February 28, 2019

Taxation of Crypto Currencies

Doug Levinson

Doug Levinson
Management Consultant/Strategy That Rocks

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Taxation Of Virtual Currencies

Like Playing Monopoly… Sort Of

As revered as U.S. currency is world-wide, it has no intrinsic value.  Since the early 1970‘s, U.S. currency has been fiat money, meaning, it’s not backed by, or linked to, anything.  So, like Monopoly Money, the perceived “value” of U.S. currency is solely a product of artificial scarcity.

Precisely how scarce U.S. currency is at any given time is no trifling matter.  The Federal Reserve Bank uses vast amounts of historical and empirical data, and some fairly arcane tools, to govern how much money is in the U.S. economy.  The Fed (with questionable levels of success) pursues a delicate balancing act “between Scylla and Charybdis.”  Too much money can overheat the economy and lead to inflation, while too little money can cause significant unemployment.  At the end of the day, however, it’s all about scarcity.  In fact, if the total amount of any currency is strictly limited (at least in theory), potential inflation becomes irrelevant.

Alternative Currencies

An economic system can, of course, be based on anything, as long as some population or community is willing to accept that item as a valid method of exchange, and that item is scarce.  An economic system could (at least theoretically) be based on anything scarce -- U.S. currency, diamonds, or tokens at an arcade.

Some alternative currencies -- called closed currencies -- are only valuable within the community that uses them.  (Tokens work fine for arcade games in the issuer’s arcade, but you can’t use them in a parking meter). Other alternative currencies, called convertible currencies (such as Bitcoin) -- can be traded for legal tender, at published conversion rates.

Enter Virtual Currencies

Digital Currencies (which are also known as Virtual Currencies) began to appear in the early 1990‘s.  Technically, they are defined (in a mouthful) as:

Digital representation[s] of value that [are] neither issued by a central bank [nor] a public authority, nor necessarily attached to a fiat currency, but [are] accepted by natural or legal persons as a means of payment and can be transferred, stored or traded electronically.

The evolution of digital currencies has essentially tracked the evolution of the internet and online gaming.  For example, what has come to be known as Crypto Currencies are Digital Currencies secured by emerging cryptographic technology.

And different types of digital currencies have evolved -- for example, “hard” digital currencies avoid transaction costs by not maintaining services to dispute or reverse charges.  (This concern can be ameliorated by the use of escrow accounts).  In contrast, “soft” digital currencies typically have a holding period before transactions are cleared.

There are legitimate reasons to favor digital currencies.  For example, avoiding credit card processing fees and currency exchange fees. Obviously, however, there are also illegitimate uses for digital currencies, such as preserving anonymity in transactions for contraband or avoiding bank secrecy regulations.  

Tax Implications Of Virtual Currencies

When it comes to income tax, it doesn't matter whether you've paid for goods or services in Euros, Rupees, gold or Bitcoin -- all compensation is income. And, in many countries, including the U.S., all income -- even income in digital currencies -- is taxable.  And unresolved questions also exist about whether digital currencies are (or should be) subject to sales and value-added taxes -- with different countries taking different positions, or having no formal position.

Significantly, virtual currencies typically do not honor the formalities of tax documentation, such as W2’s and 1099’s.  And payments in virtual currency are commonly not reported to tax authorities.  So, not surprisingly, virtual currencies are on the I.R.S.’s “radar.”  And this regulatory attention has become a political “football,” with some conservative legislators questioning the I.R.S.’s role in these methods of exchange.

Tax regulators also face difficult questions of whether virtual currencies are intangible assets, potentially subject to capital gains taxation.  And, if a digital currency is subject to capital gains treatment, what would the correct basis be?

One thing is certain: digital currencies are not going away any time soon -- legislators and regulators are going to have to consider and address the policy implications of how digital currencies are treated.

Comments? You can contact me directly via my AdvisoryCloud profile.

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