Bitcoin: Efforts at Taxation and Regulation

By admin of MillarLaw A Professional Corporation On Saturday, December 23, 2023

Is Bitcoin a Security?

The SEC is a federal agency that regulates the securities markets within the United States. The SEC enforces certain disclosure requirements and financial filings in the name of protection against market manipulation. Issuers of securities need to be registered with the SEC, as well as financial service firms and the professionals of those firms. The SEC has regulation over securities, and a security is generally defined as a financial instrument that holds some type of monetary value. This includes instruments such as stocks, bonds, options and investment contracts among many other instruments. More specifically in terms of Cryptocurrencies, the determination of whether a Cryptocurrency is an investment contract is critical. If the Cryptocurrency is determined to be an investment contract, and therefore a security, it is subject to SEC regulation and must either be registered or be subject to an exemption from registration.

The Howey Test and Cryptocurrency

The Howey Test is the standard to determine whether a financial instrument is an investment contract and is therefore subject to SEC Regulation. This is a three-part test in which the Supreme Court determined that an investment contract exists when there is (1) an investment of money; (2) in a common enterprise; (3) with a reasonable expectation of profit derived from the entrepreneurial or managerial efforts of others. If an asset does not meet all three prongs, it is not an investment contract, and not a security. Importantly, the SEC has stated that neither bitcoin nor ether are securities under the Howey test, but also specified that whether a digital asset is an investment contract at a particular time is unique to both the asset and the facts and circumstances at the it is being sold or resold. If the Howey Test is satisfied, then the issuance of the asset must be registered with the SEC or be eligible for an SEC exemption.

Cryptocurrency ETF

An ETF is a type of security that tracks an index or an asset and can be bought or sold on a stock exchange just like any other stock, and as a security, the SEC has the ability to regulate ETFs and has recently approved a Cryptocurrency a Bitcoin ETF which began trading Tuesday as a Futures ETF. There have also been a few Ethereum ETF applications submitted. Additionally, in foreign countries such as Canada, ETFs for Bitcoin and Ethereum have already been approved and are actively trading.

Tax Compliance

 Back in 2014, the IRS ruled that cryptocurrencies that can be traded for real currency met the definition of property for tax purposes. Thus, each trade or transaction is a taxable event.

It makes sense for Congress to ensure cryptocurrency investors pay taxes the same way as holders of other financial assets. But the decentralized nature of blockchain technology that intrigues investors and futurists also makes tax compliance hard.

Why? If someone buys and sells Bitcoin on a major cryptocurrency exchange, the exchange—or broker—can easily report the sale to the IRS and the investor. If those exchanges collect Social Security numbers and other consumer information the IRS needs, problem solved! Well, not quite.

Let’s say you some of your Bitcoin to buy groceries at Whole Foods, one of many major companies that now accept certain cryptocurrencies as payment. Depending on what works best, you could use a “custodial” wallet operated by a third party or a “non-custodial” wallet that allows you to retain full control of your cryptocurrency and its underlying data–and reduce the risk of being hacked.

Reporting gets tricky for those using the non-custodial wallet. There isn’t an intermediary that readily fits the standard definition of a broker that could collect the data the IRS needs. Yet, users still could buy and sell different cryptocurrencies, buy airline tickets, and then upload unspent assets to a different trading platform.

For now, a 1099 reporting requirement for exchanges that resemble traditional stockbrokers seems like a no brainer. But the rest is more complex and realistic disclosure will require careful deliberations by Treasury.

Under present law, virtual currency transactions are taxable, similar to transactions in any other property, including stock, bonds and mutual funds. With the popularity of virtual currency growing in recent years, the Internal Revenue Service (IRS) has offered increased guidance on its tax treatment―and many holders of virtual currency are not happy.

As the IRS is aware that some taxpayers with virtual currency transactions may have incorrectly reported or innocently failed to report income and pay the related tax, the IRS is aiming to increase public awareness. In summer 2019, the IRS issued more than 10,000 educational letters to taxpayers known or believed to be engaged in virtual currency transactions. In the beginning of the 2020 filing season, the IRS added a new question relating to the sale, purchase or exchange of virtual currency on the first page of Form 1040, the individual income tax return. The answer to this was subject to the taxpayer’s signature under the penalties of perjury.

IRS enforcement action is now on the rise. In March 2021, the IRS launched Operation Hidden Treasure, a joint effort between the Office of Fraud Enforcement and the Criminal Investigation Division of the IRS to search for unreported income related to cryptocurrency. So far this fiscal year, the IRS has seized over $1.2 billion worth of cryptocurrency, up from $137 million in fiscal 2020 and only $700,000 in fiscal 2019. As President Joe Biden intends to ramp up enforcement action at the IRS as a whol, virtual currency is certain to receive higher scrutiny in the coming years, particularly after the IRS’s success this year.

Most recently, the infrastructure bill passed by the Senate and under consideration in the House, contains a key provision regarding virtual currency. In this provision, tax reporting requirements will be imposed on cryptocurrency brokers, much in the same way brokers report their clients’ stock sales to the IRS. These reporting requirements are projected to bring in additional revenue of $28 billion over the coming decade. With such returns expected, this is only the beginning of tighter regulation of the cryptocurrency market as the Biden administration strives to achieve greater tax compliance.

Tax Reporting in a Nutshell

Sale or Exchange of Virtual Currency

When you sell virtual currency, you must recognize any gain or loss on the sale, just as you would with the sale of a stock or mutual fund, subject to the same limitations on the deductibility of losses. The gain or loss is the difference between adjusted basis in the virtual currency and the amount received in exchange for the virtual currency, which should be reported on your federal income tax return in U.S. dollars. The basis is the amount spent to acquire the virtual currency, including fees, commissions and other acquisition costs in U.S. dollars.

Transfer of Property

If a taxpayer exchanges virtual currency for property, the gain or loss is the difference between the fair market value of the property received and adjusted basis in the virtual currency exchanged. For the transferor of the property, the rules are slightly different and depend on the assets being exchanged. If you transfer property held as a capital asset in exchange for virtual currency, you will recognize a capital gain or loss. If you transfer property that is not a capital asset in exchange for virtual currency, you will recognize an ordinary gain or loss, at potentially significantly higher tax rates. Transfer of property involving virtual currency is complex and requires careful planning and tracking.

Payment for Services

Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on by the individual other than as an employee. Consequently, the fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to self-employment tax.

In addition, the form of compensation for services is immaterial to the determination of whether the compensation constitutes wages for employment tax purposes. Consequently, if wages are paid in virtual currency, that amount, measured in U.S. dollars as of the date of receipt, is subject to federal income tax withholding, Federal Insurance Contributions Act tax and Federal Unemployment Tax Act tax, and must be reported on Form W-2, Wage and Tax Statement.

For either type of transaction, the amount of income you must recognize is the fair market value of the virtual currency, in U.S. dollars, when received. In an on-chain transaction, you receive the virtual currency on the date and at the time the transaction is recorded on the distributed ledger.

If you pay for a service using virtual currency that you hold as a capital asset (i.e., you do not mine cryptocurrency or hold it as inventory), then you have exchanged a capital asset for that service and will have a reportable capital gain or loss. The gain or loss is the difference between the fair market value of the services received and the adjusted basis in the virtual currency exchanged.

Virtual Currency and Foreign Bank and Financial Accounts

Within the Treasury Department, it is not just the IRS that has increased scrutiny of virtual currency. The Financial Crimes Enforcement Network (FinCEN) announced in December 2020 that it intends to require reporting of foreign accounts holding virtual currency on the Form 114, Report of Foreign Bank and Financial Accounts (FBAR).

While these regulations have not yet been issued, the increased scope of the FBAR is worth noting and planning for. Many questions remain as to what will need to be reported―such as whether the requirement will include virtual currency held by an exchange outside the U.S., or virtual currency held in a wallet on a flash card or hard drive physically located outside the U.S. Still, taxpayers should start an inventory of their virtual assets in preparation for the anticipated compliance measures.

Tips for Estate Planners.

  • Early in the estate planning process via client intake forms, questionnaires, or interview questions, ascertain whether your client owns (or plans to acquire) cryptocurrency.
  • A cryptocurrency owning client needs to keep detailed records of the date of each virtual currency purchase and the amount so that capital gains income tax planning can be effectively accomplished such as (1) selling and paying the tax (or taking a loss) now, (2) gifting with a carryover basis, or (3) allowing it to pass at death to give the beneficiary a stepped-up basis.
  • If the client owns cryptocurrency stored in a software wallet not connected to an exchange, it is essential to make arrangements to protect and then transfer the private key or seed phrase to the person whom the client wishes to own the virtual currency after the client’s death. Storing the key or phrase in a safe deposit box is a frequently used technique.
  • If the client owns cryptocurrency stored on an exchange, then protection, storage, and transfer of the username, password, and security question information is needed. In addition, some exchanges use two-factor authentication.


The law surrounding cryptocurrency transactions continues to evolve and attract the attention of the IRS and FinCEN. Taxpayers should be aware of their obligations to maintain records that document the receipt, purchase date, cost basis and fair value at the time of sale, exchange or other dispositions of virtual currency. The better the records maintained, the less effort taxpayers and tax practitioners will have to spend analyzing, reporting and assessing the tax impact of these transactions come tax time―not to mention an increased defensible position and better results in a potential audit. If you have just acquired virtual currency or cryptocurrency, loop in your tax adviser so that you can effectively track the transactions and avoid the ire of the IRS.