Tag: US tax filing

IRC Section 1031: Like-Kind Exchange Treatment Of Cryptocurrencies Explained

Crypto tax expert explores the controversial position of IRC section 1031 and the use of Like-Kind Exchange for crypto taxes.

Applying the like-kind exchange treatment is a controversial position in crypto taxation, where exchanging one cryptocurrency for another qualifies for tax-deferred treatment under IRC section 1031.

In my previous article, I explained how Donnelly Tax law is on the bleeding edge of like-kind exchange (LKE) with two open audits being reviewed by the IRS.  

I explained how like-kind exchange (LKE) could save crypto traders a lot of money on their crypto tax bill.  

Today, I will 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.

IRC Section 1031: Cryptocurrencies Are A Specific Class Of Property

IRC Section 1031

26 CFR 1.1031(a)-2 states the “nonrecognition rules of section 1031 do not apply to an exchange of one kind or class of property for property of a different kind or class.” The asset classification rules of 1.1031(a)-2(b) do not apply to cryptocurrencies because they are not tangible property. There are no classes for intangible property. (Footnote 1)  

Interestingly, IRS Notice 2014-21 classified all cryptocurrencies as “convertible virtual currencies,” a sub-class of virtual currencies which satisfies the requirement that exchanged property be of the same kind or class.

IRC Section 1031: Cryptocurrencies Differ Only In Grade Or Quality, Not Nature Or Character

In determining when a property is of like kind, “The words like kind have reference to the nature and character of the property and not to its grade or quality,” according to 26 CFR 1.1031(a)-1(b).

With regard to intangible property, the regulations state:

“Whether intangible personal property is of a like kind to other intangible personal property generally depends on the nature or character of the rights involved (e.g., a patent or a copyright) and also on the nature or character of the underlying property to which the intangible personal property relates.” (Footnote 2)

The nature and character of a cryptocurrency are that it is a digital store of value using bytecode recorded on a blockchain using a cryptographic method. Variations in bytecode instruction set or blockchain protocols are just matters of grade or quality. 

When the IRS determined that the exchange of an FCC license for a radio frequency  was a like-kind exchange for a television frequency, they stated:

 “Even the narrowest interpretation of the like kind standard does not require that one property be identical to another or that they be completely interchangeable. Thus, we find that the differences in the assigned frequencies are not differences in nature or character, but are merely differences in grade or quality.” (Footnote 3)

Five years later, A similar conclusion was given by the IRS regarding matters of grade or quality:

“We note that the bandwidth of a particular frequency dictates the amount of information that the frequency can carry. In comparing the nature or character of the assigned frequency of the electromagnetic spectrum referred to in each FCC license, it is clear that the spectrum rights transferred by the Taxpayer have different bandwidths from the spectrum rights received by the Taxpayer. However, even the narrowest interpretation of the like kind standard does not require that one property be identical to another or that they be completely interchangeable. As stated earlier, the spectrum rights being transferred by the Taxpayer to AA and the spectrum rights being received by the Taxpayer from AA are all suitable for use in the Taxpayer’s business of providing Services. Thus, we find that the bandwidth differences in the spectrum rights being transferred and being received in this exchange, which underlie these FCC licenses, are not differences in nature or character, but are merely differences in grade or quality, and thus constitute like-kind property.” (Footnote 4)

IRC Section 1031: Pre-TJCA Wording Of Section 1031

IRC Section 1031

The TCJA amended the wording of section 1031 primarily by limiting section 1031 to only apply to real property effective January 1, 2018. In Appendix 1, I have reconstructed the pre-TCJA wording of section 1031.

Cryptocurrencies Are Held For Investment Purposes

Cryptocurrencies reported were held for investment purposes, according to IRC 1031(a)(1). This is the primary motivation for owning cryptocurrencies.

Exception For Property Held For Sale Doesn’t Apply To Cryptocurrencies

IRC 1031(a)(2) does not prohibit like-kind exchange between cryptocurrencies because cryptocurrencies are not one of the listed exceptions. Clearly, cryptocurrencies are not forms of stock-in-trade, property held primarily for sale, stocks, bonds, notes, interests in partnerships, certificates of trust or beneficial interests, or choses in action.

Cryptocurrencies do not qualify as “other securities”. This IRS code section doesn’t provide or refer to  a definition of “other security”. The IRS has not issued any direct guidance regarding the issue of whether cryptocurrency is a security. 

The Security and Exchange Commission (SEC) issued a 2017 report on cryptocurrencies. The SEC uses a four-prong test, known as the Howey test, to determine if a property is a security: “A [security] is [1] an investment of money [2] in a common enterprise [3] with a reasonable expectation of profits [4] to be derived from the entrepreneurial or managerial efforts of others.” (Footnote 5) The advancement of cryptocurrencies are not related to the ongoing entrepreneurial or managerial efforts of other persons, but rather to consensus algorithms.

IRC Section 1031: Procedural Requirements For Completing Section 1031 Exchanges

IRC Section 1031
  1. IRC 1031(a)(3) requires that property to be exchange be identified and the exchange happen within certain time limits.  Exchanges on cryptocurrency exchanges are instantaneous. The property given up and the property received are clearly identified at the time of the exchange.

  2. IRC 1031(b) and (c) don’t apply on cryptocurrency exchanges because only cryptocurrencies are exchanged and no other property.

  3. IRC 1031(f)  regarding related persons is not applicable because on cryptocurrency exchanges, the parties are anonymous to each other because they are matched up by an exchange. After the transaction, both parties remain anonymous. The possibility that a transfer would occur between related parties would be coincidental, unintentional, and unknown to the parties.

Receipt Of Other Property

The nature of online exchange of cryptocurrency is that they match buyers and sellers for exchanging assets without any other property as described in 1.1031(b)-1.

IRC Section 1031: Summary

The exchange of cryptocurrencies for other cryptocurrencies are like kind exchanges under IRC 1031 as supported by IRS Technical Advice Memorandums.

There are additional court cases that can be added to the evidence in favor, but this short article lays out the key issues.

Stay tuned for the next article where I will discuss why the old law is still relevant.

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Footnotes

  1. 26 CFR 1.1031(a)-2(c)(1)
  2. 26 CFR 1.1031(a)-2(c)(1)
  3. IRS Letter Ruling 200035005, May 11, 2000.
  4. IRS Letter Ruling 200532008, May 9, 2005.
  5. See SEC v Edwards, 540 U.S.389, 393 (2004); SEC v W J Howey Co., 328 US 293, 301 (1946); United Housing Found, Inc v Forman 421 US 837, 852-53(1975)

Appendix 1: Pre-TCJA Wording of 26 USC 1031

26 U.S. Code § 1031.Exchange of property held for productive use or investment

(a)Nonrecognition of gain or loss from exchanges solely in kind

(1)In general

No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

(2)Exception for property held for sale

This subsection shall not apply to any exchange of—

 (A) stock in trade or other property held primarily for sale,

 (B) stocks, bonds, or notes,

 (C) other securities or evidences of indebtedness or interest,

 (D) interests in a partnership,

 (E) certificates of trust or beneficial interests, or

 (F) choses in action.

For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.

 

(3)Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property

For purposes of this subsection, any property received by the Taxpayer shall be treated as property which is not like-kind property if—

(A)

such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the Taxpayer transfers the property relinquished in the exchange, or

(B)such property is received after the earlier of—

(i)

the day which is 180 days after the date on which the Taxpayer transfers the property relinquished in the exchange, or

(ii)

the due date (determined with regard to extension) for the transferor’s return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.

(b)Gain from exchanges not solely in kind

If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.

(c)Loss from exchanges not solely in kind

If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss, but also of other property or money, then no loss from the exchange shall be recognized.

(d)Basis

If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the Taxpayer and increased in the amount of gain or decreased in the amount of loss to the Taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035(a), section 1036(a), or section 1037(a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035(a), and section 1036(a), where as part of the consideration to the Taxpayer another party to the exchange assumed (as determined under section 357(d)) a liability of the Taxpayer, such assumption shall be considered as money received by the Taxpayer on the exchange.

(e)Application to certain partnerships

For purposes of this section, livestock of different sexes are not property of a like kind. 

(f)Special rules for exchanges between related persons

(1)In general

If—

(A)

a taxpayer exchanges property with a related person,

(B)

there is nonrecognition of gain or loss to the Taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and

(C)before the date 2 years after the date of the last transfer which was part of such exchange—

(i)

the related person disposes of such property, or

(ii)

the Taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the Taxpayer,

there shall be no nonrecognition of gain or loss under this section to the Taxpayer with respect to such exchange; except that any gain or loss recognized by the Taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

(2)Certain dispositions not taken into accountFor purposes of paragraph (1)(C), there shall not be taken into account any disposition—

(A)

after the earlier of the death of the Taxpayer or the death of the related person,

(B)

in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or

(C)

with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

(3)Related person

For purposes of this subsection, the term “related person” means any person bearing a relationship to the Taxpayer described in section 267(b) or 707(b)(1).

(4)Treatment of certain transactions

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.

(g)Special rule where substantial diminution of risk

(1)In general

If paragraph (2) applies to any property for any period, the running of the period set forth in subsection (f)(1)(C) with respect to such property shall be suspended during such period.

(2)Property to which subsection applies

This paragraph shall apply to any property for any period during which the holder’s risk of loss with respect to the property is substantially diminished by—

(A)

the holding of a put with respect to such property,

(B)

the holding by another person of a right to acquire such property, or

(C)

a short sale or any other transaction.

(h)Special rules for foreign real and personal property

Real property located in the United States and real property located outside the United States are not property of a like kind.

(i)

For purposes of subsection (a)(2)(B), the term ‘stocks’ shall not include shares in a mutual ditch, reservoir, or irrigation company if at the time of the exchange—

 

  1. the mutual ditch, reservoir, or irrigation company is an organization described in 
  2. section 501(c)(12)(A) (determined without regard to the percentage of its income that is collected from its members for the purpose of meeting losses and expenses), and

 

(2) the shares in such company have been recognized by the highest court of the State in which such company was organized or by applicable State statute as constituting or representing real property or an interest in real property.”

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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Footnotes

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

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.

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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.

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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.

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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.

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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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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.

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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.”

- Clinton Donnelly Tweet

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.

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“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.

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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.

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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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Crypto Tax Tool With A Crypto Tax Expert – The Crypto Tax Webinar: Part Three

Learn how to estimate your taxes with an excellent crypto tax tool and tips on how to estimate how much you will be paying in taxes.

Learn about how to estimate your taxes with an excellent crypto tax tool called Accointing in this transcribed Crypto Tax Webinar. Presented by Clinton Donnelly and sponsored by Accointing.

In the full live webinar, we covered:

  • How to deal with COVID 19: Paying Crypto Taxes On An Installment Plan
  • The current on-going policies regarding crypto-taxation
  • What are taxable events and how to handle them
  • The sent IRS letters and the different implications for each of them
  • The next steps in order to conduct your crypto tax submission
  • Some opinions from a top Crypto CPA in the market and average estimate of how much you will be paying in taxes
  • An idea on how to estimate your taxes with a crypto tax tool

In Part One, we discussed the tax guidance the IRS has created to report cryptocurrencies and breakdown what those IRS activities have been in the history with crypto. 

We looked at what type of enforcement the IRS is doing and reviewed how they’re slowly increasing the implementation level in how they’re going after people. We also explored some IRS letters that they sent out. 

In Part Two, we discussed how to report cryptocurrencies on your crypto tax return. We looked at the mechanics and tax aspects of that.

PART THREE: Crypto Tax Tool With A Crypto Tax Expert

In Part Three, we will discuss how to prepare a tax return and what sort of help you can get. We’re also going to discuss how to use Accointing, an excellent crypto tax tool.

Accointing is a beneficial tool, particularly for reconciliation, one of the biggest challenges when using a tool.

You can report internal transactions using the crypto tax tool Accointing. These are transactions within the actual platform. 

You need to tell the platform that those transactions were transactions recognized as being equal and the movement from one point to another. Then you can classify transfers within Accointing. 

The idea here is that you can state what should be classified as income, an airdrop, a margin fee, a margin loss, and so forth to classify them based on their depot.

What happens if I don’t disclose all my positions?

crypto tax tool

Now we’re on the slide about what happens if I don’t disclose all my positions. This slide is a bit of a misnomer. 

You don’t disclose your positions to the IRS, only your transactions and the penalties listed here are really for criminal tax evasion. 

What do you have to worry about if you didn’t report your crypto activities in 2017?

The IRS is going to spend their time going after the big fish. They've demonstrated the ability to determine who the big fish are with 10,000 letters.

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If you're what I'd call a small fish and you had less than a hundred thousand in 2017, you may not be the type of person the IRS will focus on.

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I mentioned that because many of the smallest traders that call me are super conscientious and want to report everything and be above board.

The IRS is going to focus on the most prominent players: large and middle-sized players.

What happens if the IRS identifies that you didn’t report some income in 2017, and then you reported some gains, and they hit you with penalties?

There could be an understatement of taxes, that’s a penalty, and a late payment because you didn’t pay this. 

Those two penalties themselves would typically add 50% to whatever you owed. 

If it were over $5,000 in taxes, you would be looking at another 50% more in terms of penalties and interest. 

If they felt you had engaged in tax evasion, there is a civil tax evasion penalty of 75% of whatever taxes weren’t paid.

Generally, they’re only going to use that when they’re coming after someone who is pretty egregious. 

The critical thing is you want to be clean because when you suddenly start reporting in 2020 that you made trades, and when you list the buy date as 2017, that is a logical jump for an auditor to ask, ‘why didn’t you report any cryptos in 2017 or 2018?’. 

You bought some, and you probably traded some. 

So it’s the dates that are going to force you to come clean on past filing issues. That should be a concern of yours. You can schedule a consultation with me and we can talk through the situation.

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What method can I use for crypto tax calculation in the US?

crypto tax tool

This question is related to the words FIFO and LIFO (first-in-first-out) or (last-in-first-out). 

Read More: Tax Expert: Picking The Best Method For Reporting Your Cryptocurrency Gains

These reporting methods determine which coin it is that you sold when you sell a coin. 

We know the price when we sell a coin because that’s in the transaction records, but what was the price of that coin?

You may have had coins at five different price points, and which one was it that sold? 

The one you choose determines how much gain or loss occurred on a particular transaction, and that affects your taxes. 

The tax laws said, FIFO. 

They currently refer to revenue section 1012 which says, you have to do FIFO. 

However, the IRS in the most recent FAQ in October 2019 said, you can use any method you want. 

You can choose the best reporting method after the coin has sold as long as you use what they called a specific identification approach, which is being able to show that all your coins are accounted for. You just can’t make it up. Accointing’s crypto tax tool does that. 

Accointing allows you to use FIFO, LIFO, or any method that you’d like. 

I recommend that people use whatever method generates the lowest taxes for you to pay that year. And you can change this method every single year. You might do LIFO one year FIFO another year, and then, maybe an optimized method a third year.

How do you get started with an excellent crypto tax tool?

crypto tax tool

You have to decide how much you’re going to do for yourself on your taxes and how much you want someone to help you. 

Our company does full-service tax calculation, but you’re going to be paying a couple of thousands of dollars to do all that per year. Larger traders can afford that, but smaller traders have to do that in a bit more of a budget manner. 

I recommend a crypto tax tool like Accointing to generate your crypto tax records. That’ll generate a form called form 8949, the IRS form where you list the buy and sell dates and the cost and sale prices. Everyone is on the list, meaning the gain for every transaction.

Accointing will generate that record, and they can create it in a TurboTax format. 

If you use TurboTax, it can be automatically uploaded, and Accointing makes it very convenient. 

Most of those software packages will lease with TurboTax, but Tax Act or H & R Block will be the largest one. They all have the tools to generate a tax return. However, they aren’t literate about cryptocurrency reporting. 

You’ll find instructions on the Accointing web page, which tells you exactly how to load it into TurboTax. It’s straightforward and effortless to do with the instructions. You only have to upload it to the software. So that’d be one approach.

What if your tax life is complicated or you are using an accountant, but your accountant doesn't know cryptos?

Your accountant is not interested in learning cryptos, so it may fall on you to use a crypto tax tool like Accointing to generate the tax records that you then turn over to your accountant. 

And your accountant will then know what to do with form 8949. He or she can plug it into the tax software.  

Or you can go to a full-service firm that can do everything for you if doing your crypto calculations is too overwhelming.

How do you find the right crypto tax accountant?

The best thing is to ask your accountant, bluntly, “Do you do cryptocurrency tax returns?” Ask them, “How many have you done and do you calculate the capital gains, or do you expect me to do that?” 

I had one client who, in 2018, had a CPA who said, “Yeah, I know how to do this.”

And that CPA was only learning how to do crypto returns. 

My client gave this CPA her taxes and five months later she still didn’t have it done. She gave up on it. So, she took it to another CPA who said, “Yeah, yeah, yeah, I can do this”. 

He prepared the entire tax return for her, but he didn’t sign it. And my client dug into it and found out that this guy had lost his CPA license. 

So it was just a fake return that he had made. 

My client met me, and we did her tax return after the others failed. We got the whole thing solved and saved her a fortune. She paid zero taxes that year. 

You want to ask your tax preparer, how many crypto tax returns they’ve done. You don’t want them to learn on you.

You can tell your tax preparer that you’ll do the Accointing work yourself and bring it to them. Your tax preparer will say yes to that and know what to do with the Accointing results.

Suppose you cannot do the calculation yourself, and using Accointing is overwhelming for you. Then, you need to get a professional to help, which can be done on an hourly basis. 

Or you can turn the entire work over for a higher amount and have someone do the whole thing. 

That is how you get started and get a tax return prepared.

How much will it cost me to pay my crypto taxes?

crypto tax tool

The complexity of your trading environment will have a bearing on how much you pay when you use a tool like Accointing. 

Some people like to dabble in everything and used a bit of everything. Say, they did shape shifting, margin trading, and futures. They also used Binance, Defi, and did all sorts of things. 

The more complicated your environment was, the more complicated it can be to calculate your gains. So, you have to look at the crypto tax tool and see what their pricing is.

Power Tricks For Medium To Large Fish (Crypto Whales)

I have a handful of tricks for you. 

Suppose you’re a medium and large fish. 

Note: These tricks probably aren’t for smaller fish.   

My big six tools would be for reporting your capital gains before 2018, when the law was changed. We could use a method called like-kind exchange for 2015, 2016, and particularly 2017. This is a way of not having to pay taxes on the crypto to crypto trades. That gain is passed along to the subsequent transactions. 

Starting in 2018, you couldn’t do like-kind exchange anymore, but I’ve saved people millions in this area. 

For tax harvesting, as we come into the end of the year, around October, November, you want to start thinking about how you are poised from a capital gains point of view.

Around October/November would be a great time if you have a lot of gains to do tax harvesting, this would be to take coins that are losers, and sell them for a loss and take that loss and it offsets your gain so that your taxes at the end of the year will be lower. 

There are two methods of tax harvesting:

  • One is just selling worthless coins. 
  • Another one is doing a wash where you take a coin, sell it to lock in the loss, and then the next day buy it right back because you still want to have a position for that coin. You have a long term expectation for it.

If you’re a large fish, the third idea is to move to Puerto Rico, but you genuinely have to move there. You can’t just visit. They offer a 0% capital gains tax on capital gains from cryptocurrencies.

There are a lot of complexities and a severe thing to do. You seriously have to move to Puerto Rico. You have to uproot your life, but if you’re a large fish, this might be a meaningful thing to do, to make a lot of money to reduce your taxes. 

So what are we talking about here? 

You’re going from 15% tax bracket down to a 0% tax bracket. 

So if you had $100,000 in gains, you’re looking at $15,000 in taxes. 

To save $15,000 and go to Puerto Rico, probably not the right move for you, but if you have millions, this would be something to consider. 

If you have old returns between 2017 and 2018 and you need to fix them because you didn’t report anything, especially if you’re a medium and large fish. Then you would need to look at tax amnesty solutions to minimize your tax liability.

What is your anti-money laundering liability?

If you traded on foreign exchanges, you had over $10,000 in foreign exchanges, you become liable to report those on the two anti-money laundering forms, FBAR and form 8938. 

You can bulletproof your tax return. Just go to my website. 

We have lots of do-it-yourself tools like books and an increasing number of videos we’re starting to make available online on how you can calculate your taxes using TurboTax, and how to do your anti-money laundering form filings. 

We have lots of great crypto tax tools.

Responding To IRS Communications

crypto tax tool

Donnelly Tax Law offers a crypto tax audit for an annual fee. 

Suppose the IRS contacts you about your crypto activity on your tax return. For any tax return you have exposed, and if you get contacted by the IRS, we will provide you with an analysis. You’ll be getting your A-team in place to respond to that crypto tax return.

This audit assist is critical. You can go to CryptoTaxAudit.com to learn more about that.

Dealing With COVID-19 Installment Payments

crypto tax tool

A lot of people are concerned about paying taxes. They realize if they pay their taxes, it’s going to be a big tax bill, and they might not have the money. People are worried about that. 

One of the things you have available to you is installment agreements from the IRS. People who owe a lot of money can set up an installment agreement and spread the payments out over seven years.

You can pay it month by month until your cryptos go up and start to make some money, and then pay off that tax debt in a lump sum. The IRS is excellent about lump sums. They’re remarkable about interest rates, but they do want you to pay them monthly.

If you’re concerned about that big tax bill and what you’re going to do about it, there are many ways to do it. 

See the chart above that explains some things, and if you have concerns, contact us.

Utilizing A Good Crypto Tax Tool

I invite you to go to the Accointing.com website and try their crypto tax tool. Dabble with it. There are several free features you can use. 

If you require professional advice, you can contact us. 

We have clients all over the world doing crypto calculations for US clients. 

You can schedule a consultation on our website. 

Schedule A Consultation

We can talk about your particular situation, or if you need help preparing your tax return.

Thank you for your time, and I hope you have a great weekend.

If you have a more complex situation, you can talk to the people at Accointing on their chat web page.

You can also contact me on my web page DonnellyTaxLaw.com and schedule a consultation for a fee; we can go over whatever your particular situation is.

You can also visit our website for Do-it-Yourself resources for doing your taxes.

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