You’ve probably heard by now, the IRS filed a civil petition against Coinbase to extract information on any customer with Coinbase transactions from 2014-2016. Here's the announcement from the Coinbase blog:
Protecting Customer Privacy 11-18-16
Our customers may be aware that the U.S. government filed a civil petition yesterday in federal court seeking disclosure of all Coinbase U.S. customers' records over a three-year period. The government has not alleged any wrongdoing on the part of Coinbase and its petition is predicated on sweeping statements that taxpayers may use virtual currency to evade taxes.
Although Coinbase's general practice is to cooperate with properly targeted law enforcement inquiries, we are extremely concerned with the indiscriminate breadth of the government's request. Our customers’ privacy rights are important to us and our legal team is in the process of examining the government's petition. In its current form, we will oppose the government’s petition in court. We will continue to keep our customers informed on developments in this matter.
Two Obvious Concerns
The IRS' Civil Petition raises two obvious concerns for bitcoin taxpayers:
Concern #1) If the IRS gets the information where will they stop and what precedent will it set
Concern #2) What to do if you didn't report bitcoin transactions on your tax return
Concern #1 is disturbing to say the least and worthy of it's own blog. Concern #2 can be easily addressed so let's dissect these concerns in order.
The Flawed Assertion
The IRS is asserting that "taxpayers may use virtual currency to evade taxes." Said another way, "taxpayers may use every means possible including cash to evade taxes." Evading taxpayers use every method available to stay off the radar because it's just the way they roll. The same is true for fraudsters and malicious hackers. Bad actors have been using cash to hide money since the day it was first printed. Bitcoin is an alternative digital version of cash so of course the same bad actors are embracing virtual currency like they do with every new technology.
Tool of Choice
Cash, especially the US dollar, has been and always will be the cheaters' tool of choice. Bitcoin doesn't magically change people's behavior. It has no super powers to suddenly convert a good actor into a bad actor like a conscience shifting spell. Therefore, the same proportion of evading taxpayers in the cash-based US population will also exist in the Coinbase customer list. Sarcastically speaking, the IRS' should just do a major shakedown on cash based businesses, the primetime place for tax evasion, and forego the relatively tiny customer list.
The US Tax Gap
The difference between the total tax liability of all US taxpayers and the amount of tax collected is the "Tax Gap". For example, the IRS estimates a net tax gap of $405 Billion for the years 2008-2010. IRS enforcement activities since then have reduced the tax gap by $52 billion (from $457B to $405B) The IRS' main goal is to efficiently allocate limited resources to reduce the tax gap as much as possible. The estimated voluntary compliance has also gone down from 83.1% to 81.7% which means that 18.3% of taxpayers don't file, underpay or underreport taxes. Proper use of power aside, is the extraction of a Coinbase customer list an efficient use of resources?
Voluntary
The US tax system operates on a voluntary basis with a presumption that taxpayers file in good faith. On the other side the IRS has the power to audit tax returns to keep the voluntary mechanism in check. Audits can result in just cause to subpoena information and freeze bank accounts for unpaid liabilities. A blanket extraction of information without just cause is akin to a non-voluntary system. The continued and natural progression of the Coinbase civil petition would eventually lead to the same thing with customer bank statements at every financial institution, access to your online QuickBooks and having to identify yourself with every purchase. If this unfolded, then the shift from a voluntary system to a non-voluntary system would be complete.
Overreaching
The virtual currency tax evasion assertion is flawed and will likely yield a net negative benefit. i.e. It will cost more to audit and enforce than tax liabilities collected. There is no just cause for a blanket civil petition ultimately leading to another victory for the big brotherization of government. Let's face it, this move is a scare tactic to create a new realm of fear for bitcoiners. Maybe the fear they create by overreaching their authority will be an efficient use of resources after all.
Skinny on Concern #2
Here's the skinny on the types of compliance, the reasons for non-compliance, the types of bitcoin income and the types of bitcoin taxpayers including examples and where to report bitcoin transactions. You can find out where you and your business fit into the bitcoin compliance landscape and how to get into compliance.
The 4 Types of Compliance
- Full compliance: taxpayer properly reported all bitcoin activity
- Partial compliance: taxpayer reported income but not capital gains (losses)
- Incomplete compliance: taxpayer reported activity from some wallets/platforms but not others
- Non-compliance: taxpayer didn't report any bitcoin activity
The 2 Reasons for Non-Compliance
- Intentionally avoided accounting for bitcoin transactions
- Unintentionally didn't account for bitcoin transactions
a) didn't get around to it
b) cost prohibitive
c) don't know how
The 2 Types of Bitcoin Income
- Ordinary income from sales of stuff or services
- Capital gains and losses from selling bitcoin to buy stuff
The 2 Types of Bitcoin Taxpayers
- Individuals (the W-2 employee, consumers)
Only calculate and report Type #2 Bitcoin Income - Businesses (self employed, business owners, entrepreneurs)
Have to calculate and report both Type #1 and Type #2 Bitcoin Income
Bitcoin Taxation Primer
Bob's company, BTC consulting, LLC, received 2.3 bitcoins worth $1,000 for services performed on 1-1-16 when the bitcoin price was $434. BTC Consulting, LLC, records $1,000 of income and has a $1,000 cost basis in the bitcoin or $434 per bitcoin.
The bitcoin price on 10-31-16 was $697 when they spent 1.12 bitcoins to buy a $778 color printer. The company records a fixed asset of $778 and depreciates the color printer on the books. BTC Consulting, LLC simultaneously calculates a capital gain or loss as follows:
1.12 bitcoins X $434 cost basis per bitcoin = $486.08
$778 color printer - $486.08 = $291.92 capital gain
The bitcoin price increased over 60% during the 10-month holding period so the capital gain is simply a reflection of the price increase. The capital gain is short-term taxed at ordinary rates because the holding period is less than one year.
Transaction Stats:
$1,000 ordinary income from services
$778 fixed asset
$778 Sec 179 depreciation expense
$291.92 short-term capital gain
$531.92 net income ($1000 + $291.92 - $778 = $513.92)
NOTE: Capital gains and ordinary income are reported in different places on tax returns and may have different tax rates depending on short or long-term status.
Example Scenarios
a) Tim included bitcoin income and bitcoin expenses on his company, TPB Enterprises, Inc., tax return, but not include capital losses which would have lowered his tax liability. Tim didn't calculate gains and losses because he didn't have time and he figured his bitcoin sales were net capital losses. A cursory review of Tim's tax return wouldn't show bitcoin capital gains and losses which could lead to a false conclusion that NONE of the bitcoin was accounted for. In this case an IRS audit would include the maximum $3,000 of capital losses resulting in an IRS refund for Tim.
NOTE: TPB Enterprises, Inc. is an S-Corp and files form 1120S. Tim gets a K-1 from TPB Enterprises, Inc. and reports the income on his personal 1040 tax return. Tim could have capital gains and losses reported on both his business return and personal return if he also used bitcoin as an individual taxpayer.
b) Sharon, a W-2 employee, didn't include her bitcoin transactions on Schedule D, but she knew she’d get to it eventually. She didn't understand how to do it even though bitcoin tax calculator software was available. Sharon only dabbled in bitcoin so her $432 capital gain was not a material omission considering the related tax increase of $64. She only reports the capital gain on her Form 1040.
c) Rohit, an obsessed bitcoiner, had 37 bitcoin wallets, exchanges and other bitcoin platforms with varying levels of bitcoin activity. His crypto transaction landscape made it challenging to gather a complete set of bitcoin transactions. Some bitcoin wallets didn't have a memo field, he lost access to several wallets, an exchange imploded along all his cryptocurrency and transaction history and he forgot about other wallets. Rohit filed his tax return on the extended due date but didn’t include the bitcoin until he gathers all the transactions for an amended return.
Where to Report Income for US Taxpayers
- Type #1 Bitcoin Income (capital gains & losses) is reported on Schedule D and Form 8949
- Type #2 Bitcoin Income is reported on:
a) Sole Proprietor: Schedule C of Form 1040
b) Single Member LLC: Schedule C of Form 1040
c) Multiple Member LLC: Form 1065
d) Limited Partnership: Form 1065
e) S-Corporation: Form 1120S
f) C-Corporation: Form 1120
Amended Taxes
If you're anything other than Type #1 Full Compliance in the compliance category then you need to round up your transactions, calculate your taxes and file an amended tax return assuming you already filed a tax return without including bitcoin and other cryptocurrencies. All tax returns have a step sister version of themselves called an amended return for reporting corrections and omissions. For example, the amended return for Form 1040 is Form 1040X and the amended return for Form 1065 is 1065X.
Taking Action
There are several ways to get into compliance. You can do it yourself, do it together or have someone else do it. Here are some additional resources regardless of how you choose to do it.
• Read my blog on The 5 Remedies of Bitcoin Tax Headaches for the finer details on how to calculate taxes.
• Get my book, The Ultimate Bitcoin Business Guide™ that covers this topic and more.
• Go to TheBitcoinCPA.com for additional resources and tax services.
Good luck!
The Bitcoin CPA™, Kirk Phillips