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Why IRS Cryptocurrency Efforts Continuously Fail

Posted on June 18, 2019

Gary Alford, the IRS special agent who helped bring down Silk Road, recently put taxpayers on notice that gains from cryptocurrencies are under attack. But how can Treasury and the IRS attack cryptocurrency gains, which they have specifically failed to define and easily could? That's their responsibility to taxpayers.

The IRS has said cryptocurrency is property. But anything one can possess is property. You don’t have to be an intellectual property lawyer to know that tangible and intangible assets of almost all kinds are property. But if crypto is a share of investment in an entity, exchanging it certainly can be tax free. In fact, depending on any differing legal entitlements of the investment, an exchange of cryptocurrency may not even constitute a realization event. Calling soda "pop" doesn’t create tax per se.

Stocks have suffered the same definition-related issues. There's no singular definition of stock, just like there is no definition of crypto. Sure, stocks are generally the total number of shares of a corporation’s rights allocated among its shareholders. But what rights?  Well, maybe voting rights, maybe earnings, or maybe liquidation proceeds (when they exist, of course). When those rights are lacking, however, the shares still represent the relationship between the company and the stockholder, and are generally treated as such. 

Continuity of ownership for corporate reorganizations has been extended to those who have no chance at seeing earnings. Voting stock is commonly found when shares bestow no voting rights on their owners. Even tracking stock allows holders to look primarily at a small percentage of specified assets of an entity, so long as the corporation owns the assets and all the benefits and burdens of owning those assets don't lie with the shareholders. Interests in partnerships are just as diverse in their potential “bundle of rights” and obligations, and are in many ways granted even more flexibility in the tax laws. 

Crypto investors who engage in an exchange may have taxable gain. But just like stockholders, they may not. Not defining an asset may allow the IRS to make veiled threats, but it also tips its hand: The IRS is not sure what crypto really is, and not sure how to attack an exchange or what attributes would even make it a taxable exchange. The IRS may want to be able to settle out after realizing that like stock, crypto is simply a bundle of rights of ownership that may or may not have been cashed out depending on the facts and circumstances. 

But those who own crypto have formed coalitions around the world, as groups of corporate investors have done, to ensure that tax is incurred only when there's a true realization of wealth and not merely continued ownership under modified form. Has the IRS made clear when exchanged rights are so different that the holders have cashed in, and not merely continued their investment, as it has done in so many analogous places? The IRS could threaten to tax any transfer of assets from one disregarded entity to another, but that would be another losing battle. The analogy may not be that different. Just look at series LLCs: The simple separation of funds doesn't create separate stocks or investments, and the same should be the case with cryptocurrencies. 

If the IRS wants to attack crypto gains, it must do more than say they're an exchange of property. Almost any capital infusion event is an exchange and triggers no tax upon the issuance of a legal obligation or equity investment for cash. When the separate companies holding the capital make changes, those changes generally don’t result in taxes for their owners either. 

The IRS must state what crypto is and how it should be treated if it's to be properly taxed. Like stock, there shouldn't be a one-size-fits-all definition. Common crypto, preferred crypto, nonqualified crypto, and contingent crypto should be evaluated separately.  

The IRS chief counsel corporate tax experts are well versed in how different exchange-traded investments can be defined for various purposes. Yet the “property” definition — or lacking definition — for crypto has the corporate, partnership, financial products, currency, international, and procedural folks at the IRS all asking each other who should really own the topic. Cryptocurrency is a publicly traded investment with constant exchanges. Come on. Section 1012 and its underlying regulations on stock, securities, investment companies, brokers, and calculating gain may be a good place to look, with the help of those with expertise in defining nonqualifying taxable exchanges. 

Sure, it can get complicated. Try this: Grab the folks who deal with the characterization of interests on traded exchanges most often, then define the categories of crypto investments, and then tax the nonqualifying exchanges that are clearly gains resulting from realization and recognition. Unfortunately, after recent market dips you may find many crypto investors claiming mostly losses. Otherwise, focus on the handful of folks who aren’t properly complying with the guidance and Q&As on virtual currency that the IRS has published — essentially those laundering money and engaging in full-blown evasion.   

Silk Road wasn't alone, and those criminal issues deserve attention. But for the millions of investors hoping to comply with the rules, please give them tax rules to follow. The analogies are numerous in tax. Conflating Silk Road investigations with the rights of taxpayers to obtain clear tax guidance is simply unwarranted. It makes the IRS look incapable of doing its job of clearly communicating the rules and rights applicable to taxpayers. 

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