Despite their volatility, cryptocurrencies such as bitcoin and Ethereum continue to attract investors and users. To accommodate these customers, a growing number of businesses have begun accepting digital currencies as payment for their products or services. If your company is among them, it is important to understand the tax treatment of such digital assets and to stay abreast of the changing tax and reporting requirements.
Changing Tax and Regulatory Environment
Since the first bitcoin was used to buy a pizza in 2009, the IRS has been working to define how such digital transactions should be treated for tax purposes. Although the agency has continued to refine its position on various details, it laid the foundation for its approach in 2014 when it published IRS Notice 2014-21. This notice established the underlying principle that virtual currencies are treated as property rather than as actual currencies.
The IRS has since published additional guidance for small businesses (Virtual Currencies), and a question-and-answer series on virtual currency transactions. However, crypto financial instruments are evolving much faster than the regulatory guidance so the tax treatment of some transactions remains uncertain.
Nevertheless, the tax and regulatory environment is adapting. For example, in November 2021 the Infrastructure Investment and Jobs Act extended a number of IRS reporting requirements to cover digital currency transactions (more about those in a moment).
Even more recently, on March 9, 2022, the president issued an executive order that mandated a coordinated federal approach to digital assets. The order requires various agencies to develop recommendations regarding financial stability issues, anti-money laundering concerns, and other considerations including the possible development of a U.S.-backed digital currency.
Businesses that accept digital currency payments should stay alert for regulatory changes stemming from these efforts.
Cryptocurrency Tax Rules at a Glance
If your business accepts digital currency as payment for goods or services, the payment must be reported as ordinary income. The amount of income is equal to the fair market value (FMV) of the currency at the time of the transaction. If your company immediately exchanges the digital asset for cash, the tax treatment is straightforward.
On the other hand, if you choose to retain some or all of the payment in your company’s digital “wallet,” things may get more complicated. When you eventually dispose of the digital currency—either by converting it to cash or using it in another crypto transaction—any increase in its value would be taxable as either a short-term or long-term capital gain, depending on the holding period, using the FMV when it was acquired as its basis. Conversely, a decrease in the asset’s value might be deductible, but both individuals and business entities are subject to limitations on the amount of capital losses they may deduct.
The crypto exchange or payment processor may or may not provide a Form 1099 with the information you need to compute the gain or loss—the rules are changing. Like other “payment settlement entities,” virtual currency exchanges are required to provide a Form 1099-K reporting the proceeds received by customers who engage in at least 200 transactions a year with proceeds totaling $20,000 or more. But, as noted previously, the 2021 Infrastructure Act imposed additional requirements for virtual currency exchanges, including new Form 1099-B broker reporting requirements. These are scheduled to go into effect in 2023, but there are already several proposals to eliminate or modify them.
In addition to expanded information reporting by currency exchanges, the Infrastructure Act also imposed new requirements on businesses that accept virtual currency as payment. Businesses that receive more than $10,000 in cash in one transaction or a series of related transactions were already required to report the details on IRS Form 8300. That requirement now applies to crypto transactions as well.
Regardless of whether it receives a Form 1099, any business that accepts digital currency as payment is responsible for documenting the transaction and paying the appropriate tax. The IRS considers failure to properly disclose crypto transactions to be tax fraud, which could trigger both civil and criminal penalties.
Transaction records from a digital coin exchange can be helpful, but the recordkeeping responsibility ultimately falls on the taxpayer. If you do not use an exchange and instead choose to accept digital payments directly, the recordkeeping requirements can be even more demanding, although specialized software can help automate the process.
Other Considerations
Beyond the reporting rules, there are other crypto-related tax questions to consider, particularly if you decide to retain some of the digital assets rather than exchange them immediately for cash. In addition to virtual currencies’ volatility risk, there is also the possibility of unexpected taxable events such as blockchain “forks” (similar to a stock split), which could generate additional tax liabilities. For taxpayers who decide to embrace crypto even more actively by “mining” or producing coins, the picture is even more complex, with many questions unanswered regarding deductible expenses and the ability to claim losses.
As virtual currency enthusiasts continue to advocate for their acceptance, crypto transactions are likely to account for a growing portion of some companies’ business in coming years. If your company chooses to engage in such commerce, accurate recordkeeping and close consultation with your tax professional are essential to avoid unpleasant surprises at tax time.
Please contact us if you have questions regarding the tax treatment of digital assets.