535 Fifth Avenue, 30th Floor
New York, NY 10017
Phone: 212.785.9700

3458 Ocean View Boulevard
Glendale, CA 91208
Phone: 818.634.2276

info@kbl.com

NEWS

NEWS

The Tax Consequences of Dealing in Cryptocurrency

The coolness factor of digital currency is being closely scrutinized by one of the least coolest agencies on the planet: The Internal Revenue Service. Given the speed at which these currencies have caught on — Bitcoin was released only in 2009 — the IRS hasn’t quite kept pace. They issued basic guidelines in 2014 for digital currencies, but tax experts say some of the rules are subject to interpretation.

In 2016 the IRS made it clear that it was searching for cryptocurrency tax evaders: The agency sent a broad request to Coinbase, one of the larger cryptocurrency exchanges in the United States, requesting records for all customers who bought digital currency from the company from 2013 to 2015. Coinbase balked, but a court ruled that it had to provide the records of roughly 14,000 customers, fewer than 1 percent of its patrons, who made transactions involving more than $20,000 of virtual currencies.

So, come April people who have bought and sold cryptocurrency such as Bitcoin will be expected to report any profits on their federal tax returns. And considering digital currency’s wild increases in value in 2017, there are probably many people who incurred gains or losses for the first time. But how much tax you owe will depend on how and when you acquired the digital currency.

Here are some basics about the tax implications of virtual currency:

I sold digital currency last year. What does that do to my tax return?

If you are holding digital currency as an investment, any gains or losses on the sale are treated as capital assets like a stock or bond. The gain or loss is calculated against the market value of the currency when you acquired it (your basis).

If you held the currency for more than a year, you qualify for the less onerous long-term capital gains rates (generally 0, 15 or 20 percent). Short-term gains, from digital coins held for a year or less, are taxed as ordinary income.

As on the stock market, losses can be used to offset capital gains, subject to certain rules, and losses that are not used to offset gains can be deducted — up to $3,000 — from other kinds of income. Unused losses can be carried over to future years.

I’ve successfully ‘mined’ digital currency. Now what?

All cryptocurrency transactions are recorded in a public ledger, which is maintained by a decentralized network of computers. Mining refers to the process in which new digital currency coins are created and then awarded to the computers that are the first to process these transactions coming onto the network. The people whose computers do this most quickly collect a fresh helping of cryptocurrency.

These virtual miners must report the fair market value of the currency (on the day they received it) as gross income and are ultimately required to pay federal, state and most likely self -employment taxes, assuming that the mining constitutes a trade or business.

What are the tax consequences of being paid in digital currency?

Receiving wages from an employer in a virtual currency is like being paid in dollars: it is taxable to the employee, must be reported by the employer on a Form W-2 and is subject to FICA, and federal and state income tax withholding. Independent contractors paid in digital currency must also treat that as gross income and pay self-employment taxes.

What if I paid someone in cryptocurrency for their services?

When you pay an independent contractor in excess of $600 for services performed for your “trade or business,” that should be reported to the IRS and the person receiving the payment for an amount equal to the value of the cryptocurrency when paid.

Can I reduce my tax bill by donating my cryptocoins?

Only people who itemize their tax returns can deduct their charitable donations.

For those who itemize their deductions it may be possible to directly donate their cryto currency just as they can directly donate, for example, highly appreciated stock. Just as long as the charity accepts it.

For example, Fidelity Charitable, a donor-advised fund, allows people to give money, take a tax deduction in the same year, and then invest and allocate the money to select charities over time. Fidelity Charitable works with Coinbase, the exchange, to immediately turn the Bitcoin or Ether into cash, which is then invested as its donor wishes.

Will I receive any tax forms such as 1099s from my exchange?

Generally speaking, brokers and exchanges are not yet required to report cryptocurrency transactions to the IRS., as they do when you sell a stock at a profit or loss (and you receive a 1099-B or a 1099-DIV for a mutual fund).

But you will need to keep track of every move you make. Coinbase, for example, refers you to your account transaction history for records to compute your gains and losses; it also provides customers a “cost basis for taxes” report.

How did the new tax bill affect digital currency?

The bill eliminated what some interpreted to be a tax break for virtual currency holders. Under the old rules, some cryptocoin investors applied a legal maneuver often used with real estate investments to defer their capital gains. Under what is called a 1031 exchange, taxpayers can sell one property and defer taxes as long as the proceeds were reinvested in a similar, or “like-kind,” property and met certain requirements.

The IRS didn’t say this strategy could be used with virtual currencies, but some tax experts argued that it was a reasonable — albeit debatable — interpretation since the coins were considered property. Now that the tax legislation limits the use of 1031 exchanges to real estate, this strategy no longer applies. That is if it ever did.

IRS to Target Specific S Corporation Areas as Part of New Compliance Campaign

The Internal Revenue Service’s Large Business and International Division has approved five new compliance campaigns in several areas including specific areas related to S corporations. The LB&I Division has been moving toward issue-based examinations and a compliance campaign process in which it decides which compliance issues present enough of a risk to require a response in the form of one or multiple treatment streams to achieve tax compliance objectives. The five new campaigns were identified through data analysis and suggestions from IRS employees. The goal is to improve return selection, identify issues representing a risk of non-compliance, and make the best use of the division’s limited resources.

As part of the S corporation campaign, the IRS noted that S corporations and their shareholders are supposed to properly report the tax consequences of distributions. The service has targeted three issues as part of this campaign:

  • When an S corporation fails to report gain upon the distribution of appreciated property to a shareholder.
  • When an S corporation fails to determine that a distribution, whether in cash or property, is properly taxable as a dividend; and,
  • When a shareholder fails to report non-dividend distributions in excess of their stock basis that are subject to taxation.

For this campaign, the IRS plans to conduct issue-based examinations, suggest changes to tax forms, and conduct stakeholder outreach.

As part of the campaign, any examinations that result from this campaign will probably touch upon other S corporation related issues including the methods S corporations use to determine reasonable compensation and its impact on potential under-reported FICA taxes.

Taxation of Cryptocurrency Mining Activities

There are new rules which the US Congress passed in December 2017 that change the way the IRS treats cryptocurrency. Before the US Congress put forth a clearer ruling in 2017, the classification category of cryptocurrency assets was up for interpretation according to many tax experts. That’s because many cryptocurrency miners and traders treated cryptocurrency similar to real-estate for tax purposes by citing the like-kind exchange rules of IRS Code Section 1031.

Following this ruling a miner could theoretically trade a mined cryptocurrency for another cryptocurrency without having to pay taxes. With 1031 exchanges limited to real estate transactions under the recent tax act this treatment is now out the window. Now anyone with cryptocurrency mining operations in 2018 will have to pay taxes beginning in 2019.

There are a couple of things to consider when paying taxes for cryptocurrency mining. You have two different income streams to consider. The first taxable event occurs whenever a miner mines a new coin. The IRS considers this to be income even if the miner decides to only hold the coins as “inventory”. When you mine the coins, you have income on the day the coin is "created" in your account at that day's exchange value. If you are reporting activity as an individual taxpayer, you can report the income as a hobby or as self-employment. If you report as a hobby, you include the value of the coins as "other income" on line 21 of form 1040. Your ability to deduct any expenses is limited -- expenses are itemized deductions subject to the 2% rule.

If you report as self-employment income (you are doing work with the intent of earning a profit) then you report the income on schedule C. You can fully deduct your expenses. The net profit is subject to income tax and self-employment tax. Similar treatment occurs if you operate as a multi-member LLC except that the transactions are reported on the LLC’s tax return with the individual members having their shares of the net profits or losses reported on individual K-1s.

Your second income stream comes when you actually sell the coins to someone else for dollars or other currency. Then you have a capital gain or a capital loss.

Finally, if you immediately sell the coins for cash, then you only have income from the creation and you don't also have a capital gain or loss.

Now, as far as expenses are concerned, if you are doing this as a business, you can take an expense deduction for computer equipment you buy (as depreciation) and your other expenses (for example electricity and other business expenses). But if you are doing this as a home-based business you need to be able to prove those expenses, such as with a separate electric meter or at least having your computer equipment plugged into a portable electric meter so you can tell how much of your electric bill was used in your business. Unless your expenses are very high, they won't offset the extra self-employment tax, so you will probably pay less tax if you report the income as hobby income and forget about the expenses.

Supreme Court Rules States Have Authority To Require Online Retailers To Collect Sales Taxes

The U.S. Supreme Court, in a 5-4 decision, has held that states can assert nexus for sales and use tax purposes without requiring a seller’s physical presence in the state, thereby granting states greater power to require out-of-state retailers to collect sales tax on sales to in-state residents. The decision in South Dakota v. Wayfair, Inc., et al overturns prior Supreme Court precedent in the 1992 decision Quill Corp. v. North Dakota which had required retailers to have a physical presence in a state beyond merely shipping goods into a state after an order from an in-state resident before a state could require the seller to collect sales taxes from in-state customers. That was before the surge of online sales, and states have been trying since then to find constitutional ways to collect tax revenue from remote sellers into their state.

The Court noted: “When the day-to-day functions of marketing and distribution in the modern economy are considered, it is all the more evident that the physical presence rule is artificial in its entirety”. The Court also rejected arguments that the physical presence test aids interstate commerce by preventing states from imposing burdensome taxes or tax collection obligations on small or startup businesses. The Court concluded that South Dakota’s tax collection plan was designed to avoid burdening small businesses and that there would be other means of protecting these businesses than upholding Quill.

In his dissenting opinion, Chief Justice John Roberts argued that, although he agreed that the enormous growth in internet commerce in the interim years has changed the economy greatly, Congress was the correct branch of government to establish tax rules for this new economy. He also took issue with the majority’s conclusion that the burden on small businesses would be minimal.

Prior to the decision, many states had already begun planning for the possible overturn of Quill.

Congress may now decide to move ahead with legislation on this issue to provide a national standard for online sales and use tax collection, such as the Remote Transactions Parity Act or Marketplace Fairness Act, or a proposal by Rep. Bob Goodlatte, R-Va., that would make the sales tax a business obligation rather than a consumer obligation. Under that proposal, sales tax would be collected based on the tax rate where the company is located but would be remitted to the jurisdiction where the customer is located.

 

C Corp vs S Corp or LLC:
How The Tax Cuts and Jobs Act Impacts This Decision

The Qualified Business Income Deduction section of the Tax Cuts and Jobs Act included a new deduction meant for S corps, LLCs, partnerships and sole proprietorships (commonly referred to as pass-through entities). The deduction is calculated at 20% of the trade/business income of these entities. There are limitations based on owner’s taxable income, W-2 salaries of the business, assets in the business and whether or not the business is a service or non-service entity.

Accordingly, not all pass-through entities will qualify for the 20% deduction.

The Tax Cuts and Jobs Act has also dropped the C corporation tax rate to 21% and a lot of questions have arisen from closely held business owners about converting their limited liability company (LLC) or S corporation (S corp) to a C corporation (C corp) including questions from the owners of entities that don't qualify for the 20% deduction. Does it make sense to switch to or start a C corp? The answer is not that simple. Much depends on your business and the business model you operate under.

While the federal tax rate for C corps has dropped favorably to a flat 21%, there are still limitations to a C corp’s tax structure. C corps are subject to double tax. When a C corp issues dividends on their profits, the shareholders receiving the dividends are then taxed on their personal tax return, while the C corp receives no deductions for these payments. Whereas, if you are structured as an LLC or an S corp, you are taxed on the net taxable income that flows through to the owner’s individual tax return and you can distribute the funds out of your company, without double tax. If the goal of the business is to reinvest the earnings back into the company, C corps are a favorable option to take advantage of the lower tax rates.

As a practical matter, for current operations, closely held C corporations do not normally pay dividends. Owners in these entities are often active in the business and draw a salary. The corporation gets a deduction for the salaries, but owners receiving the salary pay federal tax on that salary at a rate as high as 37%.

Upon exiting a closely held business, the sale of the assets of the business are, normally, the only viable option. Very few buyers will want to buy the ownership interest in a closely held business. If you decide to sell your business as a C corp, income generated from the sale of assets is taxed at the corporate level first and then taxed again when the net cash is distributed out to the shareholders.

Also, consider the timing issues when switching to and from a C corporation. Let’s say your business is currently structured as an S corp. You and your shareholders deem your business is better suited as a C corp and you want to convert your organization. It is fairly easy to switch to a C corp. But there is a “buyer beware” with that enterprise. You must wait five years after the switch to a C corp to switch back to an S corp. Once you switch back to an S corp, you could be subject to double taxation on built-in gains (unrealized appreciation on assets held while the entity is a C corporation) for an additional five years after the switch. At a minimum, you will need to live with the possibility of some degree of double taxation for up to ten years.

So what is the bottom line on all of this?

If you have a business that you plan on keeping fairly small, with fewer than 100 shareholders and located in the U. S, you probably want to be an S corp or an LLC. But if your goal is to reinvest profits back into your business to finance future organic growth then the C corporation is probably a good fit. If you have big plans for growing your company to position it for future sale or to go public, you might want the flexibility to take on investors, raise capital, issue different kinds of stock, and invite foreign investors into your business as a C corp.

As always, it is best to consult your advisors before commencing any changes in business structure.