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Bitcoin on the balance sheet, April 17: what the IRS has actually said, and what it hasn't

One four-year-old notice, one narrowed Coinbase summons, a §1031 door that closed in December, and a filing deadline today

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 7 sections
  1. What Notice 2014-21 actually says
  2. The §1031 door has closed
  3. The Coinbase summons, and what it tells you about enforcement
  4. The §6045 reporting gap is the reason non-compliance is this high
  5. Structural questions for entities that hold, mine, or issue tokens
  6. What to tell the reader filing today
  7. Sources

pril 17, 2018 is the tax filing deadline, and the working federal guidance on bitcoin tax treatment for entity holders is still one six-page IRS notice from 2014, one narrowed John Doe summons against Coinbase, and a statutory amendment to Section 1031 that took effect while most crypto holders were not paying attention. Nothing else has landed. Treasury has not issued regulations. The AICPA has been asking for additional guidance since 2016 and has not gotten it.

That is the posture entity holders are filing under today.

What Notice 2014-21 actually says

The IRS published Notice 2014-21 on March 25, 2014, and it remains the only substantive federal guidance on virtual currency tax treatment. Its central holding, in Q&A-1, is that "for federal tax purposes, virtual currency is treated as property," and that "general tax principles applicable to property transactions apply to transactions using virtual currency."

For an LLC or corporation holding bitcoin, the operational consequences flow from that one sentence. A sale or exchange triggers realization under IRC § 1001. Gain or loss character follows the asset's character in the entity's hands: capital if held as an investment, ordinary if held as inventory or by a dealer. The holding period begins the day after acquisition. Basis is the fair market value in U.S. dollars on the date of receipt if the tokens were acquired other than by purchase.

The notice also ruled, in Q&A-8, that a miner who "successfully mines virtual currency" has gross income equal to the fair market value of the coins on the date of receipt. For a mining LLC, that means every block reward is an ordinary income event at the USD spot price at the moment the block clears, regardless of whether any tokens are sold. The entity then takes basis in the mined coins equal to the amount it just recognized, and a subsequent sale produces capital gain or loss from that basis.

Q&A-3 requires that wages paid in virtual currency be reported on Form W-2 at fair market value on the date of payment, with withholding, FICA, and FUTA applying the same way they would for cash wages. Q&A-6 imposes Form 1099-MISC reporting on an entity that pays $600 or more of fixed-and-determinable income to a U.S. non-exempt recipient in virtual currency. An entity paying contractors in tokens has the same reporting burden it would have paying in dollars; it just has a harder valuation problem on every payment.

What the notice does not address is equally load-bearing for entity planning. It is silent on hard forks, airdrops, chain splits, token swaps, staking rewards, and initial coin offerings. It does not prescribe a specific lot-identification method for sales from a mixed basis pool. It does not address FBAR or FATCA treatment of foreign exchange accounts. The AICPA's June 10, 2016 comment letter to Treasury catalogued those gaps and asked for twelve distinct areas of additional guidance. Nothing has been issued in response.

The §1031 door has closed

Before 2018, a meaningful slice of the crypto-holder bar argued that crypto-for-crypto trades qualified as like-kind exchanges under IRC § 1031 and therefore deferred gain recognition. The argument was always shaky: pre-TCJA § 1031 required both a real estate-grade like-kindness analysis and a reasonable view of personal-property classes. Bitcoin-for-ether in particular looked difficult, given the different protocol rights attached to each token.

That argument is now foreclosed on the front side. Section 13303(a) of Public Law 115-97, the Tax Cuts and Jobs Act, amended § 1031(a)(1) by replacing "property" with "real property," and § 13303(c) set the effective date: the amendment applies to exchanges completed after December 31, 2017, subject to a transition rule for certain exchanges in which the relinquished property had been transferred before that date. For crypto trades executed in 2018 and forward, § 1031 is not available at all. Every crypto-to-crypto trade is a realization event in full.

For exchanges that actually closed in 2017 or earlier, the question is unresolved rather than foreclosed. An entity that swapped bitcoin for ether in November 2017 and wants to claim § 1031 deferral on its 2017 return still has to defend like-kindness between two protocols with different governance, different issuance schedules, and different functional specifications. Treasury has not issued a ruling on the pre-2018 question as of today. Taxpayers and their advisors are filing positions, and the position is the taxpayer's to defend if examined.

The Coinbase summons, and what it tells you about enforcement

On November 17, 2016, the United States filed an ex parte petition in the Northern District of California under 26 U.S.C. § 7609(h)(2), asking permission to serve a John Doe summons on Coinbase, Inc. for records of all U.S. customers who transacted in convertible virtual currency between January 1, 2013 and December 31, 2015. The court granted the petition on November 30, 2016, and the IRS served the summons shortly after. Coinbase moved to quash. A Coinbase customer intervened. The government's petition to enforce was briefed and argued through 2017.

On November 28, 2017, Magistrate Judge Jacqueline Scott Corley issued an order in United States v. Coinbase, Inc., No. 3:17-cv-01431-JSC (N.D. Cal.), granting enforcement in part. The order narrowed the summons to accounts with at least $20,000 in any one transaction type (buy, sell, send, or receive) in any single year during 2013 through 2015, and limited the required production to taxpayer identification information and transaction records sufficient to compute gain or loss. The IRS acknowledged the narrowed summons still covered more than 10,000 accounts.

Coinbase has since begun notifying affected users that their records were produced. On March 23, 2018, the IRS issued IR-2018-71 reminding taxpayers that virtual currency transactions are taxable and that failure to report can produce audits, penalties, interest, and in extreme cases criminal charges. Read together, the summons and the reminder are the agency telling the market it has names and it intends to use them.

The §6045 reporting gap is the reason non-compliance is this high

Coinbase and most other U.S. crypto exchanges do not issue Forms 1099-B to customers on sales. Some issue 1099-K for high-volume accounts, but 1099-K reports gross payment volume and not gain or loss, which makes it nearly useless for Schedule D preparation and actively misleading for taxpayers who see a seven-figure 1099-K and panic. The reason no 1099-B flows is that IRC § 6045 defines "broker" in terms the current exchanges argue they do not fit, and Treasury has not issued guidance bringing virtual currency transactions squarely under § 6045 broker reporting.

The consequence is visible in the numbers this filing season. Credit Karma reported on April 13, 2018 that fewer than 100 of the first 250,000 federal returns filed on its platform included any bitcoin gain or loss. That is roughly 0.04 percent. Fundstrat's Tom Lee had estimated earlier in the year that U.S. households owed about $25 billion in capital gains tax on 2017 crypto gains. The collection gap is the direct mechanical result of the § 6045 gap: no third-party document flow to the IRS, weak third-party document flow to the taxpayer, and a matching program that cannot match what it never received.

This is the backdrop against which the IRS chose to serve a John Doe summons on the largest U.S. exchange. It is also why an entity holding bitcoin this year should assume its exchange statements are the ceiling of what the IRS knows, but not the floor of what the entity must report.

Structural questions for entities that hold, mine, or issue tokens

Hedge fund structures holding crypto face a Section 475 question on day one. A fund that elects mark-to-market treatment under § 475(f) as a trader in securities or commodities gets ordinary-income treatment and annual mark, which cleans up the realization question but disqualifies capital gain treatment on any held position. Whether a bitcoin position counts as a "commodity" for § 475(f)(2) turns on CFTC classification and the fund's activity pattern; the CFTC has asserted that bitcoin is a commodity under the Commodity Exchange Act since 2015, and that assertion has not been successfully challenged. Many funds take the § 475(f) election. Others do not, and live with the realization-by-trade regime Notice 2014-21 describes.

Mining LLCs have the § 61 receipt problem every block. A mining entity with an active operation is recognizing ordinary income on a near-continuous basis at USD spot, and the only real planning move available is expense matching: electricity, hardware depreciation under § 168, hosting, and personnel costs run against the mining income stream. Whether mining is a trade or business for § 162 purposes or a hobby for § 183 purposes is a facts-and-circumstances call that has not been litigated in a published opinion as of today. Most operators take the trade-or-business position and document accordingly.

Token-issuing entities have the hardest structural problem, and § 7704 is the reason. Section 7704(a) provides that a publicly traded partnership "shall be treated as a corporation" for federal tax purposes, and § 7704(b) defines publicly traded to include partnerships whose interests are "readily tradable on a secondary market or the substantial equivalent thereof." Treasury Regulation § 1.7704-1 elaborates, and the "substantial equivalent" language has been read broadly.

An LLC that issues ERC-20 tokens representing economic rights in the entity, and those tokens trade on Ethereum-based secondary markets, has a real § 7704 problem. If the tokens are partnership interests and the trading rises to "readily tradable," the LLC becomes a C-corporation for federal tax purposes on day one. The planning answer most token-project counsel are landing on in early 2018 is to avoid the partnership-interest characterization entirely by issuing tokens as utility tokens, pre-functional payment instruments, or SAFT-style delivery obligations, and to keep the issuing entity's equity separately held. Whether the SEC agrees on the securities-law side is a different question; the § 7704 question is about federal income tax classification and is independent.

Token treasury management inside an operating entity is a cleaner problem. The tokens are property on the balance sheet. Sales trigger gain or loss from basis. Payments in tokens trigger § 6041 reporting. Wages in tokens trigger W-2 and employment tax at spot. The thing that breaks is not the tax characterization, which Notice 2014-21 resolved, but the books. GAAP treatment of crypto on a corporate balance sheet is unsettled, with the FASB declining to take up a standard-setting project in December 2017. Most entities are holding crypto as indefinite-lived intangible assets subject to impairment testing, which produces asymmetric earnings: unrealized losses hit the income statement, unrealized gains do not.

What to tell the reader filing today

The return filed on April 17, 2018 for a 2017 tax year applies the pre-TCJA § 1031 rules to any pre-2018 crypto-for-crypto exchanges, and the standard Notice 2014-21 rules to everything else. The return for 2018 filed next April will not have § 1031 available for crypto-for-crypto trades at all, which is worth internalizing before the entity executes its next rebalance.

For an entity reader, three items deserve specific attention on the 2017 return. First, any § 1031 position on a crypto-for-crypto trade should be papered with a like-kindness memo and Form 8824 completed accurately; the filing posture is defensible but not trivial. Second, mining income recognized across the year should reconcile to block timestamps and spot prices from a consistent source; an IRS examiner asking for the workpaper will want to see method, not narrative. Third, any entity that received a Coinbase account notification of produced records should assume the exam risk is elevated and file accordingly.

Beyond the return, the open question entity planners should be pricing is what Treasury does next. The AICPA's request list has been sitting on the relevant desk for two years. Notice 2014-21 does not address airdrops, forks, or token swaps, and every entity with a 2017 Bitcoin Cash position has taken a position on a point of law that the IRS has not addressed. A second notice, or a set of FAQs, would resolve most of those questions and create new planning angles. The absence of guidance is the guidance, for now.

The § 199A pass-through deduction is the other open piece, and for operating entities that hold crypto as a treasury asset, it is the more immediate variable. Proposed regulations under § 199A have not been issued. Our February operational read on §199A laid out the open questions; the set relevant to a crypto-holding operating company is a subset of those, with trade-or-business characterization of the crypto activity being the one that matters most.

Sources

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