Cryptocurrency was not well known and confusing for the general public to get comfortable with but with innovations in the industry starting in 2017, cryptocurrency is becoming more widely known and accepted as a means to do business. One of those innovations increasing the popularity of cryptocurrency is the introduction of a multi-currency wallet that holds Bitcoin Cash and Bitcoin Core in a non-custodial fashion. The wallet known as the “ Wallet” allows users to store their private keys themselves which avoids the funds to be held by any third party. Since this wallet which became available in August 2017, it is believed that there are now over 81 million wallet users in 2022.

Taxation Of Cryptocurrency

Although both the general public and the crypto community refer to bitcoin, altcoin, etc. as “virtual currencies”, the IRS in 2014 issued Notice 2014-21 stating that it treats them as property for tax purposes. Therefore, selling, spending and even exchanging crypto for other tokens all likely have capital gain implications. Likewise, receiving it as compensation or by other means will be ordinary income.

Some would think that if bitcoin is property, trades should be tax deferred under the like-kind changes rues of IRC section 1031. Under that theory someone who owned Bitcoin could diversify their holdings into Ethereum or Litecoin, and plausibly tell the IRS it created no tax obligations. Unfortunately, the Tax Cuts & Jobs Act of 2017 does away with that loophole making it clear that “like kind exchanges” which lets people swap an asset for a similar one without triggering a tax obligation are not available for non-real estate assets.

While bitcoin receives most of the attention these days, it is only one of hundreds of cryptocurrencies. Everything discussed with regard to bitcoin taxation applies to all cryptocurrencies.

Here are the basic tax rules on specific cryptocurrency transactions:

  • Trading cryptocurrencies produces capital gains or losses, with the latter being able to offset gains and reduce tax.
  • Exchanging one token for another — for example, using Ethereum to purchase an altcoin — creates a taxable event. The token is treated as being sold, thus generating capital gains or losses.
  • Receiving payments in cryptocurrency in exchange for products or services or as salary is treated as ordinary income at the fair market value of the coin at the time of receipt.
  • Spending cryptocurrency is a tax event and may generate capital gains or losses, which can be short-term or long-term. For example, say you bought one coin for $500. If that coin was then worth $700 and you bought a $700 gift card, there is a $200 taxable gain. Depending on the holding period, it could be a short- or long-term capital gain subject to different rates.
  • Converting a cryptocurrency to U.S. dollars or another currency at a gain is a taxable event, as it is treated as being sold, thus generating capital gains.
  • Air drops are considered ordinary income on the day of the air drop. That value will become the basis of the coin. When it’s sold, exchanged, etc., there will be a capital gain.
  • Mining coins is considered ordinary income equal to the fair market value of the coin the day it was successfully mined.
  • Initial coin offerings do not fall under the IRS’s tax-free treatment for raising capital. Thus, they produce ordinary income to individuals and businesses alike.

So How Do The Rules Apply When Holding Cryptocurrency In An IRA?

IRC section 408(m) generally prohibits the investment of assets of an IRA (and any self-directed qualified plan account) in certain “collectibles” including precious metals; however, there are exceptions for certain coins and bullion.

The U.S. Tax Court reaffirmed the physical possession rule in, McNulty v. Commissioner of Internal Revenue, No. 1377-19 (U.S.T.C. Nov. 18, 2021), and this ruling could have a big impact on some cryptocurrency account holders.

In McNulty, the taxpayers (husband and wife) established a self-directed individual retirement account (IRA) under IRC section 408 and directed assets held in the IRA to invest in a single-member limited liability company (LLC). Mr. McNulty was the manager of the LLC that her IRA invested in. She directed the LLC to purchase American Eagle (AE) coins and took physical possession of the coins. IRS contended that the year she received physical custody of the AE coins resulted in a taxable distribution equal to the cost of the AE coins. The Tax Court agreed with IRS.

The Tax Court stated:

“Independent oversight by a third-party fiduciary to track and monitor investment activities is one of the key aspects of the statutory scheme. When coins or bullion are in the physical possession of the IRA owner (in whatever capacity the owner may be acting), there is no independent oversight that could prevent the owner from invading her retirement funds. This lack of oversight is clearly inconsistent with the statutory scheme. Personal control over the IRA assets by the IRA owner is against the very nature of an IRA.”

The Tax Court’s focus on the “taxpayer’s control” of an IRA asset can have far reaching implications for self-directed IRA’s beyond bullion coins.  In the case of cryptocurrency, holding cryptocurrency in a cold wallet that is controlled by the IRA owner would provide the IRA owner with “unfettered control”.  A cold wallet can be detached from the internet. Hardware wallets and paper wallets are both cold wallet options. Hardware wallets use a physical medium — typically in the shape of a USB stick — to store the wallet’s private keys, making them de facto unreachable to hackers or other malicious parties.

So if you are looking to invest in cryptocurrency through a self-directed IRA, it is best to hold your cryptocurrency on a licensed and insured crypto exchange in the name of the IRA to avoid the impact of the physical possession rule of IRC section 408(m).

IRS Suspicion Of Noncompliant Taxpayers In Cryptocurrency

The IRS has not yet announced a specific tax amnesty for people who failed to report their gains and income from Bitcoin and other virtual currencies but under the existing Voluntary Disclosure Program, non-compliant taxpayers can come forward to avoid criminal prosecution and negotiate lower penalties.

The IRS suspects that many cryptocurrency users have been evading taxes by not reporting crypto transactions on their tax returns given the millions of wallets already issued.

Penalties For Filing A False Income Tax Return Or Under-reporting Income

Failure to report all the money you make is a main reason folks end up facing an IRS auditor. Carelessness on your tax return might get you whacked with a 20% penalty. But that’s nothing compared to the 75% civil penalty for willful tax fraud and possibly facing criminal charges of tax evasion that if convicted could land you in jail.

Criminal Fraud – The law defines that any person who willfully attempts in any manner to evade or defeat any tax under the Internal Revenue Code or the payment thereof is, in addition to other penalties provided by law, guilty of a felony and, upon conviction thereof, can be fined not more than $100,000 ($500,000 in the case of a corporation), or imprisoned not more than five years, or both, together with the costs of prosecution (Code Sec. 7201).

The term “willfully” has been interpreted to require a specific intent to violate the law (U.S. v. Pomponio, 429 U.S. 10 (1976)). The term “willfulness” is defined as the voluntary, intentional violation of a known legal duty (Cheek v. U.S., 498 U.S. 192 (1991)).

And even if the IRS is not looking to put you in jail, they will be looking to hit you with a big tax bill with hefty penalties.

Civil Fraud – Normally the IRS will impose a negligence penalty of 20% of the underpayment of tax (Code Sec. 6662(b)(1) and 6662(b)(2)) but violations of the Internal Revenue Code with the intent to evade income taxes may result in a civil fraud penalty. In lieu of the 20% negligence penalty, the civil fraud penalty is 75% of the underpayment of tax (Code Sec. 6663). The imposition of the Civil Fraud Penalty essentially doubles your liability to the IRS!

What Should You Do?

Especially now that like-exchange treatment is prohibited on non-real estate transactions that occur after 2017, now is the ideal time to be proactive and come forward with voluntary disclosure to lock in your deferred gains through 2017, eliminate your risk for criminal prosecution, and minimize your civil penalties.  Don’t delay because once the IRS has targeted you for investigation – even it’s is a routine random audit – it will be too late voluntarily come forward. Let a bitcoin tax attorney at the Law Offices Of Jeffrey B. Kahn, P.C. located in Orange County (Irvine), San Francisco Bay Area (including San Jose and Walnut Creek) and elsewhere in California get you qualified into a voluntary disclosure program to avoid criminal prosecution, seek abatement of penalties, and minimize your tax liability.  Also, if you are involved in cannabis, check out what a cannabis tax attorney can do for you.