What crypto tax risks do you need to be thinking about?
It is no secret that blockchain is among some of the most exciting emergent technologies of the twenty-first century. In the last few years, cryptocurrency has grown in popularity with several top financial minds endorsing investments in it. Despite becoming so popular, one thing that has been left out of the cryptocurrency conversation is taxation.
Because of this, several misconceptions exist that could cause you a lot of trouble with the IRS. You could even get prosecuted if you fail to report cryptocurrency transactions. In this post, we take a look at the tax risks that exist in crypto and how you can avoid them.
Tax Risks In Crypto and How You Can Avoid Them
Despite being the rave of many investment discussions these days, there are still grey areas when it comes to cryptocurrency. According to the IRS, cryptocurrency is subject to taxation and is generally treated the same as stock, with some exceptions. Not many people know this, which marks the beginning of their many crypto-related problems.
Here are some of the tax risks that you are exposed to when dealing with cryptocurrency and how you can avoid them.
1. Paying employees with crypto
Since the rise of bitcoin and other cryptocurrencies, many employers have been caught in a dilemma. Should we pay our employees with cryptocurrency or not? Of course, this may be acceptable to most young employees who are more open to the idea of crypto. It will also appeal to individuals who have to send money to loved ones living in other countries.
When it comes to remunerating employees with cryptocurrency, employers must use caution. Even though cryptocurrency is gaining ground pretty fast, several important laws guiding new commerce forms haven’t. What this means is that there are still several grey areas including taxation of this kind of payment.
According to the IRS, it regards cryptocurrency as property instead of currency. As such, when an employer adopts cryptocurrency payments, it is as good as paying their employees in stock. All of this may result in several administrative difficulties but generally speaking, the payment in crypto should be treated the same as normal compensation for an employee and payroll taxes and withholdings will apply.
Solution: The solution to this risk is pretty simple. Employers shouldn’t adopt cryptocurrency as a means of payment without consulting with a qualified tax professional.
2. Falling prey to myths
Even though cryptocurrency is gaining more popularity by the minute, many employers still have a lot to learn. You mustn’t get caught up in the myths relating to crypto. A few of these myths include:
- Compensation using crypto is not taxable. The IRS sees any income in crypto as equivalent to cash compensation. What this means is that you have to provide the Fair Market Value of your compensation on the reception date. This is because standard income tax rules apply.
- Airdrops and Hard Forks aren’t taxed. If you know the IRS well enough, you should know that it doesn’t regard any income as free money. The same rule applies to cryptocurrency despite the fact that it isn’t yet regarded as money. Based on the IRS guidelines released in 2019, the taxpayer must include airdropped units in their gross income. This must be at the FMV as well.
- Making payments using cryptocurrency is not taxable. To date, a lot of people still don’t know that paying others with cryptocurrency is taxable. This is because crypto hasn’t yet attained fiat currency status, it is treated as listed property. As such, you are selling assets when you use crypto to make payments based on IRS conditions. Selling property triggers capital gain taxation rules.
3. Not understanding the basics of selling/using crypto
Here’s a basic fact: Many taxpayers do not fully understand the basics of selling or using crypto. If you don’t have this knowledge, then you will get it all wrong and dive headlong into IRS trouble.
A few scenarios to consider:
- Cashing in on your crypto for fiat currency like the USD brings you capital gain or loss in the long or short term. If you are making a profit on the sale, it counts towards your annual capital gains total. However, a loss decreases your annual net capital gains.
- Exchanging one cryptocurrency for another also triggers taxation. How is this possible? This is because it still adds to or subtracts from your annual capital gains total. Since many new crypto traders don’t know this, they end up owing taxes when the year ends.
- You need to account for using crypto to pay for goods or services since you will either make a gain or loss. Such capital loss or gains must be accounted for in your tax calculations as well.
Solution: Just as we mentioned above, it is important that you gain as much knowledge about crypto and tax as possible. This will give you a clear picture of what to do and what to avoid. Learn more by clicking here.
4. Spending gains too quickly
It is no secret that the cryptocurrency market is extremely volatile. There are always massive swings in both directions (up or down). For example, bitcoin recently experienced a meteoric rise bringing its owners massive gains.
While there is the temptation to cash in on such gains quickly, you shouldn’t forget that it adds to your annual capital gains. As such, you should pay up or prepare to pay such taxes no matter how large they may seem. Most times, the problem is not calculating the potential taxes before spending the gains. Don’t make this mistake as it could get you into a lot of trouble with the IRS, including fines of up to $250,000.
Solution: It is simple, learn to calculate potential taxes on each gain before you spend. You can then put this aside and prepare to pay it during the tax season.
5. Poor tracking of buying selling
Most cryptocurrency traders fail to recognize the fact that buying and selling crypto is taxable. This means that whether you exchange crypto for crypto or fiat money, the transaction should be taxed. It doesn’t matter if you sell manually or use bots, you must account for every trade.
Never forget to track your crypto trades. This may be particularly difficult if you are new to crypto trading or you make use of bots.
Solution: Your best bet when it comes to tracking your crypto trades is using reputable platforms. There are several platforms designed to help you with tracking your crypto, one such example is Cointracking.info, which our team uses with all of our crypto clients.
6. Failing to file crypto earnings/losses
This is another major mistake that many crypto traders make and probably the biggest issue altogether. The new individual income tax forms have a checkbox that asks “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?” If you check “No” to this question but had crypto transactions for that year, you may be filing a fraudulent tax return.
Solution: The easiest way to solve this problem is to ensure you disclose any and all of your crypto activity, when filing your taxes. If you are not capable of doing this efficiently, get help.
7. Not using a qualified accounting service
If you don’t make use of an accounting firm uniquely qualified in understanding crypto taxation, you may run the risk of being left in the dark about your crypto tax liability. As blockchain technology becomes more prevalent in everyday life and in the business world, the IRS will continue to increase its scrutiny of crypto-related taxation.
Solution: Sign up with an accounting service that understands cryptocurrency and the related taxation rules. A good place to start? See how Founder’s CPA helps crypto owners file their taxes.