Blockchain. We’ve heard the term repeatedly, especially since the rise and fall in the price of bitcoin that began in mid-2017. While blockchain technology has not yet had a significant effect on most tax practices, there is one area that we tax practitioners cannot choose to neglect. We must be ahead of the information curve and be able to educate our clients on how their tax situation might change in an uncertain world.
So, what is blockchain? Blockchain technology links transactions using digital data and cryptography to create permanent, unchangeable transactions, which increases the integrity of record-keeping dramatically. Cryptocurrencies such as bitcoin, ethereum and ripple are just one group of assets that can be accumulated and exchanged using blockchain technology. Companies large and small are currently racing to build blockchain platforms for traditional assets such as homes, automobiles and intellectual property.
Let’s look at two examples that outline the advantages of blockchain. If someone pays $100 in cash to another person in satisfaction of a debt, there may not be physical proof that the debt was paid; it’s one person’s word against the other. When using cryptocurrency, the transaction is digitized and recorded on both sides, and it’s very difficult for those records to be altered or destroyed.
A second example of how blockchain could transform the business of physical assets is with the sale of cars. When a car is purchased today, there’s a long list of physical documents that needs to be signed to prove the transfer in ownership of that specific vehicle. In a future with blockchain, every detail of the vehicle may be recorded digitally, and the transfer of the car could be made with the click of a button – perhaps even through the exchange of “carcoins” used specifically for purchasing vehicles.
As you can imagine, this type of recordkeeping would have an immediate effect on the world of auditing. Large volumes of transactions would be easily searchable and digitized for quick confirmation. But what does all this have to do with tax? For the purposes of this article, we’ll focus on cryptocurrencies since that is the principal asset currently traded using blockchain.
From a tax practitioner’s perspective, we rely on the information provided to us by our clients. Therefore, it’s imperative for us to remind our clients that they should keep detailed records of all their cryptocurrency or other digitized transactions. Because the word “currency” appears in cryptocurrency, many people believe that, for tax purposes, their exchange is treated the same as if dollars were used to purchase foreign currencies, and that there is no tax consequence regarding those transactions – assuming they are not part of an investment strategy.
However, in 2014, the IRS issued guidance on virtual currency, which suggests that cryptocurrencies are capital assets, and that any buying and selling of such items results in capital gains and losses, which should be reported. Most cryptocurrencies are held in electronic “wallets,” and there are hundreds of e-wallet options available. However, the companies that operate these wallets are not obligated to report transactions either to customers or government agencies in the same way that investment banks report on securities.
What is the risk to our clients if they don’t report their cryptocurrency transactions on their taxes? We know that for traditional income sources, the IRS matches tax forms prepared by the payor with those reported by the payee on their annual returns. As of now, there is no similar reporting structure for cryptocurrencies. In fact, the IRS has sued the popular cryptocurrency wallet Coinbase to get its customer transactions records in order to prevent tax evasion. In a mixed outcome for the IRS, a court ruled that Coinbase only had to provide information about anyone with more than $20,000 of transactions. This represented only 14,335 of Coinbase’s accounts — just a small fraction of the total.
As important as it is to educate our clients on the tax ramifications of their blockchain activity, it’s just as important for us to learn the lingo of this new economy. I’ve come to realize that many of my younger clients have been active in this market for years, before blockchain and bitcoin became household words. Just as you wouldn’t talk to you clients about their traditional investments without knowing about stocks and bonds, you want to be prepared to talk about altcoins, hard forks and mining. Once you’ve done your basic research, you’ll have no trouble interpreting my concluding sentence – and no, there are no typos. As trusted advisors to our clients, whether they’re long-term hodlers or noobs, it’s important to guide them well so that they avoid getting rekt.
Editor’s note: Read “Dealing With Cryptocurrency During Tax Season” by Mike D’Avolio, CPA, JD, for more information about the general principles established by IRS regarding cryptocurrency.