Clarifying the Rules – IRS Guidance on Crypto Transactions (Part Two)
The prior post looked into the general guidance from the IRS regarding cryptocurrency transactions. This post will dive into more exacting topics related to passive income within the cryptocurrency market. For more information on various criminal tax issues, visit our pages devoted to criminal tax, tax fraud, and tax evasion.
How the IRS Addresses Mining and Passive Crypto Income
The cypto market has a variety of ways for token holders or miners to obtain additional crypto assets. The four most common forms of passive income are: 1) mining, 2) staking rewards, 3) air drops, and 4) hard forks.
Bitcoin Mining and the IRS
Mining is the process of verifying transactions on a given blockchain network. Major crypto assets such as Bitcoin and Ethereum use proof of work to secure their networks. Proof of work requires a miner to solve a complicated algorithm to verify transactions within a block. On Bitcoin, this is achieved by setting up powerful computers to solve the algorithm and verify the block. These processors require the use of considerable electricity, and hash power, making it a secure way to protect the network.
If a taxpayer mines Bitcoin they will receive a portion of the transaction fees and a mining reward for relevant blocks. These fees are paid in Bitcoin.
The IRS released guidance in 2014 addressing how mining rewards should be reported (IRS Notice 14-21). It is important to note that IRS notices are not binding law, but rather, the IRS’ current interpretation of how existing law should be applied. Under IRS guidance, mining rewards are taxable income to the miner on the date the fees are received. If the miner receives 6.25 Bitcoin on 50 days out of the year, they must determine the fair market value of the Bitcoin on the date each reward is received. That total amount in USD must be reported as ordinary income on their yearly return.
This rule is not complicated for taxpayers that mine as a hobby. However, the rules get more convoluted if a taxpayer mines crypto assets as a trade or business. This includes the potential for paying self-employment taxes on all rewards received. Whether a taxpayer is operating as a business is a question miners should pose to their CPAs to ensure they are accurately filing their returns.
Staking Rewards and the IRS
Staking is a newer, more energy efficient answer to the Bitcoin/Ethereum mining process. Staking secures a blockchain network by allowing holders of the token to setup nodes on servers around the world. These nodes verify and secure the blockchain network. To incentivize node runners, most blockchains will reward them with portions of the transaction fees from the network.
The IRS has not issued guidance on how staking rewards should be categorized under the IRC. However, the similarities to mining are obvious. The conservative, and likely accurate, approach is to include all staking rewards as ordinary income. The taxpayer will have to determine the fair market value of the rewards on the date the tokens came under their control. The total value in USD is reported as ordinary income on the yearly return.
Air Drops, Hard Forks and the IRS
We will consider the final two areas as a unit as the IRS has issued guidance that addresses both air drops and hard forks in one publication (IRS Revenue Ruling 19-24).
A hard fork occurs when a new crypto project forks from an existing blockchain. The result is a new blockchain with a new crypto asset. The original blockchain remains unchanged. The most well-known hard fork is Bitcoin Cash’s hard fork from Bitcoin. In 2017, Bitcoin Cash forked from the Bitcoin network with hopes of improving some existing issues with the blockchain. On the date of the hard fork, Bitcoin Cash ran on its own separate chain with its own crypto asset (BCH). Bitcoin remained the same.
When the hard fork happened, holders of Bitcoin were rewarded with BCH tokens at a 1:1 rate. If a taxpayer held 1,000 Bitcoins, they received 1,000 BCH tokens. The question posed in Revenue Ruling 19-24 was whether the 1,000 BCH tokens were income to the taxpayer. In the above cited guidance, the IRS concluded that the newly issued tokens were income to the taxpayer. The taxpayer must determine the fair market value of the BCH on the date the tokens were issued. That number in USDs must be reported as ordinary income. That number also serves as the taxpayers basis in BCH for use in capital gains calculations should the taxpayer sell BCH in the future.
Air drops are similar to hard forks, and many times are used to distribute tokens after a hard fork. An air drop is simply the process of transferring tokens (free of charge) to a predetermined list of wallets on a certain chain. For example, when Bitcoin Cash forked from Bitcoin, a snapshot was taken of all Bitcoin holders when the fork occurred. Those Bitcoin addresses received BCH tokens through an airdrop in the coming days. This process is used to distribute tokens to project holders for various reasons including hard forks, rewarding certain behaviors, or as part of promotional plans. Air drops are treated identically to the hard fork description above.
Criminal Tax and the Evolving IRS Guidance
The IRS continues to provide guidance for taxpayers that hold or trade crypto assets. But this guidance is largely an attempt to apply old generic property rules to an emerging asset class. This reality has led to a very cumbersome and arduous area of tax law. The rules are evolving each year with additional issues being confronted.
Evolving areas of tax law do not lend themselves to criminal prosecutions. The government must prove that a taxpayer knew the rules and willfully chose to circumvent them. That is a difficult burden when the rules are clarified each year. However, as the guidance becomes more well known, the criminal investigations division of the IRS will start look into the more egregious actors. It is becoming well known (and likely always should have been) that the sale of a crypto asset triggers a taxable event. It is becoming well known that staking and mining rewards should be treated as ordinary income. As these rules become more widely accepted, the risk for criminal investigations into crypto investors will elevate.
One overarching issue with the crypto market is many taxpayers’ underlying belief that their transactions are hidden from government oversight. While it is true that crypto traded on a decentralized exchange has a much smaller paper trail than trading Apple on TD Ameritrade, the trail nonetheless exists. If a crypto trader provides identifying information to any exchange or other entity, their identity is known and their transactions can be followed. The IRS is already formulating ways to cut through the anonymity and hold taxpayers accountable for their income and gains (discussed in a previous article).
As this area of tax law becomes more coherent, the IRS will begin going after the millions of dollars they are missing from the crypto market. The biggest fish are the ones that will fall first. Every crypto trader, and accountant, should remain up to date on the most recent guidance and adjust accordingly. As a general rule, if you sell/exchange/receive crypto assets in a taxable year, you need to strongly consider the tax consequences. This information needs to be disclosed to your accountant. At some point, crypto assets will become central to many criminal tax investigations.