Why Tax Accountants Need to Get Up to Speed on Bitcoin

Last week I was waiting in a lobby for a meeting to begin, my eyes trained on my phone watching worldcoinindex.com. Bitcoin was getting so close to $10,000. It was exciting.

A CPA I know arrived and asked how I was.

“I’m ecstatic!” I replied. “Bitcoin will probably hit $10,000 today!”

He frowned. “Bitcoin. What is that even? Isn’t that a scam?”

And it got me thinking. I know a lot of accountants, and few of them are familiar with Bitcoin outside of the occasional headline they stumble across on Bloomberg, or from catching a glimpse of a story on Fox Business or CNBC. Bitcoin, and a long list of other cryptocurrencies (referred to as alt-coins), are slowly becoming mainstream, and 2017 has been a banner year for the entire asset class.

In full disclosure, I’ve been in management accounting for the past eleven years, but I did work at a CPA firm for eleven years before that. I’m familiar with the monthly meetings regarding FASBs and tax changes, and how accounting firms try to stay up on latest developments that may affect their clients. In my current career, I also deal with CPAs, auditors and other management accountants. A revolution in money is happening right now. It’s happening quickly, and the accounting profession doesn’t seem to be on alert. So why should they be?

Imagine you are a tax accountant and you are having your annual tax meeting with one of your clients, let’s call him Joe. Joe has a lucrative IT job, and he is a rabid saver. He contributes to his 401k. He also has a self-directed Roth IRA, a handsome equities portfolio and has dipped into a few bond funds. So here you are with Joe, and you ask him, “How have your investments done this year?”

“Fantastic!” he exclaims. “I cashed out a bunch of stocks and opened up a Coinbase account. I bought ten Bitcoins at $2,500 each. Do you believe that? They’re over $10,000 now! Anyway, in October I bought another $10,000 in Bitcoin and transferred it over to my Bittrex account.”

“Bittrex account?” you ask. “What’s a Bittrex account?”

“It’s an exchange where you trade alt-coins,” says Joe.

You’re curious. “Why did you send Bitcoin to that account? Why not dollars?”

“Because you can’t send dollars to it,” says Joe. “It’s for cryptocurrencies only. Anyway,” he continues excitedly, “I started trading in alt-coins. I made a killing on Stellar Lumens and Lisk, but my Vergecoins dropped and so did my OMGs. Bad timing. Anyway, I heard that Litecoin was going to take off, so I bought a bunch of that. Since I’m holding that long term, I decided to send it to hard storage for safekeeping, along with three of my Bitcoins that I had on Coinbase. Oh, and my Ethereum too. I forgot about that. And I also got four Bitcoin Cash from the hard fork last summer just because I already had four Bitcoins. But I won’t actually get that until Coinbase delivers it to me in January. And there’s also a few other coins from hard forks. I can’t remember what they all are, and I don’t even know how to claim them.”

You’re perplexed. And you should be. The tax implications of cryptocurrency are debatable in many instances. Despite the (hopefully fading) opinion that cryptocurrencies are for criminals, many investors would rather pay their taxes than be charged with tax fraud and be fined, or worse, go to prison. Unfortunately, the tax rules for cryptocurrencies are not yet well developed.

The IRS has elected to treat Bitcoin and related cryptocurrencies as property. In this case, capital gains rules apply. Simple enough, right? When you liquidate Bitcoins into dollars either by spending or selling them, capital gains or losses are incurred between the market price on the day of the liquidation and the day of purchase. But several questions are thus begged. The price of Bitcoins and alt-coins can fluctuate widely in a single day, sometimes thousands of dollars. And while a straight sale consisting of proceeds less original cost basis is simple arithmetic, liquidation also occurs when a cryptocurrency is used as a currency. To calculate a gain or loss will you be forced to find out what the market price was at the moment of the purchase? And what if that purchase happened in a bakery in Munich? Now you’d have to see the exchange rate between the Euro and the US Dollar to calculate the gain or loss. And what if it was just for a cup of coffee and a sweet roll?

And what about Joe’s activity on Bittrex? Gains and losses from trades there are all against Bitcoin, not fiat currency. Are these trades equivalent to securities or are they more akin to like-kind exchanges? If they are gains and losses, and there are numerous trades, translating them into dollars is going to be a pretty tough task for the new staff accountant in the cube by the kitchen who spends half his day making coffee because he’s the newbie.

And then you have Joe’s Bitcoin Cash. How should this be treated? A stock split? A dividend? Just more gain on his original Bitcoins? Other income?

This conversation came up on an edition of Carter Thomas’s Coinmastery TV on YouTube. He was of the opinion that yes, these newly created Bitcoin Cash coins would be taxable. But that’s not so simple.

Bitcoin Cash came into being when the Bitcoin blockchain underwent a programming change to solve Bitcoin’s transaction processing scale. Some in the Bitcoin community chose an alternative solution to the scaling problem, producing a hard fork from the Blockchain, which occurred August 1, 2017. All Bitcoins in existence on the old blockchain now existed on both blockchains. This created an additional currency called Bitcoin Cash, and anyone with Bitcoin at that time now also owned an equal amount of Bitcoin Cash — theoretically.

We can’t really treat this as a stock split, because Bitcoin itself remained unchanged. So that is not really applicable. A dividend occurs when a company distributes equity to its shareholders. This did not happen at all. Bitcoin is not a company and did not distribute any of its value in the form of the new coin. Since the windfall doesn’t really fall into a known category, I could see this being classified as other income, but there’s a problem in Joe’s case. He hasn’t received his Bitcoin Cash from Coinbase; he just has Coinbase’s promise that they will distribute it in 2018. If Joe’s Bitcoin cash had been distributed to him in August, it would have been worth round $300 per coin. But taxpayers are on a cash basis. If he receives his Bitcoin Cash in 2018, will he now have to declare other income of perhaps $1,500 per coin? That’s a big difference in Joe’s tax liability.

And there are other coins that have hard-forked from the Bitcoin blockchain, Bitcoin Gold and Bitcoin Diamond to name two. Must Joe claim all of these as income even if he never claims the coins?

In my view, the most fair and practical way is to treat hard-forked coins as simply gains from basis in the original coin, which are not realized and taxable until they are sold. But the IRS hasn’t thought this through completely, probably because they’re not fully aware of the myriad of events occurring in the cryptocurrency sphere.

As an asset class, cryptocurrency simply does not fit neatly into the current paradigm of the tax code. The IRS realizes this, and in August published a document with guidelines, but also asked the public for commentary on how to treat this new asset class. Shouldn’t some of that input come from the accounting profession as a whole? Can meaningful input come from the profession if the profession, as a whole, does not dive in and learn to understand this asset class?

I’m sure there are accountants that have been studying these issues, but they are in the minority, and probably don’t work for your firm. Should this matter to you? Yes.

Coinbase has opened hundreds of thousands of new accounts in the past few months. At this writing they have more than 13 million accounts, more than Charles Schwab. Many of these accounts will be your clients’ accounts. Some of them will have bought Bitcoin, or two other coins available on Coinbase, Ethereum and Litecoin. If they have simply purchased and had no other transactions, there’s little in the way of tax implications. But they might be active traders, like Joe. And they also may have moved their coins from exchanges into hard storage.

The long-time Bitcoin community strongly suggests that people hold their Bitcoin in hard storage so that they possess their private keys. They are referring to a “wallet” on a device. It could be on a computer, or on a device specifically designed to hold cryptocurrencies, such as a Trezor or a Keep Key. Hard storage could be a thumb drive, or even a “paper wallet” on which the private keys to the coins are printed on paper. Is moving coins from an exchange to a hard wallet a taxable event?

Tone Vays, an experienced trader, and respected vlogger and podcaster in the Bitcoin community, insists that it is. In a conversation with fellow vlogger Jimmy Song’s YouTube podcast, Offchain with Jimmy Song, he has stated with great confidence that this is a taxable event. I’ve watched this argument develop on Twitter with many different points of view. Vays believes that simply moving the Bitcoin offline from an exchange to another medium will cause tax liability. I strongly disagree because no sale has been made and no gains or losses have been realized. I believe that this more akin to accepting delivery of physical stock certificates for stocks you were holding in your Etrade account. Who’s right? We don’t know because, again, tax policy related to cryptocurrencies is wholly inadequate for 2017.

As you research Bitcoin, you will come across a lot of material about how Bitcoin is going to change the financial world. This is true, but this will take time, and for tax year 2017, you need to do the right thing for your clients. Much of tax policy regarding cryptocurrencies will probably be determined in court, and that puts your clients at risk.

The time is now for tax accountants to learn everything they can about this new asset class and to help develop the framework around taxable and non-taxable events. The profession must step up and get involved in the conversation. CPAs and Enrolled Agents should be familiarizing themselves with the cryptocurrency asset class and how it is treated for tax purposes. They should fully understand the different flows of cryptocurrencies between holding accounts, exchanges and hard storage so that they can advise the IRS about how these transactions should be treated for tax purposes.

It’s possible that Joe may not show up this tax season in your office, but with the increasing interest and investment in cryptocurrencies, you will definitely meet him by the time tax year 2018 arrives.

When Joe does finally show up in your office, whatever you do, don’t ask him what Bitcoin is, and don’t ask him if it’s a scam. He’ll look for a new accountant.