This article originally appeared in the May 30, 2022, issue of Tax Notes Federal.]
Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law at the University of Michigan, and Mohanad Salaimi is an SJD candidate in international taxation at Michigan Law. The authors thank Lisa Zarlenga for her insightful comments. The authors are responsible for any errors or omissions.
In this article, Avi-Yonah and Salaimi propose a new framework for taxing cryptocurrency throughout its life cycle.
This article summarizes Avi-Yonah and Salaimi, “A New Framework for Taxing Cryptocurrencies,” University of Michigan Public Law Research Paper No. 22-014 (Mar. 31, 2022).
This article describes a proposal to tax cryptocurrencies based on their unique features.1 It argues that while various ways of earning or receiving crypto tokens (for example, mining in proof-of-work (PoW) protocols like bitcoin and staking in proof-of-stake (PoS) protocols like ether) generate taxable income, the tax results should take into account positive and negative externalities. It also claims that because of its volatility, crypto should not be taxed until tokens are exchanged for real-world items like fiat currency or goods and services. Finally, this article argues that when crypto tokens are exchanged for fiat currencies or goods and services, they should be treated as foreign currency if held for less than one year.
Introduction: The Crypto Life Cycle
Cryptocurrencies have been around since 2009, when bitcoin was invented, and the distributed ledger technology that underlies them has found widespread use. Even so, given the volatility of some prominent crypto, various observers, including The Economist and Paul Krugman, have been pronouncing the imminent death of crypto, which they regard as a glorified Ponzi scheme.2
In our opinion, the naysayers are wrong. We have no view on whether the rise of crypto is a positive or negative phenomenon. The same could be said about the internet, which has proven to have both pros and cons. Our view is that crypto in some form is here to stay because the underlying technology is too useful to ignore. Thousands of crypto tokens may collapse soon as the world moves into a recession — but so did thousands of dot-com companies in the late 1990s. The survivors (such as Amazon, Netflix, eBay, and Google) are today’s market-dominating behemoths. We predict that a new generation of survivors will emerge from the crypto universe as well.
If cryptocurrency is here to stay, then it becomes important to regulate it properly — and that includes taxation. The rule adopted by the IRS in 2014 (Notice 2014-21, 2014-1 C.B. 938) — a long time ago in the evolution of crypto — is to treat crypto like any other asset, so that every transaction in which crypto is exchanged for other crypto or used to acquire goods, services, or fiat money becomes a taxable realization event.3 In our opinion, that is wrong, because it ignores the defining characteristic of cryptocurrency, which is its volatility. Further, the IRS position is unadministrable.
Crypto as a Tax Haven?
Before we discuss our proposed framework for taxing crypto, we want to address one myth, which is that crypto is some kind of glorified tax haven that is most useful for tax evasion and other illegal activities. The argument is that because crypto is anonymous and there are no intermediaries (banks, brokers) involved in transmitting it, it can more easily be used for illegal activities.4
That argument is simply wrong. First, as recently demonstrated by a sanctions avoidance criminal case brought by the U.S. Department of Justice,5 no form of crypto is truly anonymous to the government, which has the resources to crack any code. Second, because crypto transactions are public by definition, they are actually easier to audit than transactions using fiat currencies.6
Consider, for example, tips. They are notoriously hard to tax because they are frequently paid in cash, and small amounts of cash are essentially untraceable (it is also difficult to trace large amounts outside the United States). However, tips in cryptocurrency can easily be traced and taxed based on the public ledger.
The same observation can be made about many small businesses that receive funds for goods and services in cash or checks. As long as the IRS does not require information reporting from banks on regular business accounts, those businesses are difficult to audit because the transactions are below the $10,000 limit that triggers bank reporting. A business earning crypto is easier to audit.
Crypto can even be used to combat some forms of tax fraud such as missing trader intra-Community VAT fraud, which has cost EU governments (and the United Kingdom) billions in tax revenue.7
Earning cryptocurrency in various ways (such as via salaries and rewards) should generally be taxable under the Glenshaw Glass definition of income.8 The one exception is a hard fork (when a crypto token is replaced by another crypto token) because that is not an accession to wealth but a software upgrade.
Having said that, we think tax law should distinguish between PoW and PoS protocols for earning crypto. PoW produces negative externalities because of the energy it consumes, which is a major problem. PoS does not have that issue, and arguably people who stake their tokens are helping others (a positive externality) by increasing the stability of the network. Because of that, we propose that crypto received through PoW should be immediately taxable, while crypto received through PoS should not be taxed until converted to fiat currency or real-world goods or services.
The defining characteristic of crypto is its volatility. Because it is so volatile, it is hard to measure gain or loss when crypto is exchanged for other crypto. Basis is hard to determine, and any gain may be illusory and disappear the next minute because the token’s value plummets.
Because of that administrative difficulty and volatility, we propose that crypto be taxed only when it is exchanged for real-world fiat money or goods and services. In other words, all crypto should be treated as like-kind to other crypto for section 1031 purposes. That change requires legislative action because section 1031 was limited to real property by the 2017 Tax Cuts and Jobs Act.
Fundamentally, our proposal is similar to the treatment of unrealized appreciation. Unrealized appreciation is not taxed because the public does not believe in Haig-Simons taxation — at least for regular taxpayers — because it is aware that until realization, the appreciation of real-world items like stocks may be illusory and fleeting.9 If we do not tax appreciated stocks until realization, we should not tax the much more volatile crypto until it is realized by being exchanged for real-world items.
An exception should be made for billionaires. Just as Senate Finance Committee Chair Ron Wyden, D-Ore., has proposed taxing billionaires on unrealized appreciation, a case could be made for taxing them on unrealized crypto gains. The reason for this exception is that for billionaires, unrealized appreciation represents power because they can invest and borrow against it to buy major assets (consider Elon Musk and Twitter).10 However, that rationale does not apply to ordinary taxpayers.
When crypto is used to acquire fiat currency or goods and services, it should be taxed because at that point its value becomes fixed — that is, it is realized. But the IRS view that cryptocurrency should always be taxed as an asset is wrong because it is unadministrable. Under the agency’s view, every time a taxpayer uses crypto to buy a cup of coffee, she must calculate her basis in that particular token and pay tax on the gain. The IRS is not capable of auditing that many transactions.
Instead, we suggest a bright line: If crypto is held for less than a year — that is, if it is not a long-term capital asset — it should be treated as foreign currency. That would mean that the gain on transactions of $200 or less is exempt and that basis is determined on a reasonable method basis (for example, averaging) rather than item by item. If crypto is held for more than a year, it is an investment and should be taxed as such — that is, as an asset subject to Notice 2014-21. This treatment preserves neutrality between crypto and fiat foreign currencies when crypto is used as a currency.
The U.S. framework for taxing cryptocurrency is unadministrable and ignores the defining feature that distinguishes crypto from other assets: its volatility. A new framework is needed that recognizes crypto’s unique features. Congress should act to provide that framework, overruling the IRS’s position in Notice 2014-21.
1 Stablecoins are not included in this discussion, which focuses on the volatility of cryptocurrency.
2 The Economist, “The Crypto Infrastructure Cracks,” May 12, 2022; and Krugman, “Crashing Crypto: Is This Time Different?” The New York Times, May 17, 2022.
6 Spencer S. Hsu, “U.S. Issues Charges in First Criminal Cryptocurrency Sanctions Case,” The Washington Post, May 16, 2022.
8 That is, that income generally is clearly realized undeniable accessions of wealth the taxpayer has complete control over. Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955).
9 Zachary D. Liscow and Edward G. Fox, “The Psychology of Taxing Capital Income: Evidence From a Survey Experiment on the Realization Rule,” SSRN (May 17, 2021).
10 Reuven S. Avi-Yonah, “Why Tax the Rich: Efficiency, Equity, and Progressive Taxation,” 111 Yale L.J. 1391 (2002).