How the IRS and some clever software can remove the dread come tax time

Dec 08, 2016

If you’re an avid reader of blockchain and cryptocurrency news, you’ve already seen that the IRS has been asked to step up its game in implementing a more robust tax strategy for virtual currency users. Calvin Ayre reports that the Treasury Inspector General for Tax Administration (TIGTA) recommends the IRS immediately review its now 2-year-old policy and well-expired list of guidelines. Several mainstream media outlets and trade publications picked up the story, and I’m glad they did; the taxation of digital currency is a debated but essential topic for the growing industry.

TIGTA’s report was comprehensive and rather brutal - they pointed out “little evidence of coordination” between different parts of the IRS on policing virtual currency transactions. In summary, they found that the actions of the IRS in addressing virtual currency tax noncompliance are not coordinated, and that they have no way of verifying virtual currency transactions because current third-party methods of reporting taxable transactions to the IRS, such as Form W-2, Form 1099-MISC, and Form 1099-K do not suffice.

So what’s the solution? Well, in my opinion it’s two-fold. Firstly, the IRS updates its tax guidelines. TIGTA proposed three recommendations revolving around new strategy, better guidance and revised third party reporting documents, to which the IRS have already agreed to implement. Secondly, and I believe of equal importance, tax software needs to be updated so that any user or investor of cryptocurrency can compile a report at the end of the fiscal year, showing unrealized gains and losses from their entire virtual currency portfolio, and hand it to their accountant in a format that is easily understood, consistent, and accurate. This could quickly fill the third party tax reporting abyss.

In defense of the IRS, and the Virtual Currency Issue Team (VCIT) they put together in 2013, building an overarching, government enforced strategy on a new and relatively complicated concept is a tough ask. But it’s also one that the growing number of bitcoin and alternative digital currency adopters are crying out for. When the IRS does make its changes, updated tax software will make the task of fulfilling one’s obligations far easier. Virtual currency users would have far less to worry about during tax time; no matter how many transactions they made, no matter how much bitcoin was spent, how much was earned swapping altcoins, or how much interest was earned on a Dash masternode, accounting software would fill a major void. And it would be welcomed by the Office of Audit: “The IRS has already established that taxpayer compliance is higher when income is subjected to third-party information reporting. We believe that by identifying virtual currency transactions through third-party information reporting documents, the risk of taxpayer non-compliance can be reduced.”

While only a small percentage of the population knows how cryptocurrency works, this “magic internet money” is gaining significant traction. The total market capitalization of cryptocurrency is now worth $12 billion USD, up from $7 billion USD in January. Big banks are clamoring to adopt the technology behind it, individuals are enjoying success from an unorthodox form of investment, people in impoverished countries are using it as an alternative to fiat, and hundreds of thousands are making cross border remittances at cheaper and faster rates than ever before. One of the only hindrances now is knowing exactly what to do at tax time.

The IRS currently identifies virtual currency as property for federal tax purposes, and in July, a Miami judge ruled that bitcoin isn’t money, and that “it falls under a statute that is so vaguely written that even legal professionals have difficulty finding a singular meaning.” I see that cryptocurrencies should be treated in three distinct ways: a commodity that can be traded according to the day to day whims of the market, an investment that can act as a personal “monetary reserve,” or a means of transacting for goods and services. In all cases, the value of the cryptocurrency is tied to some fiat value. At Node40, as a US Corporation, we are required to file taxes. Since most of our customers pay with digital currency, we needed a way to calculate the USD cost of all incoming transactions and then determine if there was a gain or loss when we converted to USD, so assigning value to each transaction was an absolute requirement. Day traders are involved in cryptocurrency because it is simply another vehicle for exchanging value between assets. Long term investors have to gauge performance by comparing a cryptocurrency’s value with other assets using a common base. And merchants set a cryptocurrency price based on the fiat conversion.

There are many ways to compare a cryptocurrency’s value against a fiat currency. Just like precious metals, you can compare the purchase price with the current market price to estimate your unrealized gain/loss. That works for a snapshot of value, but what happens when you use a cryptocurrency, or exchange it for some other asset? Because of the way cryptocurrency transactions are created, it isn’t a simple calculation of starting value vs purchase (transaction) value that determines gain/loss. Consider this: if I buy a $5 coffee, the value of the transaction is $5. I can choose to pay for that coffee any number of ways. I could use five $1 bills. Or 500 pennies. Whatever denominations I combine in order to come up with $5 can be considered the inputs to the transaction. Inputs and outputs are how most cryptocurrencies work. A number of inputs are selected until the value is equal to or greater than the purchase price of the coffee (i.e. $5). Unlike fiat currency, the inputs of a cryptocurrency transaction can vary depending on when the cryptocurrency was received. This means that there will be a slight discrepancy in the base value of the cryptocurrency inputs compared to the market value, meaning the transaction could have yielded a slight loss or a slight gain. Now imagine the gains/losses for a full year of transactions. The number could significantly affect what you should or should not be reporting come tax time.

If we are going to start treating cryptocurrency as something more than “magic internet money,” we need to put in some serious consideration about how it works and to define best practices for meeting the IRS upcoming tax guidelines while simplifying our own reporting requirements. Profits and losses are important to any successful business, and if you are going to transact in cryptocurrency you need the tools that will allow you to make decisions based on accurate accounting. Every corporation needs to record their taxes appropriately, even if its losses and gains are made from a completely novel form of business, a type of finance our parents don’t know about. With assistance from the IRS, some intrepid business will solve this problem, and we’ll all be the beneficiaries.