What Moved Cryptocurrency From the Fringes to the Mainstream? Ingenuity and the Attention of the IRS

Digital Assets | Peter S. Goodrich | Mar 12, 2020

Iconic American humorist Will Rogers once said, “The only difference between death and taxes is that death doesn’t get any worse every time Congress meets.” One might amend Rogers’ quote to add, or every time someone finds a way to make money. Because, as we know, no matter how obscure or esoteric a concept is, if it makes money, like death follows life, taxes will follow profits.

Let’s say, with the advent of the internet, a number of people over a number of years invent a public decentralized peer-to-peer electronic cash system. To address the associated double-spending problem, the inventors set up a consensus mechanism involving the creation of virtual currency or digital assets. They call these digital assets “cryptocurrency” due to the cryptographic algorithms that support the transaction validation process or consensus on the network. And their peer-to-peer electronic cash system for cryptocurrency is called a “blockchain.”

Now, to get a visual on the structure of blockchain, imagine each block in the chain is a train car. Within each train car is information about one peer-to-peer cryptocurrency transaction. These train cars containing cryptocurrency transactions are lined up in a sequence, that is, in the order that each transaction occurred. In addition, each train car also references the transaction (train car) that immediately preceded it. And so, with each new validated transaction, an additional train car is added, thus creating a chain of train cars, nee “blocks.” And hence the name “blockchain.”

Basically, blockchain is a ledger, and like any ledger, it is a record-keeping system or database. But, it is important to note that blockchain is a “public ledger,” meaning anyone can access it. However, within the blocks it keeps not only the identities of participants in a secure and (pseudo) anonymous form, but also their cryptocurrency balances, and records of transactions between those in the network.

With all of that said, initially, for the Internal Revenue Service (IRS), since cryptocurrency was not really money (sort of like the money in a game of Monopoly, you might say), the Service viewed it as an outlier. But then, something happened. People started using this “Monopoly money” to actually buy, not hotels on a game board, but in-real-life goods and services. Furthermore, those “transactions” involved people trading those digital assets. Now, the whole construct of the blockchain was starting to look vaguely familiar. Especially when you add the fact that the value of cryptocurrency became pegged to the U.S. dollar and fluctuated in value based on market forces.

This all began to sound to the IRS like just about every kind of…property. Also, participants began making money when “transferring” these currencies between them. And that looks an awful lot like property, too, one with…a capital gain. Perhaps most important, participants in the blockchain could take what is called “convertible” virtual currency and exchange it for what is called “fiat.” Translation: real money. The kind of money that, yep, gets taxed.

So, once cryptocurrency started making “real money,” it got the attention of the IRS, and we all know what follows when that happens. In the IRS’s defense, we need to remember that, after all, that is its job. To tap all sources of possible tax revenue because if it doesn’t our government won’t have any money to run itself. So, what is the IRS up to vis-a-vis cryptocurrency?

If you have some knowledge of cryptocurrency, you may know names like Ethereum and XRP (nicknamed “Ripple” after the creator Ripple Labs), but the name that gets the most play is Bitcoin. While Bitcoin had several precursors, including “ecash,” “b-money” and “bit gold,” on January 3, 2009, the bitcoin network came into existence following the publication of a paper by its creator, Satoshi Nakamoto, titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” Today, there are an estimated 1,000 cryptocurrencies in existence with no slowdown of new entries predicted. Talk about getting the IRS’s attention.

This explains two significant recent moves by the IRS. The first is simple, but significant. If you happen to peruse a tax form for 2019, you will see a new addition. One line asks a straightforward question:

“At any time during 2019, did you receive, sell, send, exchange or otherwise acquire any financial interest in any virtual currency?” Simple as that and there are only two answers: Yes or no. That’s it. Perhaps it goes without saying, but as with any question the IRS asks you, answer honestly. If the answer is “No,” no further action is required. If the answer is “Yes,” you should do what over 10,000 of your fellow taxpayers should do.

Those lucky citizens received from the IRS what some are calling “Crypto Letters,” but there’s nothing cryptic about their message: We think you may have (oops!) omitted on past forms income resulting from virtual currency transactions. And if you think the IRS is just making a good guess here, they will also tell you that your reporting does not jibe with other records that they have in hand.

So, whether you did or did not get a letter, and/or will have to answer “yes” on your 2019 return, the first thing you should do is not freak out. It is not like agents from the Treasury Department’s Financial Crimes Enforcement Network will be knocking on your door. But don’t tarry either. This first move by the IRS resembles what it did some years ago when it decided to chase down all that hidden money offshore. Like that effort, the crypto push is in the “polite” stage. So, here is what you do:

Contact companies like ours that have expertise in this space. Have us get to work with our software tracking your cryptocurrency activities and amending any tax years that require it. And remember, crypto earnings get treated as property in the eyes of the IRS. Cryptocurrency efforts like mining (see the Crypto-ssary) and other crypto-related activities can involve major investment and yield certain tax implications. More generally, if you, let’s say, buy a cryptocurrency at $1,000 and trade it for $5,000, that original $1,000 reduces the gain.

In summary, cryptocurrency has most definitely moved from the fringes to the mainstream and is in the crosshairs of the IRS. Bottom line: Just start treating the money you make there like all the money you make. After all, if you think about it, unless you have stacks of cash stashed somewhere, most of your “real” money is in a virtual file somewhere, too.

And, finally, one prediction: Cryptocurrency will become so integrated into the financial sphere, that governments will jump in and create their own cryptocurrencies. Meaning, maybe just maybe someday you will pay your crypto-taxes in, yes, cryptocurrency.

Crypto-ssary of Terms

Altcoin—Refers to cryptocurrencies that are not Bitcoin.

Blockchain—Ledgers secured by cryptography that are basically public databases accessible by everyone, but that can only be updated by the owners.

Bollinger Band—A margin surrounding a cryptocurrency’s price that can help indicate whether a coin is being overbought or oversold.

Cold Storage—When a cryptocurrency is moved “offline” to protect it from hacking.

Exchange—Media or platforms where cryptocurrencies are bought or sold.

Fiat Money—Currency, such as the U.S. dollar, that is issued by a government.

Fork—When a blockchain splits into two separate chains

Hardware (cold) Wallet—A computer that securely stores cryptocurrency.

ICO—Stands for Initial Coin Offering that resembles an IPO in the stock market.

Market Cap—Consists of the total value held in a cryptocurrency calculated by multiplying the total number of coins by the current price of one unit.

Mining—A process requiring immense computer processing power that attempts to “solve” the next block.

Mining Rig—Usually consists of multiple high-end graphic processors specially designed to processes proof-of-work blockchains

Node—Computers that possess copies of blockchains and work to maintain them.

Pump & Dump—When an altcoin gets recurring attention prompting sudden price increases often followed by deep decreases.

Software (hot) Wallet—When storage of a cryptocurrency only exists as software files.

Stable Coin—When a cryptocurrency has very low volatility.

Whale—This is a person who owns outsized amounts of cryptocurrency.