The major tax myths about cryptocurrency debunked

Cryptocurrencies and taxes may not be a perfect match, but taxes seem inevitable, and the US Internal Revenue Service (IRS) has made it clear that it goes after people who don't report. With IRS citations To Coinbase, Kraken, Circle, and Poloniex, in addition to other enforcement efforts, the IRS is on the hunt. the The IRS sent 10,000 letters in different versions calling for compliance, but all were nudges to encourage taxpayers to comply.

The IRS search for cryptocurrencies has often been compared to the IRS search for foreign accounts more than a decade ago. Unfortunately, it is unclear if there will ever be a crypto amnesty program that emulates the offshore voluntary disclosure programs that the IRS has formulated for offshore accounts.

Related: More crypto reports from the IRS, more danger

The IRS made its first major crypto announcement in Notice 2014-21, classifying it as property. This has great fiscal consequences, accentuated by sudden price changes. The sale of cryptocurrencies can generate profits or losses and be subject to taxes. But even buying something with crypto can lead to taxes. Paying employees or contractors does too. Even paying taxes in crypto can lead to more taxes.

We are already seeing crypto audits by the IRS, and by some states (notably, the California Franchise Tax Board), and more are sure to follow. At least now, there are tax return preparation and tracking alternatives that can make the process easier than it was in the early days. Everyone is trying to minimize taxable crypto earnings and defer taxes where legally possible.

Still, it's easy to get confused about tax treatment and take on tax positions that can be difficult to defend if caught. With that in mind, here are some things that I have heard, which I will call crypto tax myths.

Myth 1

You cannot owe any tax on cryptocurrency transactions unless you receive a Form 1099 from the IRS. If you did not receive a Form 1099, you can check the box on your tax return that says you did not conduct any cryptocurrency transactions.

Really: Taxes may still be due, even if the payer or broker does not file a Form 1099. A Form 1099 does not create taxes where no tax is previously due, and a large amount of taxable income is not reported on Forms 1099. A Form 1099 could be wrong, in which case, explain it on your tax return. But if you are audited and your best defense is that you chose not to report your transactions because you did not receive a Form 1099, that is weak.

Myth 2

If you hold your crypto through a private wallet rather than an exchange, you don't need to report the crypto on your tax returns.

Really: Purse or private change, the fiscal rules are the same. The drive to hide ownership by shifting wealth to anonymous holding structures is not new. When Swiss banks began disclosing their American account holders to the IRS and the United States Department of Justice, many American taxpayers tried almost everything, but almost all paid in the end, usually with large penalties. The cryptocurrency question on IRS Form 1040 is not limited to cryptocurrencies held through exchanges. If you say "no", even though you have crypto through a private wallet, you are possibly making false statements on a tax return signed under penalty of perjury. You may be betting you will never get caught, but thousands of American taxpayers who have bank accounts in Switzerland can attest to how bad that bet can be played.

Myth 3

If you hold your crypto through a trust, LLC, or other entity, then you don't owe tax on crypto transactions and you don't have to report. Also (the myth continues), income generated through LLCs is tax-free.

Really: Owning cryptocurrency through an entity can keep income off your tax return. But unless the entity qualifies (and is registered) as a tax-exempt entity, it is likely that the entity itself has tax reporting obligations and owes taxes. For tax purposes, LLCs are taxed like corporations or partnerships, based on their facts and tax choices. Single-member LLCs are not counted, so the LLC's income ends up in the sole owner's return. If your entity is a foreign entity, there are complex US tax rules that may make you directly liable for certain income produced within the foreign entity.

Myth 4

If I structure the sale of my crypto as a loan (or some other non-sale transaction), I do not have to report the income.

Really: Consider whether you are lending or selling the crypto. The IRS and the courts have strong doctrines to ignore bogus transactions. Are you recovering the same crypto that you are lending? Are you charging interest on the loan and paying taxes on the interest as it is received? Some loans may not be valid. And if you sell cryptocurrencies and receive a promissory note, that can further complicate your taxes with installment sales calculations.

Myth 5

An encryption exchange is a type of trust, as it cannot unilaterally change the exchange's policies. Therefore, you do not own the crypto in your account for tax purposes and you do not have to report transactions through an exchange.

Really: The IRS has not said any of this. The IRS guidance suggests that the IRS views taxpayers as owners of the cryptocurrency held through their exchange accounts. It seems highly unlikely that the IRS would consider cryptocurrencies held through an exchange account to be the property of the exchange itself (as trustee), rather than the property of the account holder. Taxpayers often own their assets through accounts maintained by institutions, such as bank accounts, investment accounts, 401 (k), IRA, etc.

In most cases, tax law treats taxpayers as owners of the money and assets held through these accounts. Some special accounts like 401 (k) s and IRAs have special tax rules. And having an account treated like a trust is not necessarily a good tax outcome. Beneficiaries of trusts, and particularly foreign trusts, have onerous reporting obligations. So, before considering crypto exchanges like trusts, be careful what you wish for. Calling something a trust does not mean that income generated within the trust is exempt from income tax.

Myth 6

Congressional amendment to Tax Code Section 1031 limiting exchanges of the same type to real property does not make crypto-to-crypto exchanges taxable.

Really: Section 1001 of the tax code states that a taxable profit results from the "sale or other disposition of the property." Selling any type of property for cash or other property can generate a taxable profit. The IRS says that cryptocurrencies are owned, so trading cryptocurrencies for other cryptocurrencies is a cryptocurrency sale for the value of the new crypto.

Before the Section 1031 amendment went into effect in 2018, a crypto-for-crypto exchange could have been fine as a similar exchange under Section 1031. But the IRS is rejecting this position in tax audits and has issued guidance. that denies duty-free treatment for certain cryptocurrency swaps. That's not a precedent and it doesn't cover the waterfront, but it tells you what the IRS is thinking. In any case, now that Section 1031 has limited exchange treatment similar to real estate, crypto-to-crypto exchanges are taxable unless they qualify for another exception.

To carry out

Each taxpayer has the right to plan their affairs and transactions to try to minimize taxes. But they must be wary of quick fixes and theories that sound too good to be true. The IRS seems to believe that many crypto taxpayers are not complying with tax law, and it is worth considering being careful going forward and cleaning up the past. Be careful out there.

This article is for general information purposes and is not intended to be and should not be taken as legal advice.

The views, thoughts and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.