What if a person could receive a cryptocurrency fork that covers their tax bill legally, meaning the IRS gets paid and the person keeps all of their “pre-tax” earnings? This sounds like a win-win, if it is possible!
Using Blockchain to Pay Tax Debts: Can a “Bitcoin Tax” Fork (BTAX) Pay Your Tax Bill?
Important Note: This article is not an offering/invitation (such as a white paper) to participate in any cryptocurrency/token issuance; rather, this article is simply a theoretical discussion for academic purposes! BTAX (as defined in this article) does not exist!
General Tax Rules
To summarize what we do know about crypto taxes,
For U.S. federal income tax purposes, a convertible virtual currency (“CVC”) is treated as property (Notice 2014-21, Q&A 1). The purchase/sale of CVC like Bitcoin is the same as buying and selling property for general taxation purposes, meaning gains will usually be subject to income tax (potentially capital gains). A “convertible” virtual currency is a virtual currency that can be:
(a) Digitally traded between users and
(b) Purchased (and sold/exchanged) for U.S. Dollars (or other currencies including virtual currency).
More nuances were discussed in my first core tax blog (link below):
Upon a sale, a U.S. person may have to pay full capital gain income tax (up to 20%), or even worse, ordinary income tax (up to 39.6%).
Bitcoin is Taxable - What Do?
The Problem
Remember, in the U.S., the path of least resistance in the U.S. is conservatism, treating crypto transactions as taxable gains when in doubt, and paying your fair of those taxes on a timely basis – easier said than done with crypto. For example, the hard part is, the requirement to liquidate crypto holdings into USD in order to pay the tax. For example, how can a U.S. citizen pay taxes on (1) taxable gains locked up in Steem Power from the Steemit rewards system (a whole different discussion due to the Power Down restrictions); or (2) exchanging Bitcoin for Altcoins/Tokens in a taxable exchange (but owing the IRS income taxes on the appreciation in Bitcoin) - with no USD to pay the IRS in either case.
Scenario A – USD Sale: If a person made a $1 million gain in the US from selling Bitcoin, he/she could effectively hand over $200,000 USD in capital gains to the IRS (held constant assuming long-term capital gain). It’s probably more with state income tax and other surtaxes the IRS imposes, but let’s keep it simple.
Scenario B – Taxable Crypto Swap: The same if a person bought 1 Bitcoin for $1 USD (i.e. basis, this is a very old investor), and then later exchanged the 1 BTC for Litecoin worth $1 million USD, there is a long-term capital gain on the appreciation of Bitcoin to $1 million USD. In this case, there is no actual US dollars to pay the tax bill to the IRS (other than selling some of the Litecoin for USD). This assumes no like-kind exchange treatment (separate article on this in my blog).
Solutions
So, to summarize, Bitcoin is property, and gains on the sale of Bitcoin (or trading it for other property) is generally a taxable gain for US income tax purposes.
Remember, Knowledge is Power. We know that Cryptocurrency is subject to U.S. income taxation only when it is Convertible Virtual Currency - (1) digitally traded between users and (2) tradeable for US dollars/currencies and other virtual currencies. This is of course until the IRS guides further.
Less Realistic Solution (IMHO): The simplest solution would be everyone adopts a currency that is not a Convertible Virtual Currency, i.e. it cannot be traded for any other cryptocurrency or USD. This would mean the currency would effectively only be used for bartering. But that is unlikely, and the IRS could quickly and easily change the rules to pull the rug out from underneath everyone and treat all “barter-based” virtual currencies as convertible virtual currencies.
More Realistic Solution (IMHO): Maybe the developers can Fork a new currency, that has value and can be exchanged into USD (directly or indirectly) to cover the tax bill on Bitcoin gains, and thus a person can still keep the same amount of “pre-tax gain” while at the same timing paying the IRS what is owed to the U.S. government?
Generally Defining Forking
I add no value to Steemit by re-hashing the full discussion of forking here. But in general, in a fork, the existing blockchain is split into two blockchains – the old blockchain and a new blockchain (i.e. in the case of a “hard” fork). In hard fork scenario, if there isn’t full adoption of the new blockchain (and abandonment of the old), the two blockchains will continue to run parallel thereafter (similar to BTC and Bitcoin Cash, or Ethereum and Classic).
A great explanation of forks is found at Coindesk.com: https://www.coindesk.com/short-guide-bitcoin-forks-explained/
Can we Fork a Bitcoin to Cover Tax Bill - BTAX Fork?
One way to cover Bitcoin tax bills (and lock in the pre-tax value of Bitcoin gains) is creating a forked currency that the community agrees is worth a percentage of the value of Bitcoin (assume 33% for Long term capital gain of 20% in the U.S. plus a “gross up” of 13%).
For example, upon the triggering of a certain USD value of Bitcoin, the blockchain is duplicated through a fork, with a new fork known as “Bitcoin Tax (BTAX). The cryptocurrency BTAX would track at approximately 33% of the value of Bitcoin, therefore whenever someone exits the Bitcoin holding, they can sell BTAX and exchange it for USD and send it to the IRS (or other country agency) as an estimate.
Challenges
The biggest challenges with a Tax Fork are:
(1) Everyone has to agree on the value of the BTAX and not dump it immediately to cash out.
(2) Maintaining price stability so that the BTAX price tracks based on Bitcoin.
(3) The IRS or other governments perceives this as an abusive pyramid and outlaws it.
Will the IRS go for this?
Possibly they don't like it, but there could be benefits. The BTAX would be tradeable for USD (or tradeable for more Bitcoin that can be traded for USD). The USD should be used to make an estimated tax payment to the IRS during the prescribed due dates, meaning estimates are made timely and accurately. The IRS may even at some point be benefit through increased income tax compliance by accepting tax payments in Bitcoin or even this BTAX.
Could BTAX be mined/accumulated for speculation instead of used to pay tax?
Sure why not, however see discussion below regarding the receipt of BTAX being taxable.
Would receipt of a forked currency BTAX to pay my taxes, take me in a circle because this Altcoin would create taxable income to me?
Most likely, the value of a forked currency BTAX would be a taxable gain to the recipient (whether on receipt or disposition is up for discussion, as laid out in my prior article). Therefore, the tax rate used to set the BTAX value should in theory be “grossed upward” to account for this tax impact.
For example, for a US person that sells Bitcoin at a $1 million long term gain (and a $200k capital gain tax bill), receiving BTAX worth $200k to cover the tax bill could be taxed at ordinary rates. A $200k gain at ordinary rates is estimated $80k (using 39.6%). Therefore, the intended value of the BTAX would be “grossed up” by 39.6% to be $333,333. A gain of $333,333 on selling BTAX would be taxed at approximately $133,333 payable to the IRS (at 39.6% ordinary rates), leaving $200k USD left over to cover the original IRS tax bill on the original $1 million Bitcoin gain, assuming 20% long-term capital gains rates.
The potential U.S. tax outcomes of the Bitcoin Cash hard fork are discussed in a prior blog post, to add some context.
Other Countries
It doesn’t have to be 20% (33% gross) value of BTC to set the BTAX tracking value, it could be a tax rate that captures issues specific to other prominent countries in the world.
Takeaway
This is a rough idea with probably a million holes, especially given my lacking technical knowledge of blockchain technology and forking. You may have a completely different idea which accomplishes the same objective, if so please share!
I routinely write blogs on tax topics, and am structuring an informational guide. Next core topics to be discussed are taxation of Steemit earnings and taxation of mining earnings.
About the Crypto Tax Blog
I have seen some interesting feedback as I have worked through my blog which covers the U.S. income taxation of cryptocurrency, an unclear and developing area of tax law. I feel there are many that appreciate the academic perspective of the tax blog. In addition, some of us (including me) find the prospect of Cryptocurrency taxation completely confusing with no guidance. A $150 Billion USD “industry” surely needs better tax help. I am not in love with high taxation, high tax rates and unclear tax rules. Rather, I am passionate in helping others navigate murky waters of taxation. As the crypto community’s tax bill may be the most underrepresented multi-billion dollar tax issues, this is where I would like help educate and inform.
Disclaimer: This series contains general discussion of U.S. taxes in a developing and unclear area of tax law. As always, you should consult your own tax advisor in your jurisdiction to determine your specific situation as this is not personal advice; and consider any future guidance by the Congress/IRS after the date of this article. Under Circular 230 to the extent it applies, this article cannot be used or relied on to avoid any tax or penalties in the U.S., its States or any other jurisdictions.
Picture Credits
https://pixabay.com/en/users/geralt-9301/
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