The plunging value of many cryptocurrencies and nonfungible tokens has led to worries about the tax implications faced by crypto investors and companies.
Of particular concern are recent requirements from the 2021 infrastructure bill pertaining to crypto. The bipartisan infrastructure law passed by Congress last November requires crypto brokers to report their gains on a 1099 form, while businesses and exchanges that receive more than $10,000 in cash and equivalents will need to report their gains and losses. President Biden also signed an executive order in March calling on the Treasury Department and federal regulators to develop greater oversight of the digital assets market.
“That executive order directs executive agencies to come up with rules for regulating crypto,” said Rochelle Hodes, a principal in the Washington National Tax Office at Crowe LLP. “They’re calling it a whole of government approach where many agencies are going to be part of this process to come up with ideas and proposals.”
So far, much of the guidance on crypto assets from the Treasury Department and the Internal Revenue Service has been vague, but the Biden administration did include some proposals in its Greenbook and the Build Back Better Act that have now stalled as the evenly Congress seems unable to reach further agreement on tax changes down the road. That has left holders of NFTs, which until recently were part of a booming market, scratching their heads.
“The only piece of guidance that we’ve gotten that’s relevant to NFTs is that the exchange of one cryptocurrency for another piece of property comes into play because NFTs trade on the blockchain, and you can’t buy things on the blockchain with fiat, U.S. dollars,” said KPMG tax principal Anthony Tuths. “The only thing you can use is something that trades on the blockchain so you need to use Bitcoin, Ether, or some stablecoin. At least we have that piece of guidance, that if I want to buy an NFT and I go on chain and I exchange some cryptocurrency in exchange for that, then I’ve had a taxable realization event. With respect to the cryptocurrency that I own, when I’m acquiring that, and then the fair market value of that cryptocurrency as on the date and time when I exchange it for the NFT, that should become my tax basis in the NFT. And that’s about all the guidance we have.”
Back in 2014 the IRS issued a notice saying that virtual currency would be treated as property and that has formed the basis for much of the guidance ever since, even as the crypto market rapidly evolves.
“We have in some cases arcane rules that were not drafted for digital assets and digital currencies,” said EY Tax global innovation leader Jeff Saviano. “It’s a bit clunky right now to apply existing tax legislation and tax rulemaking to these digital transactions. I think that will change. We’re starting to see there’s some guidance in the U.S. on the tax treatment of digital currencies, which are important, since that’s often the consideration for transactions with digital assets. In the U.S. anyway, those transactions are treated as barter transactions. They’re property for property.”
DeFi and Web3
Technology has been changing quickly in the crypto space with the advent of NFTs that can be sold and tracked over the blockchain. The concepts of a metaverse, an immersive virtual world, and decentralized finance, or DeFi, are also being tied to blockchain technology as part of what’s being referred to as Web3. Definitions vary for these buzzwords, depending on who is using them.
“The way that we are looking from a tax perspective at Web3 is the promise of significant changes to payment systems and the shift from traditional finance to decentralized finance and DeFi, the shift from our current fiat currency reliance to digital currencies, whether it’s publicly issued, government-issued central bank money or private issuance of money, for example, with stablecoins,” said Saviano. “But we’re finding that the tax implications of Web3 are much more profound than perhaps the tax implications of the metaverse itself. What’s emerging is that Web3 will be incredibly impactful for us tax people.”
Despite all the buzzy terms, there are still some basic ideas to keep in mind, especially with the ever volatile crypto market during a time that’s being called the “crypto crash.”
“The top thing is number one, keep good records of transactions,” said Trudie Kanter, a partner in the tax group at Crowe. “If it’s more than a handful, consider using some of the tracking software available today. Today there are a number of them out there. You have to make sure taxpayers keep good records of transactions, and know and understand the output of the software if you do end up using the software. Number two, whatever you use to track your software, make sure you account for all wallets and exchanges. So if your tracking software doesn’t support certain wallets, then you can always upload a CSV file or manually enter that data. The reason this is important is wallets and wallet transfers are not taxable. If you don’t have all the wallets connected, the system could assume that one of the transfers to a wallet is treated as a sale, so it’s very important that you holistically capture all the transactions among your different wallets and exchanges that you hold your assets in. Basically wallet-to-wallet transfer is not taxable. Then you have to make sure you’re doing the transfer properly.”
She also suggests taxpayers choose a cost basis method and be consistent. “The IRS allows for FIFO, first in first out, or a specific identification method, so if you decide to change the method, you will likely need to amend prior years,” said Kanter. “That’s something we have seen clients struggle with. In past years, they might have done FIFO, and as the price increased, they might have wanted to choose a different method. The problem is once you choose a method, you basically are locked in, unless you go back and amend tax returns in prior years.”
For NFTs, other advice may apply on the cost basis. “What we tell our clients is an NFT is a piece of property, so if you sell it, you have a tax basis in it, and you have a gain or loss,” said Tuths. “And assuming you’re not a dealer, then you should be holding it as a capital asset, and you should be getting a capital gain or loss. The one exception, of course, is if you were the creator of the NFT, perhaps you are in the trade or business of creating NFTs. In that case it could be ordinary income to you, and in fact self-employment taxes could come into play at that point too.”
The IRS’s recent rules requiring e-commerce companies to report payment transfers of $600 or more to a buyer or seller in a calendar year on a Form 1099-K, down from an earlier threshold of $20,000, are likely to have an impact on crypto as well.
“It’s not crypto specific, but the lowering of the 1099-K threshold to $600 is going to affect a lot of the apps that stand between the customers and service providers, and also the payment apps,” said Hodes. “If a trade or business is involved when you receive payment through a payment app, and if you choose to get crypto as part of your payment, then you have all the questions about where you are going to put it. A lot more people are going to be getting those 1099-K’s for payments made in 2022, and they’re going to be very surprised when they get those 1099-K’s in 2023. Businesses that have to issue them are now working on putting those changes into place. It’s not just the TaskRabbits, Venmos and Lyfts. There are lots of businesses, basically the online marketplaces, if they match buyers and sellers, if they stand in the middle and guarantee the payment between buyer and seller, but they’re not the seller, all of those types of services are subject to that new $600 threshold, which is far, far lower. I talked to somebody who maybe had three a year that met the higher threshold of $20,000 across 200 transactions. Now $600 without any de minimis is just going to overwhelm them, and we are going to see a lot of these because they are web-based or app-based systems or technologies where the 1099 is coming in. I think you’re seeing a convergence of crypto and 1099-K reporting, but it’s cash too, not just crypto.”
Taxpayers can’t count on receiving a 1099 from their crypto provider, but they still need to be prepared for the IRS’s compliance expectations.
“If you receive compensation in crypto, the income reported on Form W-2 or 1099 is your cost basis in the crypto you received,” said Kanter. “Note that you will have income even if the payor does not provide you with a Form W-2 or 1099.”
Crypto holders should keep in mind other tax recommendations, including those who are in the NFT market. “If you use your virtual currency (such as ETH or SOL) to purchase an NFT, you essentially sold your ETH or SOL which is a taxable event,” said Kanter. “The purchase price of the NFT less transaction fee is your sale proceeds. You compare such proceeds to your cost basis, the difference is gain or loss reportable on your tax return.”
For taxpayers who founded or collaborated on an NFT project, she suggests they work with a tax advisor to understand their tax filing and withholding obligations on the revenue earned at mint and subsequent sales.
The decentralized finance space also requires some expert tax guidance that accountants can provide. “If you have significant or material transactions in DeFi protocols such as lending, borrowing, liquidity pool, etc., you would want to work with a tax advisor since there is currently no clear tax guidance in this emerging phase,” said Kanter.
Keeping track of transactions can be difficult, especially if taxpayers change providers, and determining the fair market value could be challenging, especially in a cratering crypto market.
“If you switch crypto tax tracking software, you could end up with different gains and losses for each year,” said Kanter. “This is primarily due to a number of reasons including the source of FMV on crypto-to-crypto transactions. If you are seeing material variances, we suggest that you work with a tax advisor to evaluate and assess the final output and amend prior year tax returns, if needed.”
Overall, she suggests taxpayers stay current with the latest IRS guidance, including FAQs, to ensure their transactions in digital assets are accurately reported on their tax returns. The IRS provides some of that limited guidance here.
NFT developers who are marketing artworks and music may also have to deal with taxes on royalties and licenses.
“The creator may grant the purchaser a limited license, or they might grant them a full license,” said Tuths. “Depending on what’s in there, there may be a royalty stream back to the creator. For tax purposes, it has to be taxed the way that a royalty and a license would.”
Some NFT developers are already embedding royalty technology in their digital assets, and they can be tracked on the blockchain.
“To the extent that some of them become popular and they become valuable to put on other pieces of merchandise, and it’s capable of making money in its own right, then the license has to be respected and paid over,” said Tuths. “You actually don’t have a choice because it’s embedded in a smart contract, so to the extent that the transaction is happening on chain, any payments with respect to the item, whether it’s a royalty payment or a resale amount, that goes on chain. To the extent that the smart contract says a piece of that payment should go to the original creator, it will bypass the seller or licensor and go right to the creator.”
Some U.S. states are coming out with guidance on NFTs. “The state tax authorities, just recently, like New Jersey and Arizona, came out with guidance, but their guidance is more directed at cryptocurrencies than NFTs,” said Tuths. “Some of them make it a little broader and use the term digital assets, which is broad enough to encompass NFTs, whether it is meant to or not, but that’s kind of slow in coming out.”
State and international taxes
States like Wyoming are also starting to draw up rules for decentralized autonomous organizations, or DAOs, that enable crypto trading.
“We actually have one state where you can form a DAO with limited liability under Wyoming law,” said Saviano. “My own belief is that we’re going to see technology developed for networks themselves and network-based assets. When networks build things together, they need governance and organizations that are efficient and that meet their decentralized needs. I think DAOs will become an incredibly important governance tool for those stakeholders, the very nations, to determine the legal and tax implications of those organization forms. That will take some time, and we’re starting to see some early green shoots of activity around the world. And I think DAOs are becoming an incredibly important governance tool across Web3 and the metaverse.”
Some foreign governments are also issuing guidance and more broadly the Organization for Economic Cooperation and Development has been crafting international rules.
“Governments around the world are looking at this,” said Tuths. “Just in the past two months, we’ve seen guidance come out of the United Kingdom, the E.U., Australia. Even the OECD came out with its framework, but most of these are directed at virtual currencies, and not so much NFTs, but we’re getting there. But these are not regulations or laws. Rather these are frameworks for discussion to produce laws in the future, so we’re still in early stages.”
Some governments are also exploring the creation of their own digital currency, as the Chinese government did with a digital yuan. Biden’s executive order directed the federal government to explore the possibility of a U.S. central bank digital currency.
“There was an expression of interest from the Department of Commerce for the implications of digital assets,” said Saviano. “I think that’s tremendously exciting as a U.S. citizen, first and foremost, that you’ve got the executive branch taking bold steps. The research and reports we think will be an important progression of these issues within the U.S.”
He also sees possibilities from EY’s other work on other blockchain technologies, including digital currencies and smart contracts, as an opportunity to enable governments to carry out social policies. “We have a collaboration with MIT and the World Bank called the Prosperity Collaborative, and we do quite a bit with governments around the world to identify opportunities for innovative technology like this, to improve communities and allow governments to make better decisions and offer their services more efficiently to citizens,” said Saviano. “I think there’s a tremendous opportunity and there’s also tremendous activity coming out of the pandemic from governments to look to these technologies as digital public goods, to actually take some positive steps in the world.”
However, to avoid future crypto meltdowns and restore confidence among investors after the precipitous decline in stablecoins like TerraUSD and Luna that were supposed to hold their value against the U.S. dollar, but instead contributed to the crypto crash, stablecoin providers may need to begin offering collateral to burned investors to convince them to stay in the market, as some are starting to do.
“For every dollar of stablecoin that’s issued, they’re maintaining liquid assets under U.S. law, and then that’ll protect consumers and citizens,” said Saviano. “I think the collateral becomes important, and the regulation of stablecoins and central bank digital currencies becomes important. We saw some of that in the last few weeks. To ensure that you’ve got appropriate collateral as the stablecoin issuer is incredibly important.”