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Cryptocurrency has a Special Role in Income Taxes

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Cryptocurrencies have been around for longer than you think, and we’ve only heard from the Internal Revenue Service (IRS) twice – in 2014 and 2019 – on how they think crypto should impact your tax burden.

From the beginning, the IRS has designated virtual currency as property. Because of this identification, cryptocurrencies are subject to capital gains taxes.

What is Crypto or Virtual Currency?

The most popular cryptocurrencies are house-hold names by now – Bitcoin, Ethereum – but there are thousands out there that you haven’t heard of.

All crypto or virtual currency is a digital representation of value that works outside of national currencies. But just like currency, crypto can be used to exchange value in terms of transactions.

While being marked as “property,” crypto has some of the same properties and characteristics of stocks and are subject to rising and falling values like any investment.

One reason people are pursuing cryptocurrencies is because it is secure. Transactions are encrypted with specialized computer coding and put into a blockchain. A blockchain is essentially a public ledger that lives in the digital world.

 

How do Cryptocurrency and Long-Term Capital Gains Work?

At the onset of cryptocurrency popular, the IRS made sure to put out an initial notice to secure their piece of digital currency income.

That ruling – IRS Notice 2014-21 – stated that the IRS considers cryptocurrency to be property. As property, it is subject to capital gains taxes that are reported on Schedule D and Form 8949 if necessary.

If you hold your cryptocurrency for more than a year, any profits are considered long-term capital gains and are subjected to those tax rates. If you owned your crypto for a year or less before spending or selling, profits are classified as short-term capital gains that are taxed at your ordinary income rate.

If you are worried about how you’ll be taxed, our team of tax strategists can help. There are also tables available online for the current year’s short-term and long-term capital gains tax rates.

 

The 2019 Revenue Ruling and What It Means

In 2019, the IRS released their first updated guidance on cryptocurrency in five years. Many questions needed answering on how to handle some of the interactions of virtual currency. To understand the 2019 guidance, we’ll need to explain two actions first.

Hard Forks

The easiest way to think of a hard fork is when you receive a new credit card if your old one is thought to be compromised. In crypto, the currency on one of those distributed public ledgers undergoes a change that results in a permanent move away from the initial ledger. Sometimes this creates a new cryptocurrency.

The most famous hard fork occurred in 2016 when the Ethereum blockchain included a crowd-sourced venture capital fund called The Distributed Autonomous Organization (DAO). An error in the blockchain code of the DAO enabled someone to steal $45 million in cryptocurrency from the DAO. DAO leadership used a hard fork to create a new cryptocurrency. This made the old cryptocurrency worthless and deprived the digital robber of that $45 million.

Airdrops

Each cryptocurrency holder has a digital wallet. An airdrop occurs when virtual currency is distributed to the wallet address, typically for free. The goal of an airdrop is to create awareness and broad distribution for a blockchain project. It can also be used in hard forks, distributing new cryptocurrency to the holders of the old cryptocurrency.

The 2019 Revenue Ruling provided FAQs with some answers, but also raised more questions about the future of cryptocurrency and taxes. Here’s some of the things that are explained:

  • If a hard fork happens and you receive the same fair market value of new cryptocurrency that you had in the old cryptocurrency, no gross income is recognized.
  • If you get airdropped a new cryptocurrency, then you have an accession of wealth and you must recognize that new cryptocurrency as gross income of that date.
  • If you transfer virtual currency from a digital wallet or account belonging to you to another wallet that is yours, this is a non-taxable event.
  • If you receive virtual currency in exchange for providing services, you recognize ordinary income. Your basis in the virtual currency is the fair market value when the currency is received.
  • If you receive cryptocurrency as a gift, no income is recognized until you sell, exchange, or somehow get rid of the currency. Your basis in the virtual currency gift differs depending on whether you will have a gain or loss when you sell or get rid of the holding.

 

Some Advice from The Richest Doctor

In David Auer’s book, The Richest Doctor: A Modern Parable of Financial Independence, there’s a ton of information about understanding risk and investing smarter. It’s important to learn and know what type of investor you are – the “Too Busy to Learn” investor, the “Accredited Investor Level,” or one of our higher levels. Although the book is for physicians, there is great advice for all high-income professionals.

If you are prepared to learn the ins and outs of cryptocurrency, the better chances you have of investing and understanding the ramifications of gains on your tax picture. We recommend reading up, finding a mentor that is already successful in cryptocurrency investing, and also reading The Richest Doctor to understand how investing and cryptocurrencies might play a part in your financial independence.

There are a lot of nuances to cryptocurrencies. There’s much more to crypto than we could cover in this article. Good luck with any moves you make in this space, and don’t hesitate to reach out to the Provident CPAs team with tax questions!

How Understanding Tax Rules Can Maximize Profits from a Business Sale

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A record number of American business owners are selling up. It pays to know what this means for your next tax return if you’re ready to close a deal.

More people than ever are looking to become their own boss in 2019, so if you’re ready to sell your business, you may find no shortage of takers. New sales records were set in 2016–2017 and these were again broken in 2018. But achieving a truly successful sale means navigating the best ways to avoid taking a hit on taxes. Here are some key things to consider before closing a deal.

The money from your business sale is subject to income tax

This is the first thing to consider in order to minimize losses to the IRS. Selling your business doesn’t mean it’s no longer a source of income because it will make you money when it changes hands.

The type of business being sold—LLC, sole proprietorship, S Corp, or partnership, etc.—affects how much tax you pay, as does selling your business as assets or as stock certificates. In any case, business owners must declare the full amount gained from the sale on their next income tax return.

Consider closing the sale through installments or deferred payments

Business owners may be reluctant to accept anything less than the entire purchase price at closing. This is understandable and removes the risk that a buyer might default on installments, but it isn’t always possible, as many deals mandate a structured, incremental buyout. It’s also not necessarily the best tax move. Accepting all sales proceeds in a single year will land you in a higher tax bracket.

Agreeing to installments over several years can lower the tax liability of your business sale since you pay much of the tax over time as you get the payments. In such a competitive buyer’s market, offering installments could also make your business more attractive to buyers who won’t have to pay everything at once.

Installments also mean you remain part of the operation until closure. This keeps the original owner around to offer advice and ensure things are being run properly, which minimizes performance risk and lowers the likelihood of the buyer defaulting on installments.

Where you live could be a tax advantage (or a liability)

Your state of residency is a benefit or a burden when selling your business because state and local income tax can be applied on top of federal taxes.

Stock sales are generally more favorable than asset sales in this scenario. If your business makes an asset sale it will typically owe taxes in the state or states where it has assets, sales, or payroll, or has gained income in the past. Stocks, on the other hand, are usually taxed in the state of residence.

This means that a business owner living in the “right” state (and choosing an all-stock sale) could avoid a significant tax bite. Of all states, only nine are exempt from income tax: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming.

Business owners making an all-stock sale while living in any of those could avoid tax entirely, even if the company does business in another state. In addition, stocks are generally immune from the transfer, sales, and use taxes.

Your sale could qualify as totally tax-free

When one C or S corporation buys another, it’s possible to set the deal up as a capital gains tax-free merger. One way to do so is through a stock exchange or “corporate reorganization.”

The “buyer” and the “seller,” in this instance, can swap stocks in their respective companies until the buyer is in full possession of the other’s business. This can avoid income tax completely since a stocks-for-stocks exchange classifies as non-cash assets.

Sellers must receive a certain percent of the buyer’s stock (typically between 40 and 100 percent) for this kind of deal to go through. Two important notes here:

  • Even if sellers get off tax-free on a stock exchange, they’ll still be taxed later if they choose to sell the shares.
  • Federal law prohibits selling shares gained in this manner for a set period if the seller wants to hold on to that tax-free status.

For taxes filed in 2020, many taxpayers will pay 15 percent long-term capital gains tax if they’ve been holding new shares for over a year and decide to sell. The standard income tax rate will apply if they choose to sell new shares they’ve held for a shorter time.

The corporate reorganization process is complex and laid out in Section 368 (a) of the Internal Revenue Code. If your business wishes to go this route, it’s vital to speak to a qualified CPA who can guide you safely through it.

Each of the above suggestions are potential tax implications; everything has its own element of risk and there are frequently exceptions to rules. Connect with Provident CPAs to get the full picture on which sales solution will save your business the most come tax time.

Provident CPA and Business Advisors offer a wide range of services in taxes, accounting, and beyond. Our core focus is to help professionals achieve financial freedom and build a better business. Get in touch today to start strengthening your finances.