If you haven’t tapped into the power of cryptocurrencies, where have you been? As they become more popular, the spectrum of their use continues to expand. Try a simple search for “what can I buy with Bitcoin?” You’ll get hundreds of thousands of search results. However, income tax implications regarding cryptocurrencies have become more complex as their acceptance in the global marketplace has increased.
What is Cryptocurrency?
The best way to describe cryptocurrency is to say it is digital money or virtual currency. It is accepted by many businesses. Cryptocurrencies are under the control of software developers. They can be transferred, stored, held for investment, or traded electronically. The digital currency most people are most familiar with is Bitcoin. Unlike traditional currencies, cryptocurrencies are not highly regulated. There are some businesses that accept cryptocurrencies for payment simply to avoid fees imposed by credit card companies and online payment processing services.
Even though cryptocurrencies are not highly regulated, every single transaction is digitally recorded and stored in the blockchain. These public ledgers are accessible to everyone. They can be downloaded and transactions traced.
What the IRS Knows About Cryptocurrency Transactions
Starting with the 2020 tax year, IRS Form 1040 asked individuals if they have received, sold, exchanged, sent, or acquired cryptocurrencies at any time during the previous year. Just the fact that the question now appears on official tax forms should serve as a warning. The IRS is positioning itself to enforce compliance with any and all applicable tax rules.
Tax Implications and Cryptocurrency Transactions
Presently, the IRS considered cryptocurrencies to be “property.” Since it is property, you must report any gain or loss you experience when exchanging cryptocurrencies for goods, services, USD, Euros, or another cryptocurrency. If you do not report your crypto transactions on your Form 1040 and you get audited, you are likely to face interest charges and penalties, In some extreme cases, you may face criminal prosecution.
To calculate federal income tax on cryptocurrency transactions, you have to know the FMV (Fair Market Value) in USD of the cryptocurrency on the date you received it as well as on the date it is used to purchase something. Most of the popular cryptocurrencies are listed on exchanges such as the Coinbase exchange. When cryptocurrencies are exchanged for any property, service, or another cryptocurrency, you realize a loss or a gain just like when making stock sales in a taxable brokerage account.
- A taxable gain is when the FMV of what you received exceeded the cryptocurrency’s value.
- A taxable loss is when the FMV of what you received in exchange for your cryptocurrency.
The taxable gain or loss from a cryptocurrency exchange is based on how long you held onto the cryptocurrencies before it was used in a transaction.
Taxes and Using Cryptocurrencies to Pay Employees or Independent Contractors
If you use cryptocurrencies to pay wages, it must be reported to the IRS and the employee using a Form W-2. It still counts as wages and it is still subject to federal income tax, FUTA tax, and FICA tax. If cryptocurrency is used to pay an independent contractor for services rendered for your business, the contractor is subject to paying self-employment taxes on the cryptocurrency’s FMV. If you pay an independent contractor $600 or more in a year, it must be reported using a Form 1099-NEC.
Cryptocurrency Receipts and Taxes
Taxable income or gain must be calculated on cryptocurrency accepted for goods or services. You first must determine the fair market value of the currency on the date the transaction is made and convert it to US dollars.
Business owners, workers, and independent contractors must be aware of federal tax rules pertaining to cryptocurrency. Compliance is necessary and ignorance of the rules is no excuse. To make sure you are in full compliance, you should keep detailed records of every transaction. Your records should include:
- Date you received the cryptocurrency
- The FMV of the cryptocurrency on the received date
- The FMV on the date it was exchanged
- Trading exchange used to determine its FMV
- The reason for holding the currency (personal use, investment, business)