Crypto Legality and Tax in the U.S | An Introductory Guide
The legality of cryptocurrencies has always been a gray era in the United States since the creation of blockchain in 2009.
When Bitcoin and altcoins attracted mainstream attention during their late-2017 bull run, hundreds of unregulated crypto companies and projects cashed in on the general naivete of newcomers to the new digital gold rush.
For example, bad actors exploited new investors through exit scams from fraudulent initial coin offerings (ICOs) and multi-level marketing (MLM) pyramid schemes, and digital wallets and exchange hacks. In 2018, over $1.1 billion were stolen from virtual asset investors, a record amount. Shockingly, that paled in comparison with 2019, when criminals absconded with over $4.4 billion in crypto assets.
As a result, the U.S.’ leading regulators and legislators like the SEC, CFTC, FinCEN, and Treasury have increasingly turned their attention to the crypto space since 2018, to get the U.S. virtual asset industry compliant with international regulations like the FATF travel rule and to ensure that crypto investors are taxed appropriately.
New developments like Libra (2019) and a possible Fed-backed “digital dollar”, known as a central bank digital currency (CBDC), is also further complicating the crypto regulatory landscape in the U.S.
In this guide, we’ll look at the United States’ legal classification of cryptocurrencies and crypto companies as well as crypto tax obligations.
Are cryptocurrencies legal in the U.S?
In the United States, Bitcoin and other cryptocurrencies are legal to own, mine, and trade. These allowances come with increasing demands from American regulators though, so it’s important to distinguish what type of cryptocurrency you’re investing or transacting in.
How do U.S. regulators view cryptocurrencies?
United States federal agencies take very different views on the nature of cryptocurrencies like Bitcoin, due to its versatility.
- The U.S. Treasury and FinCEN classified Bitcoin as a convertible virtual currency in 2013. This meant that money service businesses (MSBs) who deal in CVCs are defined as money transmitters by the Bank Secrecy Act (BSA). Therefore they need to comply with BSA regulations for MSBs. Luckily, this doesn’t apply to individual users.
- The Commodity Futures Trading Commission (CFTC) views Bitcoin as a commodity,
- The Securities Exchange Commission (SEC) views certain ICO tokens and crypto derivatives as securities due to the Howey Test.
This muddled regulatory approach to crypto assets in the US has led to much dissent between federal agencies, which led to Congressman Paul Gosar presenting the Crypto-Currency Act of 2020 draft bill to Congress in 2019 and 2020, trying to divide digital assets into 3 different categories (crypto-currency, crypto-commodity and crypto-security) and assign a different regulator to each.
How does the IRS treat virtual currency for tax purposes?
In the U.S., all tax matters fall under the oversight of the Internal Revenue Service (IRS). The U.S. taxman first shifted its focus to Bitcoin and other “virtual currencies” (as it labels cryptocurrencies) way back in 2014.
The IRS published its IRS Notice 2014-21 to explain how it applied tax law principles on virtual currencies. It drew the conclusion that virtual currency should be treated as property for federal tax considerations.
The IRS defines virtual currencies as follows:
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.
While under certain conditions it may act like “real” fiat currency like the U.S. Dollar, it does not have legal tender status in any jurisdiction.
Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency (CVC), such as Bitcoin. Investors can also find more of their questions answered at Publication 544, Sales and Other Dispositions of Assets.
Do I need to pay the IRS tax on crypto earnings?
In short, yes. To which extent, becomes very tricky and complicated, and will be explored in a different article.
“The sale or other exchange of virtual currencies, or the use of virtual currencies to pay for goods or services, or holding virtual currencies as an investment, generally has tax consequences that could result in tax liability.”
If any crypto asset is treated like virtual currency according to the above definition, it will be taxed as such by the IRS.
If you’re not trading or selling cryptocurrencies in a professional manner, but merely holding it as an investment and capital asset, you will also be taxed differently
Short and long term tax gains
When you sell your virtual currency, you will need to declare short or long-term tax gains. Any holding period (the day after you’ve acquired the crypto, to the day that you sell it) that exceeds one year before you sell it makes you liable for long-term capital tax gains.
You can learn more here: see Publication 544, Sales and Other Dispositions of Assets.
If you purely hold cryptocurrency as a capital asset and have more questions on how the IRS taxes crypto ownership in the U.S., you can visit their FAQ section. There are nearly 50 questions and answers on a wide range of tax topics.
The IRS’ controversial new 2020 tax question
In 2020, the IRS announced a new tax form that required U.S. taxpayers to declare before 15 April whether they were involved in any virtual currency transactions in 2019.
Section 1 of Form 1040 (“Additional Income and Adjustments to Income.”) requests taxpayers who sold, bought, exchanged or acquired virtual currency crypto to answer “Yes” or “No”. For those that answer affirmatively, they will need to maintain records that support their tax return information.
You can learn more about the new Form 1040 tax requirement here. This Forbes article also looks at the IRS’ long game and how they intend they close the net around crypto investors over time.
Do companies that transact crypto need money transmitter licenses?
In 2013, after a few years of tiptoeing around the subject, FinCEN finally classified U.S. money service businesses (MSBs) such as crypto exchanges, “ mixers” and other business entities who deal with CVCs as “money transmitters”. They are therefore subject to the BSA’s travel rule and FinCEN regulations. These regulatory requirements can get even more complicated based on their state laws.
In May 2019 FinCEN issued their CVC guidance to consolidate a decade of enforcement actions and to determine how money transmitters are regulated when dealing with CVCs.
These money transmitters would, therefore, need to:
- Get licensed by each state they operate in
- Register with federal regulator FinCEN licensed by FinCEN as an MSB
- Create and enforce a strong anti-money laundering (AML) program,
- Ensure they implement compliant Customer Due Diligence (CDD) recordkeeping and submit Suspicious Activity Reports (SAR) and Currency Transaction Reports (for transmittals exceeding $10,000) to FinCEN.
In 2019 FinCEN took it one step further and confirmed in their CVC May Guidance that MSBs would have to implement the BSA’s Travel Rule requirement to share transmittal information for transactions exceeding $3,000 in value.
If you are a money service business (MSB) with specific legal questions, we invite you to get in touch with Kelman Law here so we can provide you with the answers you need.
Are crypto assets securities?
The SEC has been reluctant in the past to issue clear guidances on the nature of cryptocurrencies, Due to the complexity of virtual assets’ underlying technology as well as the plethora of reasons why investors and businesses get involved with crypto, the SEC has avoided creating one-size-fits-all guidances.
The nature of securities is dependent on the facts of each ICO so there is no specific rule that can be made to clear up the confusion.
- It is a monetary investment
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the managerial efforts of others
The last point is key. The profit from cryptocurrencies like Bitcoin and Ethereum are predominantly not managed by third parties like exchanges, and still rely on the user to trade and sell their crypto as they wish.
However, this is not the same with ICOs, where investors buy into a project and its team, and where the ICO is selling tokens to raise funds, similar to shares on the stock market. This means that some ICO are subject to U.S. securities law and may need to be registered.
This explains why SEC really have their knives out for illicit ICOs, targeting ICO projects that range from BitClave (May 2020, had to return $25m to investors), Block.One’s $4 billion ICO of EOS, Telegram to even Steven Seagal! You can view a full list of the SEC’s recent cyber-security enforcements here. In 2020, the idea of launching your ICO in the U.S. is pretty much a non-starter.
Furthermore, the SEC has also shot down every Bitcoin electronically traded fund (ETF) application until now due to the volatility and manipulation of Bitcoin’s price. SEC chairman Jay Clayton stated in 2019 that a Bitcoin ETF won’t happen until the market is better regulated.
Have you been affected by an illegal ICO?
Since 2017, thousands of ICO investors have suffered losses totaling billions of dollars. If you are an investor who has been financially impacted by a fraudulent or negligent ICO, Kelman Law would love to hear from you.
We’ll set up a free 30-minute consultation to review your case, and if possible, help you claim damages, as we’ve done with many other clients, including the investors of Mt. Gox.