)
Similarly, any projects trying to make the case that they did not hold an unlawful securities offering, should have declared income on their token offering and paid the subsequent income tax. For projects that raised $20M in an ICO, you might owe 35 percent (or ~$7M) in taxes.
One of the biggest challenges facing crypto today is regulatory uncertainty. Unsure of the law and how it applies to their projects, many crypto entrepreneurs are hesitant to take action. After seeing other projects fined hundreds of thousands of dollars for being out of compliance, they are understandably nervous about making the same mistakes.
The bottom line is that making a good faith effort to be in compliance is 9/10ths of the battle.
I’ve spoken to many crypto traders who haven’t filed tax returns because they’re scared they will mess it up. But not filing tax returns is not the right approach and will leave you exposed to criminal penalties.
For hodlers, I recommend you instead do your best, act in good faith, let your CPA file the return, and keep your fingers crossed.
Originally published at cryptolawinsider.com on April 10, 2019.