Crypto Tax Expert: Like-kind Exchange (LKE) Is Highly Effective And Equally Controversial

Find out how Donnelly Tax Law is on the bleeding edge of like-kind exchange (LKE) and how it saves crypto traders big money.

Like-kind exchange is a topic fueled with such controversy that many tax professionals  disagree on it.

In an article published on Cointracker, on November 15, 2019, Christopher Wrobel (Special Counsel to the Associate Chief Counsel, IRS) walked back Suzanne Sinno’s (General Attorney, IRS’s Office of Chief Counsel) comments from two days earlier at the AICPA National tax conference in Washington, DC.

Wrobel stated, “that while like-kind exchanges are disallowed for cryptocurrency starting in 2018, for pre-2018 transactions, they are still a grey area that will be decided on a case-by-case basis.

This controversial topic has IRS lawyers in such a twist that they’re publicly editing one another.

IRS special counsel, Wrobel, says like-kind exchange is held on a case-by-case basis, and I currently have two crypto tax audit cases heading into review with the IRS special counsel. 

We have written the legal briefs in the IRS’s hands right now with a reasonably compelling argument for like-kind exchange.  

That puts Donnelly Tax Law on this controversial topic’s bleeding edge with two open audit cases containing significant arguments for like-kind exchange. 

Like-kind exchange is no small tax savings strategy for crypto traders.  

My firm, Donnelly Tax Law, has helped taxpayers owning cryptocurrencies to avoid taxes on over $40 million in gains by using Like-Kind Exchange calculations.

This article will explain how like-kind exchange works and how it saves big money on your crypto taxes.

What is like-kind exchange (LKE)?

like-kind exchange (LKE)

Like-kind exchange (LKE) is the way most crypto traders agree cryptos should be taxed. You only are taxed when you convert back to cash. The U.S. tax law permitted this type of trading under section 1031, frequently called “like-kind exchange” (LKE).

An easy way to think of this is that the second property inherits the original property’s purchase price (basis) and purchase date during an exchange.

How does like-kind exchange (LKE) defer the gain until profits are taken?

Section 1031 allows the deferring of gain when exchange property.

For example, say you buy $2000 of BTC. When the value reaches $3000, you exchange the BTC for XRP. The gain of $1000 is considered deferred.  The cost basis of XRP is the same as BTC or $2000. If XRP is later sold for $5000 in fiat USD, the gain would be $3000 because the cost basis is $2000, not $3000.

Like-kind exchange (LKE) treatment does not make the gain tax-free.  The gain is deferred. It is eventually taxed as sold for fiat.

Deferring gain is important, especially when prices drop. Consider our example above. The price of our XRP holdings had collapsed to $2500. The gain when going to fiat would be only $500. The taxpayer is saved from having to pay tax on earlier gains, which later evaporated.

How do like-kind exchange (LKE) trades qualify quicker for long-term rates?

like-kind exchange (LKE)

Since the second property inherits the first property’s purchase date, it qualifies for long term capital gain tax rates sooner when converting to fiat. Once a property is held for over a year, it qualifies for long term capital gains taxes, usually 15%. (Footnote 1)

How does like-kind exchange (LKE) reduce penalties and interest?

Here is where like-kind exchange (LKE) gets exciting for crypto traders.

Tax returns for 2014 to 2017 can be amended to report the like-kind exchanges without incurring an additional tax liability. This technique removes the audit risk of unreported crypto trades. There are no penalties or interest risk for reporting like-kind exchange (LKE) trades because there are no additional taxes owed.

The IRS charges an accuracy penalty and interest when it discovers unreported gains. Many customers come to me with unreported gains, especially for the 2017 tax year.

Would like-kind exchange (LKE) help me?

like-kind exchange (LKE)

Like-kind exchange (LKE) is recommend for traders who need to report crypto-to-crypto trades before 2018. (Footnote 2)

Traders who would not benefit from like-kind exchange like-kind exchange (LKE):

One trader claimed he did crypto-to-crypto trades but turned out he always went back to cash before buying the next crypto. 

One trader had huge crypto-to-crypto trade gains, but on December 28, 2017, he panicked and sold everything for cash. A day later, he reinvested all the cash back into cryptos.  By cashing out, he had to recognize all the capital gains.

Why like-kind exchange (LKE) is the best way to report 2017 gains?

Consider this scenario: An investor buys 10 BTC on 1/1/2017 for $9600. On 12/21/2017, he exchanges the 10 BTC for 535 LTC at a fair market value of about $162,000. LTC price declines until he relents and sells all the LTC on 12/30/2018 for $17,000. Assume that the investor was in the 33% tax bracket in 2017 and the 32% tax bracket in 2018. Long term capital gains rate is 15%.

If the investor were to report each trade as capital gain, what is the tax impact?

Capital Gain Scenario: The investor pays $50,160 in taxes in 2017. But the gain of $152,000 is illusionary. In 2018, the market collapsed, resulting in a $145,000 loss.  BUT, there is a $3000 limit on claiming a capital loss, so the capital loss carryover to 2019 is $142,000. The net tax burden over the two years for this transaction is $49,160.

like-kind exchange (LKE)

Like-Kind Exchange Scenario: Under like-kind exchange, the investor pays no tax on the trade in 2017. The LTC inherits the original purchase price and purchase date of the BTC when treated as a like-kind exchange. This is shown in red down below. Although prices dropped in 2018, the selling price is still higher than the original price of the BTC, so there is a small gain. Since the holding period is extended because of like-kind exchange (LKE), the sale is taxed at lower long term gain rates. The net tax burden over the two years for this transaction is $1,110 or a savings of $48,050.

like-kind exchange (LKE)

Amending Returns to add LKE: If this investor hadn’t reported his gains in 2017, amending his 2017 and 2018 returns results in a smaller tax using like-kind exchange (LKE). Also avoided are the substantial late payment penalty and interest on taxes.

Will using like-kind exchange (LKE) attract an audit?

Original filing of a like-kind exchange (LKE) return has never generated an audit for my clients.

Can a return be amended to use like-kind exchange (LKE)?

like-kind exchange (LKE)

I have filed dozens of like-kind exchange (LKE) returns without audit. The only time I have difficulty is when a large refund is claimed on an amended return. This gets an extra review, but you should still get it if you are entitled to a refund.

One client was selected for audit, but this was related to unreported K-1 income.

Is using like-kind exchange (LKE) legal?

In December 2017, Congress passed the TCJA tax law, which modified Section 1031, limiting like-kind exchange (LKE) to only real estate.  Over the prior decade, section 1031 was used for more purpose to defer gain. There was a debate; it was time to limit the application of 1031.  It was not because of cryptocurrencies alone that it was changed.

The law only applies to tax years 2018 and forward.  The law doesn’t apply to prior years. The law change has no implications for the legality of non-real estate like-kind exchange (LKE) trades in prior years.

If you are looking for some formal IRS document that says like-kind exchange (LKE) is permitted for cryptocurrency trades, it doesn’t exist. It will never exist.  The IRS tries to educate taxpayers on what the tax law and regulations specifically say.  They leave the application up to you.

Stay Tuned

Stay tuned, or subscribe to my newsletter, for my next post where I lay out the legal case for like-kind exchange (LKE) by exploring the controversial position that exchanging one cryptocurrency for another qualifies for tax-deferred treatment under IRC section 1031.

For the most professional, worry-free way to have your crypto taxes prepared and filed, click here.

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Footnote 1: 20% if you are in the top tax bracket.

Footnote 2: At the end of 2017, Congress changed Section 1031 to only apply to real estate

Crypto Tax Expert Details IRS Cryptocurrency Timeline

The IRS cryptocurrency timeline detailed from 2013 to the present day by Crypto Tax Expert, Clinton Donnelly of Donnelly Tax Law.

Note: Not all actions, advice, guidance, provided by the IRS are non-binding legally on the taxpayer.

The Beginning Of The IRS Cryptocurrency Timeline

2013 – 2015
The IRS served a “John Doe” summons on Coinbase seeking information from accounts “with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013-2015 period.

April 2014
The IRS releases Notice 2014-21, a.k.a. Virtual Currency Guidance accompanied by several FAQs with references to several publications: “Taxable and Nontaxable Income,” “Basis of Assets,” “Withholding of Tax on Nonresident Aliens and Foreign Entities” and more. 

December 12, 2014
Treasury Decision TD-9706 solicits comments on the proper reporting of virtual currency on as Specified Foreign Financial Assets on form 8938.

May 6, 2016
IRS & FBI announce legal victory of imprisonment for 20 years of founder of Liberty Reserve for money laundering. Liberty Reserve was a non-blockchain virtual currency.

November 8, 2016
The Treasury Inspector General for Tax Administration (TIGTA) warned IRS that better guidance needed on reporting tax implications of virtual currency transactions.

FAQs Are Non-Binding To The Taxpayer On IRS Cryptocurrency Timeline

IRS cryptocurrency timeline

July 26, 2017
IRS Taxpayer Advocate calls IRS FAQs a trap for the unwary.  FAQs are non-binding.

March 2018
The IRS reminded taxpayers that income from virtual currency transactions is reportable on their income tax returns. Wrongfully reported income tax could be seen as tax evasion and could include a fine of up to $250,000 or 3 years in prison.

July 2018
IRS announces through the Withholding & International Individual Compliance Area: “U.S. persons are subject to tax on worldwide income from all sources, including transactions involving virtual currency.”

July 13, 2020
IRS release press release about achievements of the J5. A five nation task force to coordinate investigation and enforcement efforts in tax evasion including the area of virtual currencies. The J5 have built the FCInet as a decentralized virtual computer network that enables agencies to compare, analyze and exchange data anonymously. It helps users to obtain the right information in real-time and enables agencies from different jurisdictions to work together while respecting each other’s local autonomy. Organizations can jointly connect information, without needing to surrender data or control to a central database. FCInet doesn’t collect data, rather it connects data.

IRS Begins Sending Virtual Currency Education Letters On IRS Cryptocurrency Timeline

IRS cryptocurrency timeline

July 2019
The IRS started sending the educational letters (6173, 6174, 6174-A) to taxpayers last week of July 2019. By the end of August, more than 10,000 taxpayers received these letters. Taxpayers’ names were obtained through various ongoing IRS compliance efforts.

October 9, 2019
The IRS releases Revenue Ruling 2019-24, providing further guidance on Airdrops and Hardforks. 

October 9, 2019
The IRS publishes a list of frequently asked questions about virtual currencies. This document was revised again a few months later.

January 2020
The IRS adds the Crypto Question to Form 1040 for 2019: At any time during 2019, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency.

February 2, 2020
IRS & FBI announce Ohio resident charged with operating darknet-based bitcoin “mixer,” which laundered over $300 million.

February 2020
The U.S. Government Accounting Office (GAO) published a report GAO-20-188 stating the IRS guidance in 2014 & 2019 was not clear as to which parts are authoritative and which parts were subject to change. IRS and the Financial Crimes Enforcement Network (FinCEN) have not clearly and publicly explained when, if at all, requirements for reporting financial assets held in foreign countries apply to virtual currencies (Forms 8938 and FBAR).

March 2, 2020
IRS & FBI charged two Chinese nationals with laundering over $100 million in cryptocurrency from exchange hack.

March 2020
The IRS has invited crypto companies to discuss how they “balance taxpayer service with regulatory enforcement,” consisting of panels on technology updates, tax return preparation, and more.

May 2020
IRS wants crypto tax software companies to help with crypto tax audits

July 2020
IRS seeks contractors to uncover privacy coin transactions

July 22, 2020
IRS Criminal Investigation wins case. Man admits operating unlicensed ATM Network that laundered millions of dollars of Bitcoin and cash for criminals’ benefit

August 4, 2020
IRS and DEA announce American darknet vendor and Costa Rican pharmacist charged with narcotics and money laundering using virtual currency.

Crypto Tax Reporting Becomes IRS Top Priority On IRS Cryptocurrency Timeline With The New 1040 For 2020

IRS cryptocurrency timeline

August 2020
IRS releases a draft for the new 1040 form moving the “Yes” or “No” virtual currency question which asks, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency? Yes or No” from Schedule 1 to the top of the new 1040 form.  

August 14, 2020
IRS begins second round of virtual currency education letters dated August 14, 2020.  

August 28, 2020
IRS memo says that cryptocurrency earned from carrying out microtasks is taxable.

New Approach By The IRS To Use Rewards To Hack Crypto On IRS Cryptocurrency Timeline

IRS cryptocurrency timeline

September 4, 2020
The IRS offers reward of $625,000 to anyone who can “reliably produce useful results on a variety of real-world CI cryptocurrency investigations involving Monero and/or Lightning” reflecting a new approach by the IRS to use rewards to hack cryptocurrency, a field dominated by hackers.  Proposals are due Wednesday, September 16, 2020, at 08:00 EDT. 

September  8, 2020
The IRS’s criminal investigation department signed a $249,900 contract with blockchain analytics firm called Blockchain Analytics and Tax Software, LLC, to amplify crypto tracing tools.

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International Crypto Tax Competition – Stephan Livera Podcast: Part Four

Learn from tax experts about international crypto tax competition and determine if making a move is worthwhile.

Dennis Wohlfarth of Accointing and Clinton Donnelly of Donnelly Tax Law join Stephan Livera to talk about Bitcoin tax recordkeeping, and strategies to minimize tax. In the full podcast, we chat about:

  • Current Bitcoin tax treatment
  • Capital gains Bitcoin tax treatment
  • Bitcoin tax recordkeeping
  • Bitcoin tax strategies locally
  • Bitcoin tax strategies for those willing to go overseas
  • International crypto tax competition

In part one, we talked about Bitcoin tax treatment and Austrian economics on Stephan Livera Podcast, episode 183, and our guests were from the company Accointing and Donnelly Tax Law

In part two, we talked about Bitcoin tax recordkeeping.

In part three, we talked about how various crypto tax situations should be treated locally and internationally from a crypto tax law perspective.  

Today, our podcast show notes are about international crypto tax competition and determining if moving is worthwhile.

International Crypto Tax Competition

international crypto tax

What are the ways that people could explore if moving is worthwhile?

Clinton Donnelly: Let’s take the situation with someone who’s not an American.  

I’d propose that the best place for your money is to invest in the United States. 

It is the largest tax Haven in the world because the financial industry is an essential part of the US economy, and they’ve created powerful incentives to attract foreign money. 

Notably, there are zero capital gains on your crypto assets in the US if you’re a foreigner.

If you go to Bank of America, Citibank, or Wells Fargo, or any of these major banks as a foreigner, you can easily open up a bank account. But you’ll have to go there physically and open one up. 

It’s not going to be a question as to why somebody from Australia or Switzerland is coming to the US to open up a bank account because the US wants to be the world’s marketplace.

Opening a bank is not going to be a problem, and you’ll want to do it with these major banks because they’re accustomed to international wire transfers. 

Suppose you have an account at a US bank. In that case, nobody will question it from an anti-money laundering perspective if you are trying to transfer money back to Australia. As you know, it’s widely respected as opposed to a BVI (British Virgin Islands) bank or credit card. 

The US does information sharing between countries regarding how much money citizens have in foreign bank accounts.  

The US has FATCA Law. 

All the world’s banks have to tell the US (the IRS) twice a year about American bank accounts in foreign countries. In response to that, the OACD countries created common reporting standards, CRS

I think about a hundred countries have signed up to where once a year, they will report back the total amount of each citizen’s bank account to their home country.

And the US didn’t sign that. The US did not sign the common reporting standards. 

What that means if you have a bank account in the US, the US doesn’t tell any other country about it. So, it’s kind of ironic. 

I guess maybe that’s like being the bully. 

The U.S. demands that everybody gives information to them, but they won’t share it with anyone else. This is because the US is the most prominent financial player out there. 

So they can have this, and whereas it is considered a bit of a tax haven or a low tax jurisdiction, but for everybody who’s not a United States citizen.  Thus making it a great place to put your money because it’s a rich investment area. 

You can move your money out of cryptos when you want to put it into some of the world’s safest banks and invest in some of the best real estate in the country and Wall Street. 

There’s a lot of affluent financial areas with powerful incentives. 

You’ve just got to use a US credit card, like a Bank of America credit card that you can use buying things all over the world for the rest of your life, and your local jurisdiction would have no visibility to it unless you disclosed it to them. So that’s a very attractive thing to do without having to change residents.

Stephan Livera: That could be one idea if you don’t even want to become a US citizen. All of that by just opening an account in the US.

Then there are the other options for moving or getting residents in BVI (British Virgin Islands) or multiple places. I presume that’s also an option that some of your clients might explore.  For some of them it might be worthwhile to consider that.

Clinton Donnelly: I do a lot of consulting in this area. For virtually every country, the principle of taxation is that you’re subject to taxation if you’re in the country for more than six months. 

Typically, you’re subject to taxation on your worldwide income in that jurisdiction where you’ve lived for six months. 

Now, the US has a different tax law. They tax their citizens on their worldwide income, regardless of where they live in the world. So it’s a little different wrinkle for Americans, but a common underlying theme in international taxation is that it is based on residency. 

Residency is typically defined six-months or approximately 183 or 185 days. It varies how you define it, but roughly the six-month thing. 

This creates a massive international tax loophole, which I would call a three-country shuffle, where if you’re never more than six months in one country in a given period, you can keep moving around. It’s kind of like the digital nomad strategy. 

You keep moving around, and you’re not going to have to report taxes to anyone. So, again that’s not for a US citizen. It is assuming you’re not a US citizen. 

Now US citizens have a different problem. US citizens are taxed under income worldwide. However, two massive tax breaks are given to US citizens:

One is, for every dollar they pay in taxes to a foreign country. They get about a dollar to dollar credit back on their tax bill, which is nice. 

The US taxes are lower than most other developed countries. I have clients living in Germany, and their German tax bill is higher than their US tax bill. We still do a US return. They take the German credit, and then they don’t owe anything back to the US. 

That’s if you’re an American citizen living in a low jurisdiction where you are still going to have to report back to the US, and you’ll probably end up paying taxes back to the US.

Now for American citizens, there is a fantastic loophole called Puerto Rico. Puerto Rico is a little country South of Florida next to Cuba, and this area is a possession of the United States. It’s not a state, although there’s always talk about statehood. It’s a possession now in the US tax law. 

Puerto Rico is treated as a possession, kind of like as though you’re living in a foreign country of all of US possessions, and they’ve negotiated the right to tax their citizens. 

If you’re a Puerto Rican citizen, all your income comes from being in Puerto Rico. You do not file a US tax return. Puerto Rico pays its share to the US government on your behalf. So this creates an interesting loophole. Puerto Rico is a Caribbean country, not a lot of indigenous resources. Earthquakes, tsunamis, hurricanes have crushed them.

I mean, the country is bankrupt. However, they created an incentive called act 60 formerly, act 22, where it’s a 0% tax on your capital gains. 

So if you’re an American whale and want to do this, you can move to Puerto Rico, which does mean actually moving there. 

It’s not like, visit for a day and then go back to California. No, you are moving to Puerto Rico for at least six months of the year, in which case, 0% tax on your capital gains on the Bitcoin that you sell when you’re in Puerto Rico. This is a fantastic thing. 

Now, there are some costs.  You have to make a $10,000 donation to Puerto Rican charities. There’s a $5,000 annual fee you pay. And you’ve got to buy a house or apartment in Puerto Rico, and you can’t rent it out. There are some serious out-of-pocket costs, but it’s probably worth it for that extra 15% savings. If you were a whale Bitcoin holder in the US, that’d be the movement for you.

Stephan Livera: Fantastic. So that’s a very nice breakdown there. 

So if you’re a non-US person, it might make sense for you to do this whole three different countries, different residencies, etc. But if you’re in the US potentially, one idea is moving to Puerto Rico. 

One other idea I was interested in discussing related to what we were just saying is what it takes to break your nexus with your home country. 

So, as I understand, it’s like you have to break that six months or 180 days aspect.  

Are there any other things there that people have to think about when breaking that connection so that they can access the lower tax rate?

Clinton Donnelly: Usually, getting a divorce helps. 

I’m just being silly. 

Usually, it is the “Let me go back to visit mother” and that sort of thing, you know.  There is a bit of travel to it. If you take that strategy, you’re at least saying I’m going to be outside. 

Depending on which country you’re from, staying outside that home country for, you know, 9 to 11 months of the year, at least to break the connection.

A couple of things to think about are think of the cost of living. 

You can think about creating awareness of other cultures for your family and speaking other languages. 

There are several websites where you plug in two cities, and they’ll tell you the comparative cost of living. 

And I will tell you, it’s the cost of living that changes a lot between different countries. I just think it’s a great thing to do is once you start traveling, you get the bug. 

What I find is I’ve worked with digital nomads as they travel a bit, and then they decided to have a home base, and they stay there, you know, five months a year, and then they move around or that sort of thing.

If you are not a US citizen, if you're willing to do a three-country shuffle, put your investments in US crypto exchanges, have crypto or at least in wallets, and then use US banks. You can move towards a pretty close to zero tax situation and see the world simultaneously.

Stephan Livera: That’s very impressive.

Exploring The Dynamic Between Different Countries Of The World And International Crypto Tax

Stephan Livera: I think another area that you were touching on as well, Clinton was just around the dynamic between the different countries of the world.

So as you said, it’s almost like there are specific pressures where some countries try to push reporting taxation levels onto others. 

But then there’s also this dynamic where you said that it’s almost like the richer countries allow individual nations to keep lower taxes and have relatively fewer rules around that. 

Could you explain that dynamic a little for us?

Do richer countries allow individual nations to keep lower taxes?

Clinton Donnelly: There was a real concern right before globalization in the eighties.  

Starting in the eighties, we had issues with international drug trafficking. We had, people like Ferdinand Marcos in the Philippines, who pretty much alluded his own country and took the proceeds and took them to Swiss and Lichtenstein banks and trusts. 

The creation of anti-money laundering laws through FATF

The international community got together and said, we have to stop this. So they created anti-money laundering laws coordinated through the financial action task force (FATF).  

The International Monetary Fund (IMF) and the (OECD) are the Organization of Economic Co-operation and Development of about 34 countries that did not like tax havens. 

For example, tax havens, like Seychelles and the British Virgin Islands (BVI), believed these little countries were siphoning off a lot of money and bringing no value to their area. So they clamped down on those using the same anti-money laundering laws, and what that ended up doing was it forced people back to the OECD countries that made it a club of the halves.

The OECD countries treat themselves as plus countries. So, that crushed the small island tax haven network. 

But at the same time, in Europe, we have rich countries like Germany and France, and we also have tiny countries, Luxembourg, Netherlands, who have tiny revenue streams. They need to allow them to have more latitude to have incentives or lower tax options to bring business there. 

The EU is excellent about that, but other countries of the world have to fend for themselves. 

This is a massive issue, by which countries compete with each other. There’s massive competition. 

The US used to have some of the highest corporate tax rates.

It was at 35%; I think France was higher. But then, the UK and Ireland slashed their corporate tax rates significantly. The UK slashed down to 20% on a phase method. Ireland brought it down for foreign countries working in Ireland down to 12.5% corporate tax. This is a big incentive and part of why Google, Facebook, and Apple all move their call centers to Ireland. 

So what the US did to change its international competitiveness is they slashed their corporate tax rates down to 21% and made it exceptionally aggressive. So it is designed to bring big companies who might have been in other countries back home to the US. There is a real war going on for multinational corporations’ tax revenues by countries that are lowering their tax rates to bring them in.

So this will only get more competitive, as people in countries start to do that, they’re going to have to fund it by putting more of the tax burden back on the individual. 

In the US, I looked at a pie chart, and individuals pay roughly 80% of all the US taxes to the IRS. The rest of it is corporate taxes. 

The argument would be, if they put a tax on companies that make sure you buy a shirt in Australia, then your shirt will be more expensive because you’re paying the company’s tax, right? 

Company taxes are indirectly taxed back on the individual. As individuals, we can vote with our feet and move just as I talked about with the three-country shuffle and keep our assets in the US. 

We see the same struggle in the US. 

We have some high tax states like California, New York, and because of remote offices and this sort of thing, people are starting to flee from big states like New York and California.

They’re not willing to pay high property taxes, high sales taxes, high-income taxes anymore.

We're in a period of transition where we as individuals have a lot of power to change our life's tax dimension and make sure we're getting as much value as we can out of the money we have to pay.

Stephan Livera: That was an incredible breakdown. Great information there, Clinton. One of the exciting things there is that dynamic that you were teasing out: there’s this kind of competition between different countries, and for some smaller ones, like say the BVI or Vanuatu, part of the way they compete is they have low tax, etc. 

And for some of them, the offshore investment or the citizenship by investment programs that they offer a part of a good part of their taxation is part of their revenue, that’s part of how they kind of make money.

Clinton Donnelly: An interesting country in South America is a country called Panama. It’s still country, but everybody knows that if anything gets unstable, the US will invade it in a heartbeat because of the Panama Canal. 

Now, what happened is Panama has a tax regime where if a company or an individual drives their income from outside of Panama, then it’s not taxed in Panama. Okay. So it’s a true territorial system. 

What’s happened is that multinationals who want to do business all over Latin America set up their headquarters in Panama. They take all their money in Latin America back to Panama, Panama doesn’t tax it because it’s a drive from outside of Panama.

This is just a unique arrangement that has enabled Panama to attract incredible amounts of business because almost all the Latin American countries are unstable Argentina, Brazil, Colombia, and Venezuela. 

I mean, it’s a volatile mess there, but Panama has the most reliable banking system in all of Latin America. The problem is it was a bit of a shady tax haven and was blacklisted once. It’s got many issues, but it’s moving to progress and improve things, so I would keep an eye on it. 

If you were an individual living in Panama, you’re not American citizens.

So any other country, they’re not going to tax your income. 

If you’re a remote worker, because you’re getting your income from outside of Panama. It’s a lovely tropical country where they speak Spanish and a bit of English, and it’s got a great airport.

Stephan Livera: Right. And, so I guess the other thing there is, the question of getting residency, citizenship and so on. You might not necessarily need citizenship, but you might need the right to live and work there. 

Clinton Donnelly: It is easy. Go to Panama. You put down money, and you open up a bank account. 

You put $20,000 in the bank account and, you get a lawyer about $3,000. 

They can get you, what’s called a friendly nations visa, and this would be 45 countries that Panama likes. Australia is one of them, you know, all of Europe, pretty much, you get a friendly nation visa. You are now a permanent resident of Panama. 

You need to visit for two weeks every two years. But otherwise, you can set up bank accounts, and you have residency there, and you can travel all the world, still say your Panama citizen, keep your business operating out of Panama. You know, so you’re not going to be taxed cause it comes from outside of Panama. 

Stephan Livera: Yeah. It’s interesting because I’m thinking back through Bitcoin people or people who’ve famously attacked Bitcoin people like Peter Schiff, he’s in Puerto Rico, as I understand.

I think even Eric Vorhees has talked about it and went to. I think, but I’m not sure. Correct me if I’m wrong, but I think he might’ve gone to Panama. But the other point I wanted to raise is everyone’s got their different view on the justice of taxation and AML laws. 

You might be against them, but I think one factor that is potentially playing in favor of the individual.  A typical book a lot of people read is called The Sovereign Individual

And part of that is this idea of going to better countries or going to better jurisdictions for better tax laws or other laws. 

I think most people grow up and have this inertia– I grew up here, so I’m going to live here, and I’m going to die here. But perhaps we’re moving more into a world where people can work remotely. 

They can then start accessing some of these overseas tax planning and overseas tax structuring to improve the level of competition between the different countries. And ideally, keep it a bit lower for the individual. What do you guys think?

Dennis Wohlfarth: Yeah. I think that’s one big part. Clinton also said you have to think about where you want to spend like the next years, right? 

I moved to Zug, Switzerland, to the Crypto Valley or at least what they call it because we started our company there. 

It’s a tax Haven for people from Europe because you can easily move there. It’s just; you have to think about all the consequences, right? 

For example, you’re not allowed to keep a key to your parents’ home when they live in Germany, because you’re just not allowed to have a residence in another country. 

If so, the other country would tax you on your group to income, and there are also the 185 days you have to be there in this other country. 

So you need to be aware of the cultural differences. You need to be aware if you speak a different language. You need to think about the costs of living, especially in Switzerland.

And Switzerland, for example, is entirely different from area to area. So it’s not just, I moved to the border of Switzerland. If you come from France or Italy or Germany, you have different areas, and they are small, like Zug, and have excellent taxation law on crypto because you don’t pay any crypto taxes. 

You just pay a wealth tax at the end of the year. It would be easy for a European citizen to move there. You just have to keep in mind that you kind of give up your home or where you grew up. 

You can move back in the future pretty quickly. It depends on your situation. If you have a family, it’s maybe even harder to move there.

“As Clinton said before, the future of all these taxation laws, especially for crypto, will be another five or ten years until they figure out the correct regulations there.”

- Dennis Wohfarth, Accointing Tweet

My team and I are encouraging everyone to accept these regulations because it also brings grip to the next stage, right? 

It’s not just a bad thing. If new regulations are coming in, you have better guidelines. 

You would know exactly how to behave. And with those guidelines, you can find loopholes to go around these taxes. 

If you don’t have any guidelines, it’s tough to decide what to do, because it’s just not defined yet. Right? That’s a big part to consider for the future.

Stephan Livera: Yeah. Clinton, anything to add?

Clinton Donnelly: I talked to a client, from Serbia, and said he had lived through the time when it was broken up, it became very lawless, and there was no real central government. 

And, the criminal element kind of dominated law and order. So there was a real breakdown. 

And when I was talking to him, he said, “I want to pay taxes! I’ve lived in a country where we didn’t pay taxes, and it was chaos. I want to pay taxes, and I want a stable government.” 

And I thought, wow. It was refreshing because so many people think that even paying a dime to a government or some crime is a value that governments give to you. 

And as you were saying Stephan, we should become shoppers to a certain extent. We can make choices about the tax impacts on our lives. The governments generally like you to stay put in one spot and never move, like everybody who has a hand on you can tax you there. They don’t like you moving around because it’s tougher for them, basically changing your residency.

Tax burdens are outrageous, worldwide and it has to do with the number of services we expect governments to give us.

We want the governments to give us social insurance, that if we get old, they’re taking care of us. 

We want the roads to have no potholes. 

We think that the government ought to do stuff to make things better and regulate and define what it means to be organic, all these sorts of things. Let’s have the government do it.

Every time you say the government ought to, you have to rephrase it and say, I want to pay more taxes so that the government ought to do this.

Governments never shrink themselves, so the only way you can sometimes vote is with your feet and move somewhere else, and the grass isn’t always greener on the other side. 

Suppose you have substantial family ties that you love going visit, you know, the big family on Sunday, and having a pasta dinner. In that case, you know, you’re going to miss that if you take off and go live somewhere else.   

But you might replace it with something more exciting and adventurous in your life. So you have to look at the whole picture. It’s not just the tax issue.

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Bitcoin Tax Strategies Locally and Overseas – Stephan Livera Podcast: Part Three

Learn about Bitcoin tax strategies locally and overseas with tax experts Clinton Donnelly and Dennis Wohlfarth on Stephan Livera’s podcast, episode 183.

Dennis Wohlfarth of Accointing and Clinton Donnelly of Donnelly Tax Law join Stephan Livera to talk about Bitcoin tax recordkeeping, and strategies to minimize tax. In the full podcast, we chat about:

  • Current Bitcoin tax treatment
  • Capital gains Bitcoin tax treatment
  • Bitcoin tax recordkeeping
  • Bitcoin tax strategies locally
  • Bitcoin tax strategies for those willing to go overseas
  • International crypto competition

In part one, we talked about Bitcoin tax treatment and Austrian economics on Stephan Livera Podcast, episode 183, and our guests were from the company Accointing and Donnelly Tax Law

In part two, we talked about Bitcoin tax recordkeeping.

Today, our podcast show notes are about how those various crypto tax situations from part two are treated from a crypto tax law perspective locally and internationally.

Bitcoin Tax Strategies Locally

Bitcoin tax strategies

What are some different ways various Bitcoin Tax Recordkeeping situations are treated from a crypto tax law perspective?

Clinton Donnelly:
If I sell Bitcoin and buy a car, I have capital gains when I dispose of that Bitcoin. 

I bought it at a lower price, and I’m selling it at a higher price. That’s equivalent to what I’m paying for the car, that’s the capital gains. 

And we see countries like Portugal are saying, if you pay for Bitcoin, we’re not going to have a VAT tax involved, which is kind of a duplicate tax: a VAT on top of capital gains. 

In the US, it’s just the sales tax, which is the taxes on what is sold, not how you paid for it. So it’s a bit of a different structure.

Cryptocurrencies are turning the tax regimes upside down with blockchain technology, DeFi, and smart contracts.

These exciting innovations are transforming the financial industry and turning our whole notion of currency and property upside down, especially from a tax and accounting perspective.

How do we do accounting when we are no longer trading in Fiat currency, and we’re trading in a Bitcoin? 

It’s an asset that’s continually changing value relative to the Fiat’s in which we have to report our business results to the tax authority. So, everything’s getting very complicated. 

The tax authorities find that defining cryptocurrencies merely as assets or merely as a property is not adequate, because it’s changing so fast. It’s becoming far more than mere property. 

Nor is it adequate to call it currency because it’s not only embraced by one government and everything that is involved with that.

We're seeing that tax authorities are holding back in moving forward with new taxation regimes targeted at cryptocurrencies because they don't know where it's going. They don't want to hamper progress by having tax rules making no sense as technology progresses.

I think we’re going to see taxation rules that are much like property continue, at least for the next five years until there’s a real settling down of this massive finance evolution. That’s frustrating to some people, but I think there will be something newer and better coming out of it.

Stephan Livera:
So for most people who are just holding it’s going to be treated as property, and it’ll just be the capital gains tax (CGT)

I suppose most people are looking for ways to minimize taxes on that legally. I guess one of them is tax-loss harvesting, and another might be moving to a better jurisdiction or things like that might be typical strategies that people are employing. Or the collateralized loan idea is putting out some Bitcoin and getting USD so that you’re not incurring a capital gains event. 

Are these the typical strategies that you see in your experience? Are there any other ones that people are employing?

Clinton Donnelly:
Yes. Lots of those people are putting in trust and then getting payments from the trust. These are all variations. 

There’s a bit of a shell game here. You’re moving the tax to the different places the tax eventually gets paid.  

The thing you mentioned with the collateralized loans: that’s a great strategy. Suppose you want to use a short-term asset’s value until it’s been collateralized long enough to characterize it as a long-term asset and then sell it at the long term capital gains rates. That makes sense. But these are just small micro strategies.

Bitcoin Tax Strategies For Those Willing To Go Overseas

Bitcoin tax strategies

Let’s say you’re a Bitcoin whale, and you have massive positions in Bitcoin. If you see yourself liquidating a lot of this, then the one strategy would be to relocate if you want to improve on the long-term capital gains rate.

Let’s put a framework in place to how you can make that decision.

So you want to ask yourself some questions if you were to relocate. 

But first off, you would be selling where you currently live and moving somewhere else, so you would be incurring new expenses. 

What’s the cost of living there? 

What’s the quality of living? 

Will you find yourself so bored living on an island in the South Pacific that you fly back to Sydney every month to go to an opera show? 

There are some quality of life things. 

You also have issues relative to banking access. 

When liquidating some Bitcoin, you want to put that into a bank and get access to it. 

Ask yourself if you can open up a bank in that foreign jurisdiction?

People may ask why you are coming to Bali to open up a bank account, for example.

They may wonder why you are coming to the British Virgin Islands to open up a bank account if you live in Europe or live in Australia.

These are valid, “know your client” type of due diligence questions that may be difficult for you to open up a bank. If you don’t have a bank, will moving elsewhere be a foolish thing to do? 

Let’s think about the cost of that. 

If your upside is that you have a $100,000 worth of Bitcoin, long-term capital gains rates, let’s use the US rate at 15%. That means your tax is $15,000. 

What can you do? 

That’s going to reduce $15,000 if you move somewhere that you might end up spending. It might be zero tax right there, but you might be spending more than the $15,000 to have moved there.

If you had $100,000 Bitcoin, then we’re talking about a lot of money. 

You might be slowly liquidating your positions over multiple years in this scenario and might be thinking about how much you will liquidate yearly? 

Will it be $100,000? Well, you’d typically be generating a $15,000 tax. Will you do better living somewhere else? 

It’s possible on an ongoing basis if you’re doing that. 

Portugal has an attractive tax regime with zero tax, and it’s also a beautiful cultural area in Europe. That’s an excellent thing.   

The British Virgin Islands, any of the Caribbean countries, and Seychelles, all have an interesting tax regime. The problem with these banks is that if you’re doing something with a Seychelles bank, BVI (British Virgin Islands) bank, or any other bank in the world, it will raise a red flag.

It isn't easy to work with any country in the gray area when it comes to anti-money laundering laws. An option in the US would be in Puerto Rico. It’s an exciting option for Europeans and non-Europeans (Americans).

I’d be happy to dig into those some more if you’d like.

Stephan Livera:
Sure. Let’s talk a little about some good places around the world, as you mentioned. 

I know Portugal, Singapore, and Switzerland all have no capital gains tax and Germany, as Dennis mentioned. 

I think if you hold for more than one year, there’s no capital gains tax. Depending on where you look around the world, some places might be a little better and others, not so much. 

You can find out more about International crypto competition and the ways people should explore options to determine if it were worthwhile for them to consider moving in part four of the Bitcoin Tax Strategies Podcast notes.

READ MORE: Puerto Rico For Crypto Traders

Final Part Of The Bitcoin Tax Strategies Podcast

Stay tuned for the final part of the Bitcoin Tax Strategies Podcast with our host Stephan Livera. 

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CRYPTO TAX ALERT: IRS Starts Sending New Virtual Currency Education Letters

Crypto Tax Expert writes about crypto client experience and perspective on the new round of Virtual Currency Education Letters from the IRS.

The IRS has officially resumed mailing out virtual currency education letters to taxpayers suspected of inaccurately reporting all their crypto income.  

The IRS first mailed the Virtual Currency Education Letters in July and August of 2019 to about 10,000 taxpayers. 

Dozens of crypto owners contacted me having received the first round of virtual currency education letters, and all of them had crypto holdings in 2017 above $900,000.

The first round of virtual currency education letters showed that the IRS knew who the crypto whale traders were.

IRS Sends a New Round of Virtual Currency Education Letters

This week (August 24, 2020), a crypto owner contacted me, having just received a virtual currency education letter.

virtual currency education letters

However, his 2017 maximum crypto holdings were less than $150,000.

“The recent virtual currency education letter suggests that the IRS now uses much looser criteria for determining whom to send letters.”

What is the significance of this development with the new round of virtual currency education letters?

crypto tax lessons

The federal income tax is a voluntary system in that taxpayers voluntarily report their income to the IRS. The IRS uses audits to find and punish tax evaders. The IRS cultivates a healthy fear in the public to encourage broad voluntary compliance. It is easier for the IRS to send out these education letters to motivate taxpayers to fix their mistakes, then to commit valuable IRS time and resources doing actual audits.

Restarting the education letter campaign again shows the IRS is increasing their focus on non-reporters of crypto income.

“Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest, and penalties,” said IRS Commissioner Chuck Rettig. “The IRS is expanding our efforts involving virtual currency, including increased use of data analytics. We are focused on enforcing the law and helping taxpayers fully understand and meet their obligations.”

What are these virtual currency education letters?

IRS letter

There are three different virtual currency educational letters: 6173, 6174, and 6174-A.

Directly receiving any of these virtual currency education letters identifies you as a person of interest to the IRS.

Letter 6173 is sent to those whom the IRS suspects of having possibly engaged in tax misreporting of a criminal level. 

I strongly encourage you to amend your tax returns quickly to avoid legal complications if you have received Letter 6173. Also, engage a criminal tax lawyer.

Letter 6174 and 6174-A are similar and sent to taxpayers suspected of misreporting their crypto income at a non-criminal level. 

Letter 6174-A is a little more verbose than in 6174. I’ve not identified any difference between the situations of those receiving either letter. These are the most common letters.

What do the virtual currency education letters say?

crypto traders

The letters state, “We have information that you have or have had one or more accounts containing virtual currency but may not have properly reported your transactions involving virtual currency, which include cryptocurrency and non-crypto virtual currencies.” 

The taxpayer is encouraged to amend or file tax returns accurately, reporting crypto income. 

The warning is added, “If you do not accurately report your virtual currency transactions, you may be subject to future civil and criminal enforcement activity.”

Trust me, that’s not a good thing for anyone.

Specific instructions are given to mark a crypto return and provide a particular mailing address for sending the returns. 

These instructions are important because it allows the IRS to track that you acted on the letter.

Recipients who don’t act when receiving a virtual currency education letter will be more likely to get audited.

If you prepared your return, I recommend engaging a professional to assist in the review and amendment of returns, to be safe.

Should you call the IRS telephone hotline information?

enrolled agent crypto

The letters offer a telephone hotline number. The IRS will only provide general advice. 

Be aware, the IRS records all phone calls and keeps a log of the phone numbers of who calls the IRS. 

These call logs and recordings can be used by an auditor or revenue officer if you disclose any clues about your situation.

What can be done about the virtual currency education letters?

crypto tax advice

For most people, the odds of getting audited are low. But if you have received a letter, your odds are high of an audit. 

Getting a professional recalculation of your crypto income and amending 1-3 years of returns is not inexpensive, but getting audited will be several times more expensive. 

Undergoing an IRS audit can also significantly impact a person’s emotional, marital, and financial strain.

At Donnelly Tax Law, we recommend:

– Amending your crypto tax returns using our bulletproof crypto return methodology

– Consulting with an experienced crypto tax return preparation professional about your risks.

How can Donnelly Tax Law help?

US crypto tax services

We believe every crypto taxpayer can have a “Bulletproof Crypto Tax Return.”  

Our website offers powerful do-it-yourself resources and full-service crypto tax preparation services. 

We’ve helped taxpayers owning cryptocurrencies:

  • Avoid over $40 million in gains by using Like-Kind Exchange calculations.

  • We have prepared over 850 anti-money laundering reports required for many crypto traders. 

  • We have prepared over 1025 tax amnesty returns needed by crypto traders correcting back filings. Our acceptance rate is 100% success.

  • Moreover, we’re one of the few firms with experience defending crypto returns at an IRS audit. 

We are experts at filing returns for expats and foreign corporations.

  • We have clients in 48 countries.

Schedule A Consultation Today

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Crypto Tax Reporting Becomes IRS Top Priority – The New 1040 For 2020

Discover what the IRS is doing with crypto tax reporting by understanding the upcoming changes to the form 1040.

What is the IRS doing with crypto tax reporting?

The IRS has just released draft versions of the new Form 1040 for reporting personal income taxes. In the form, the IRS has moved their enforcement of cryptocurrency taxation to the most prominent position possible.

In 2019, the IRS had added a cryptocurrency question to an optional form called Schedule 1. The question asks, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency? YES or NO.” 

For 2020, this question moved to just after the address.  The question occurs before listing your kids in the dependents block.  Cryptos before kids! Cryptos before wages!

Highlighted in yellow below is the new question on the 1040 form.

What is the significance of this for crypto tax reporting?

crypto tax reporting

This prominent placement forces every taxpayer to admit whether they dealt in virtual currencies. It is a simple Yes or No question.  No taxpayer can claim they never saw the question.

Why is this question important? 

Because when you sign a tax return, you are swearing to the following statement from page 2 of the form, “Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete.” Under U.S. law, perjury is a felony punishable by three years in prison.

Why are crypto owners concerned?

2019 was the first year this question appeared on the tax form.  Many crypto traders who had never reported their crypto income before became nervous. Here’s why. When you report the sale of property like cryptocurrencies, you must report the purchase price and date. That purchase date might be in a previous year.  That could expose a taxpayer to an audit unless you go back and correct all previous returns.

Why should non-crypto owners be concerned?

The question asks about virtual currencies. What are virtual currencies? The IRS says, “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. Cryptocurrencies are only one type of virtual currency. 

Other types of possible virtual currencies include frequent flyer miles, store loyalty card points which can be used like cash to buy store products, even purchase cards where you prove you bought nine pizzas, then the tenth one is free.  In short, virtually everyone has an interest in some virtual currency.  Perhaps everyone should answer yes to this question?

What is the legal issue for crypto tax reporting?

crypto tax lessons

The term virtual currency is not a part of the law or tax regulations. The IRS notice defining virtual currency and the 2019 FAQ on virtual currency are non-binding.  The National Taxpayer Advocate has called out the IRS for publishing non-binding FAQ, stating that they are a trap for the unwary.

The U.S. Government Accounting Office (GAO) published a report GAO-20-188 stating the IRS guidance in 2014 & 2019 was not clear as to which parts are authoritative and which parts were subject to change. IRS and the Financial Crimes Enforcement Network (FinCEN) have not clearly and publicly explained when, if at all, requirements for reporting financial assets held in foreign countries apply to virtual currencies (Forms 8938 and FBAR).

Will the statute of limitations protect me from IRS audits?

The statute of limitations protects taxpayers by limiting how much time the IRS has to audit returns. The IRS has three years from the due date for filing the return or two years from when the debt was paid whichever is longer. However, if there is a false return or tax evasion, there is no limitation.  If the unreported income relates to financial assets where the counterparty is not a U.S. person, then the statute is extended to six years. (This pretty much describes all exchanges with anonymous persons on a crypto exchange, U.S. or foreign.)

The IRS has already begun audits of non-criminal crypto returns fro 2017. I am currently defending two clients from IRS audits of their cryptocurrency income.

Is the IRS question even lawful?

Many have asked if this question represents a substantial and unconstitutional overreach on the part of the Internal Revenue Service, and it should be withdrawn. It is excessive for the IRS to require a taxpayer to declare on the new Schedule 1 if he has “any financial interest” in cryptocurrency. This question violates many of the taxpayer’s constitutional rights. Mandating that taxpayers declare whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency subjects taxpayers to an abridgment of numerous constitutional protections. 

Is the question overly broad?

The First Amendment overbreadth doctrine allows a challenge to the validity of a statute on its face only if the law is substantially overbroad. City Council of Los Angeles v. Taxpayers for Vincent, 466 U.S. 789, 799-801, 104 S. Ct. 2118, 80 L. Ed. 2d 772 (1984). A law is overbroad when, although it constitutionally regulates some conduct, it sweeps so broadly that it also covers a substantial amount of constitutionally protected conduct. MDK, Inc. v. Vill. of Grafton, 277 F. Supp. 2d 943, 948 (E.D. Wis. 2003).

The United States Supreme Court has stated that “[a] statute may be deemed unconstitutional only if it is ‘substantially’ overbroad ‘judged in relation to the statute’s plainly legitimate sweep.’” Broadrick v. Oklahoma, 413 U.S. 601, 615, 93 S. Ct. 2908, 37 L. Ed. 2d 830 (1973). A finding of substantial overbreadth “requires the court to find ‘a realistic danger that the [policies] will significantly compromise recognized First Amendment protections of parties not before the Court.’” N.Y. State Club Ass’n v. City of N.Y., 487 U.S. 1, 11, 108 S. Ct. 2225, 101 L. Ed. 2d 1 (1988) (quoting Taxpayers for Vincent, at 801).

In analyzing an overbreadth challenge, a court must first construe the challenged statute—or in this case, the question on IRS Form 1040 Schedule 1—because “it is impossible to determine whether a statute reaches too far without first knowing what the statute covers.” United States v. Williams, 553 U.S. 285, 293, 128 S. Ct. 1830, 170 L. Ed. 2d 650 (2008). Next, the court determines whether the statute, as construed, “criminalizes a substantial amount of protected expressive activity.” Williams, 553 U.S. at 297. If so, the Court must determine “whether the statute is ‘readily susceptible’ to a limiting construction which would render it constitutional.” Snider v. City of Cape Girardeau, 752 F.3d 1149, 1158 (8th Cir. 2014) (quoting Virginia v. Am. Booksellers Ass’n, 484 U.S. 383, 397, 108 S. Ct. 636, 98 L. Ed. 2d 782 (1988)).

Likewise, a governmental directive may be held unconstitutional if “it seeks to prohibit such a broad range of protected conduct that it is unconstitutionally overbroad.” Taxpayers for Vincent, at 796. 

Holding property—in this case, cryptocurrency—is not a taxable event. Reporting the fact that your own cryptocurrency is not a taxable event. As a result, the question is overbroad and should be withdrawn.

Does this crypto tax reporting question have a chilling effect on First Amendment Rights?

crypto traders

“The aim of facial overbreadth analysis is to eliminate the deterrent or ‘chilling’ effect an overbroad law may have on those contemplating conduct protected by the First Amendment.” Turchick v. United States, 561 F.2d 719, 721 (8th Cir. 1977) (footnote omitted). 

The Supreme Court stated that “[a] statute may be unconstitutional if it is so overbroad as to “chill[] . . . individual thought and expression,” such that it would “effectively preclude or punish the expression of particular views.” Nat’l Endowment for the Arts v. Finley, 524 U.S. 569, 583, 118 S. Ct. 2168, 141 L. Ed. 2d 500 (1998) (citations omitted).

In 1968, the Supreme Court reasoned that “a government regulation is sufficiently justified if it is within the constitutional power of the Government; if it furthers an important or substantial governmental interest; if the governmental interest is unrelated to the suppression of free expression; and if the incidental restriction on alleged First Amendment freedoms is no greater than is essential to the furtherance of that interest.” United States v. O’Brien, 391 U.S. 367, 377 (1968).

The question on the proposed Schedule 1 does not survive intermediate scrutiny, as the Supreme Court has held that it must “further[] an important or substantial governmental interest; if the governmental interest is unrelated to the suppression of free expression; and if the incidental restriction on alleged First Amendment freedoms is no greater than is essential to the furtherance of that interest.” United States v. O’Brien, 391 U.S. 367, 376-77, 88 S. Ct. 1673, 20 L. Ed. 2d 672 (1968). This overbroad question chills free speech and should not be included in the tax form.

Does the IRS question violate taxpayers’ legal protections?

Mandating that taxpayers declare whether they received, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency subjects taxpayers to an excessive fine.

What is the Excessive Fines Clause of the Eighth Amendment?

“Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.” U.S. Const. amend. VIII. In analyzing an excessive fines claim, the court must first decide whether a penalty is a fine before determining if it is unconstitutionally excessive. Dewees v. United States, 272 F. Supp. 3d 96, 100-01 (D.D.C. 2017).

The Supreme Court has stated that a payment to the government is only considered a “fine” under the Eighth Amendment if it is “punishment for some offense.” Austin v. United States, 509 U.S. 602, 609-10, 113 S. Ct. 2801, 125 L. Ed. 2d 488 (1993). The purpose of the penalty must be primarily retributive or deterrent rather than remedial. Id. In the context of forfeiture, for example, a penalty that is solely “designed to punish the offender” is considered punishment and is thus limited by the Excessive Fines Clause. Id. at 333-34.

The question in which a taxpayer must declare whether he receives, sold, sent, exchanged, or otherwise acquired any financial interest in any virtual currency is primarily retributive or deterrent. It is not remedial. Taypayers will experience this situation regularly. The mandate will not deter them from doing so. While tax penalties have in the past been held to fulfill a remedial purpose are not subject to the Excessive Fines Clause, cryptocurrency was not contemplated by the Court by the Supreme Court 80 years ago when the standard was announced in Helvering v. Mitchell, 303 U.S. 391, 58 S. Ct. 630, 82 L. Ed. 917, 1938-1 C.B. 317 (1938). The Supreme Court reasoned that tax penalties are remedial because they exist as “a safeguard for the protection  of the revenue and to reimburse the Government for the heavy expense of investigation and the loss resulting from the taxpayer’s fraud.” Id. at 401. There is no fraud in this circumstance where income is not realized. The question does not create a loss of revenue for the government.

What is the Due Process Clause of the Fifth Amendment?

crypto tax advice

A due process means that a person has been afforded an adequate “opportunity to be heard at a meaningful time and in a meaningful manner.” Mathews v. Eldridge, 424 U.S. 319, 333, 96 S. Ct. 893, 47 L. Ed. 2d 18 (1976), quoting Armstrong v. Manzo, 380 U.S. 545, 552, 85 S. Ct. 1187, 14 L. Ed. 2d 62 (1965). Courts judge procedural due process challenges to property deprivations by weighing (1) “the private interest that will be affected by the official action;” (2) “the risk of an erroneous deprivation of such interest through the procedures used, and the probable value, if any, of additional or substitute procedural safeguards;” and (3) “the Government’s interest, including the function involved and the fiscal and administrative burdens that the additional or substitute procedural requirement would entail.” Id. at 335.

Arguably due process is violated when this property right is deprived of a taxpayer, especially when there is no value recognized, that is, the cryptocurrency is not converted to a fiat currency or exchanged for another service or product of value. The fact that a taxpayer has cryptocurrency impacted a taxpayer’s privacy interest; there is significant the risk of an erroneous deprivation of the taxpayer’s property right; and it creates an undue burden in light of any governmental interest.

What is the Equal Protection Clause of the Fifth Amendment?

The threshold element of an equal protection claim is disparate treatment. Tippins v. Parish, 2019 U.S. Dist. LEXIS 177875, at *23 (W.D. Mich. Oct. 15, 2019), citing Scarbrough v. Morgan Cty. Bd. of Educ., 470 F.3d 250, 260 (6th Cir. 2006); Center for Bio-Ethical Reform, Inc. v. Napolitano, 648 F.3d 365, 379 (6th Cir. 2011) (“To state an equal protection claim, a plaintiff must adequately plead that the government treated the plaintiff ‘disparately as compared to similarly situated persons and that such disparate treatment either burdens a fundamental right, targets a suspect class, or has no rational basis.’”). 

An equal protection plaintiff must be similarly situated to his comparators “in all relevant respects…” Nordlinger v. Hahn, 505 U.S. 1, 10, 112 S. Ct. 2326, 120 L. Ed. 2d 1 (1992). Further, a sufficient injury in fact is concrete and particularized, and actual or imminent as opposed to merely hypothetical. Lujan v. Defenders of Wildlife, 504 U.S. 555, 560, 112 S. Ct. 2130, 119 L. Ed. 2d 351 (1992)). It is the plaintiff’s burden to demonstrate that his claim satisfies all of these elements. Id. at 561.

Here, it is clear that the owners of cryptocurrency are being treated differently than other taxpayers. As such, an equal protection claim can be argued as the government treats these taxpayers “disparately as compared to similarly situated persons and that such disparate treatment either burdens a fundamental right, targets a suspect class, or has no rational basis.” Ctr. for Bio-Ethical Reform, Inc. v. Napolitano, 648 F.3d 365, 379 (6th Cir. 2011), quoting Club Italia Soccer & Sports Org. v. Charter Twp. of Shelby, 470 F.3d 286, 298 (6th Cir. 2006), overruled on other grounds as recognized by Davis v. Prison Health Servs., 679 F.3d 433, 442 n.3 (6th Cir. 2012). Answering the question affirmatively singles out cryptocurrency owners for treatment unlike other taxpayers.

Does this crypto tax reporting question discriminate against commerce?

crypto tax reporting

The question is also discriminatory on a cryptocurrency owner’s commerce. “If a restriction on commerce is discriminatory, it is virtually per se invalid.” Oregon Waste Systems, Inc. v. Department of Environmental Quality of State of Or., 511 U.S. 93, 99, 114 S. Ct. 1345, 128 L. Ed. 2d 13 (1994).

Under Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279, 97 S. Ct. 1076, 51 L. Ed. 2d 326 (1977), a state tax will be sustained against a Commerce Clause challenge as long as the tax (1) is applied to an activity with a substantial nexus with the taxing state; (2) is fairly apportioned; (3) does not discriminate against interstate commerce; and (4) is fairly related to the services provided by the state. Id. The Complete Auto test emphasizes the importance of looking past the formal language of a tax statue to its practical effect. Direct Mktg. Ass’n v. Huber, 2011 U.S. Dist. LEXIS 9589, at *14 (D. Colo. Jan. 26, 2011), citing Quill, 504 U.S. at 310.

Applying this test to cryptocurrency, there is no substantial nexus, the action is not fairly apportioned, discriminates against interstate commerce; and is not fairly related to the services provided. 

Further, it is clear that the practical effect is to create a discriminatory environment for cryptocurrency owners.

Summary On The Latest Crypto Tax Reporting

crypto tax returns

The question on virtual currencies represents a substantial and unconstitutional overreach on the part of the Internal Revenue Service; it should be removed—especially until the laws and regulation of cryptocurrency is more definite and the courts have had an opportunity to determine the validity and constitutionality of these laws. 

Although IRS Commissioner Chuck Rettig has noted, “The IRS is committed to helping taxpayers understand their tax obligations in this emerging area,” and that the new guidance “will help taxpayers and tax professionals better understand how longstanding tax principles apply in this rapidly changing environment,” this question runs afoul of constitutional protections and should be withdrawn.

The choice by the IRS to elevate the importance of their question after significant legal issues have been raised, is troubling. 

Given the overly broad definition of virtual currency, if all taxpayers answered YES, then the question becomes trivialized and useless for data mining purposes.

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Bitcoin Tax Recordkeeping – Stephan Livera Podcast: Part Two

Learn about Bitcoin tax recordkeeping with tax experts Clinton Donnelly and Dennis Wohlfarth on Stephan Livera’s podcast, episode 183.

Dennis Wohlfarth of Accointing and Clinton Donnelly of Donnelly Tax Law join Stephan Livera to talk about Bitcoin tax recordkeeping, and strategies to employ to minimize tax. In the full podcast, we chat about:

  • Current Bitcoin tax treatment
  • Capital gains Bitcoin tax treatment
  • Bitcoin tax recordkeeping
  • Bitcoin tax strategies locally
  • Bitcoin tax strategies for those willing to go overseas
  • International crypto competition

In part one, we talked about Bitcoin tax treatment and Austrian economics on Stephan Livera Podcast, episode 183, and our guests were from the company Accointing and Donnelly Tax Law

We talked about Bitcoin and tax strategy.

Today, our podcast show notes are about Bitcoin tax recordkeeping with our two crypto tax experts. 

In part one, we left off curious about how people typically deal with having multiple wallets or multiple exchange accounts.

Bitcoin Tax Recordkeeping: Dealing With Multiple Wallets Or Exchange Accounts

Bitcoin tax recordkeeping

What’s the typical way that you and your customers usually deal with multiple wallets or multiple exchange accounts?

Dennis Wohlfarth:
At Accointing, we allow our customers to directly connect their exchanges with either an API or a direct connection if the exchange offers that. For Bitcoin and auto blockchains, we import all the historical data through an xPub and yPub, or standard Bitcoin addresses. 

You can then combine all that into one portfolio, and we keep track of the entire money flow in your system. 

That means if you send something from your first exchange to your Bitcoin wallet, Accointing handles that connection through the transaction ID, and we create a so-called “internal transaction.” These internal transactions are not a taxable event. They even create a fee because of the transfer fee that you can use later as a cost that you spend to transfer those Bitcoin.

Tracking Your Money Flow

Use the internal transaction through Accointing to transfer the cost basis from the first wallet to your second wallet, and it is always kept with that Bitcoin. This internal transaction is excellent because you can go back and dive into your money flow, and you have everything completely tracked.

It’s nice to have for tax purposes and to prove to your bank where you got the funds. If you trade with higher amounts, banks want to know where you got that investment from because it could be some money laundering activity. If you can track the entire history, it makes it more accessible.

Bitcoin Tax Recordkeeping: Self-Spending Is Not Taxed

Bitcoin tax recordkeeping

Stephan Livera:
I see. Yeah. That’s one way to aggregate across all of your wallets and all of your exchanges into one thing. 

The other part is when you sell. That’s a capital gains event, typically, and you want to have the record to say this wasn’t a sale, this wasn’t me spending. It was me, self-spending. And so that’s not treated as a capital gain, etc., and therefore not taxed.

Bitcoin Tax Recordkeeping: Taxable Events

Bitcoin tax recordkeeping

Dennis Wohlfarth:
Exactly. Or you even use it when you send a gift or did some other activity with it so you can prove where. 

For example, in Germany, we are currently suing the government, and are in court because we don’t agree with the government on the tax regulations. 

We don’t agree that payment should be a taxable event. We believe that people who report their taxes in Germany are being truthful. These truthful people report some gains and, in theory, have to pay taxes, but it’s unfair. The government can’t prove that other people don’t report taxes or are guilty of tax fraud. They don’t have a way to go into the blockchain point or different exchanges because they are all over the world.

Therefore, they cannot prove that you traded, but they want forthright people to pay taxes, which is not legal in Germany. That’s why we’re currently suing the government there and fighting the tax regulation. To make it clear to them that they can do that for everyone, which is highly unlikely, or they’re not allowed to file taxes on crypto investments or crypto trading. 

That’s one part that we try to do for the German community. Clinton knows more about the US part. Some inspiring things are happening in the future. I mean, a few exciting discussions are starting where they are trying not to treat payments as a taxable event, which would be nice. Considering everything happening in the market regarding Lightning and Defi coming in, I don’t know how they want to do it.

Bitcoin Tax Recordkeeping: Taxation From A Capital Gains Point Of View

Stephan Livera:
Let’s talk a bit about that. This idea of payments and the taxation that occurs on them, theoretically from the capital gains tax point of view. 

So I guess what you’re getting here is for example’s sake, let’s say you buy $100 worth of Bitcoin, and then it’s $200 worth of Bitcoin. If you spent a portion of that, the point you’re getting out there is theoretically a capital gain on which the government wants their pound of flesh.

What are some different ways those situations are treated from a taxation law perspective?

You can find out more about how different situations are treated from a tax law perspective in our upcoming post along with Bitcoin tax strategies locally and overseas.

Stay tuned for Part Three of the Bitcoin Tax Strategies Podcast with our host Stephan Livera. 

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