Following a July 2020 webinar in which the IRS confirmed that virtual currency tax reporting regulations were in the pipeline, we discuss questions that these regulations will need to address.
- In July, the American Bar Association Tax Section hosted a tax webinar where IRS officials confirmed that tax information reporting regulations covering virtual currency transactions are in the pipeline. However, this was already on the IRS’s published guidance plan.
- Part of the urgency is that virtual currency tax-reporting regulations are a critical piece of the IRS’s enforcement effort on crypto. But crypto tax reporting raises numerous, novel questions that are not easy to answer.
- In the Refinitiv white paper 2020 Crypto Tax Update Sound & Fury, we provided a recap of the year in crypto tax and considered what has been answered and what is still outstanding.
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On a tax webinar in July hosted by the American Bar Association Tax Section, IRS officials confirmed that tax information-reporting regulations covering virtual currency transactions are in the pipeline.
This announcement was nothing new though. We have known about this regulatory project since at least last October when the IRS included virtual currency tax-reporting regulations in its 2019-2020 priority guidance plan.
However, the 2019-2020 plan year ended on June 30 and nothing had since been released, so it was reassuring to know that the IRS is still working on this. As we wait for the upcoming regulatory guidance, we should consider some of the questions those regulations will need to answer. And easy questions they are not.
By way of background, the IRS priority guidance plan lists the regulatory and related guidance projects that it expects to complete for a plan year. The plan year runs from July 1 to June 30.
In the fall of 2019, the IRS included regulations for reporting of virtual currency transactions under Internal Revenue Code section 6045 as part of the 2019-2020 priority guidance plan. This currently covers tax reporting by brokers for U.S. customer accounts.
2019 IRS guidance and tax reporting
Earlier in 2019, the IRS published on its website a new set of frequently asked questions relating to the taxation of virtual currencies as well as a new revenue ruling on the tax treatment of crypto “hard forks” and “airdrops.”
It also sent some 10,000 “informational” letters to taxpayers who may have had virtual currency transactions reminding them of their tax filing obligations. So there have been efforts already by the IRS to enforce crypto tax compliance through increased taxpayer awareness and, of course, the ever-present threat of a potential IRS audit.
But third-party tax information reporting — in which a financial institution, for example, may be required to report the sale of Bitcoin by a customer to both the IRS and the customer — is probably the key element to achieve effective taxpayer compliance. Outside the crypto world, it has long been known that third-party information reporting regimes work effectively.
If you earned $1,000 in your bank account and you know that the bank has reported this to the IRS and to you on a tax statement, you are more likely to report and pay tax on the amount on your tax return.
First, you have accurate data because the bank provides you with the information, but you also know that the IRS will have the same information. On the tax agency’s part, tax reporting also means that the IRS has data points to cross-check your tax return for reasonableness.
IRS statistics show that compliance rates where there is no tax information reporting can be as low as 37 percent. However, this rises to 93 percent compliance when tax information-reporting is implemented. These statistics occur in the world of traditional financial payments rather than that of crypto.
The statistics on these compliance rates hint at how critical the virtual currency tax-reporting regulations could be for the IRS’s crypto tax enforcement effort. Nevertheless, the issues posed by virtual currencies will not make drafting the regulations easy. Neither would it be easy for a broker or other intermediary to implement.
Questions to be addressed by regulations
What questions would the virtual currency tax reporting regulations need to tackle?
What assets will be in scope?
How will the regulations classify different types of crypto assets? Crypto assets, of course, are not monolithic. Which crypto asset types will be in scope or out of scope for reporting? Will the IRS focus on what it has labelled “convertible virtual currencies,” and will there be further elaboration on what that term includes?
Will the regulations discuss tax treatment of exchange tokens versus security or utility tokens? Will some crypto assets be treated like securities, or perhaps as a commodity, or perhaps classified as a separate category for reporting purposes?
Who will need to report?
Currently, tax regulations under section 6045 require brokers and barter exchanges to report. Brokers are generally required to report sales for cash on transactions involving securities and commodities.
But would the virtual currency tax-reporting regulations expand the scope of persons required to report to include crypto exchanges and other institutional intermediaries that facilitate crypto trading? How will those parties be defined?
What reporting will be required?
Under the current broker reporting rules, certain securities are classified as “covered securities.”
For these securities, brokers are generally required to not only report sales proceeds but provide cost-basis information. Existing cost-basis determinations are difficult enough, especially in the case of certain debt instruments or corporate action events or transfers.
However, what do you do with cost basis on crypto assets where a customer can transfer virtual currencies between broker custodial accounts and their own private wallets? How do you deal with crypto events like airdrops or staking or crypto currencies that undergo hard forks? What should be done about gifts of virtual currency or third-party transfers into a customer account?
What format will reporting take?
The regulatory project is promulgated under section 6045. Currently, section 6045 broker reporting is conducted utilizing Form 1099-B.
In the current crypto landscape, the tax-reporting format (if any) differs among different participants in the industry. Some may not report at all. Some report on Form 1099-B. Some may report on Form 1099-MISC, for miscellaneous payments as the name implies.
Meanwhile, others have chosen to report on Form 1099-K, which is used by third-party settlement processors. Will the regulations focus only on Form 1099-B reporting? Or will the IRS help to clarify what type, or types, of reporting should take place under specific circumstances? How will the new reporting rules affect existing information reporting processes for other payment types?
Will there be tax withholding?
U.S. tax information regimes are generally accompanied by withholding mechanisms.
In the financial payments world, where payments are made to a U.S person who has provided proper certification of their tax identification number (TIN), there is generally no withholding.
The broker that has the TIN can file the appropriate tax reports to the IRS and the customer, and the return can be matched to the taxpayer through the TIN.
But if the customer does not provide the TIN, regulations generally require the broker to withhold at a rate of 24 percent on payments to the customer. This is called “backup withholding” and can apply to proceeds of sale.
Will there be backup withholding on undocumented accounts in the crypto area too? Would this apply only to transactions in cash versus coin-for-coin exchanges? Would the IRS provide a grace period for crypto intermediaries to document U.S. account holders?
Tax compliance in the age of crypto
We know that virtual currency tax-reporting regulations are coming.
Part of the urgency is that it is a critical piece of the IRS’s enforcement effort on crypto. But crypto tax reporting raises numerous novel questions as noted above that are not easy to solve.
In the meantime, brokers and other withholding agents have to report based on their best guess as to what is required under current law. Dealing with this fluid legal landscape seems to be the nature of tax compliance in the age of crypto.
The Refinitiv white paper 2020 Crypto Tax Update Sound & Fury can help you learn more about the year in crypto tax and what your organization needs to be aware of when the IRS provides final guidance on crypto taxation.
