Crypto-currency may be a tax nightmare for the Internal Revenue Service (IRS) and give criminals an angle even Al Capone didn’t have.
Commodities Futures Trading Commission Chairman Christopher Giancarlo was testifying in front of the Senate Agriculture, Nutrition and Forestry Committee in a hearing entitled State of the CFTC: Examining Pending Rules, Cryptocurrency Regulation, and Cross-Border Agreements.
During the hearing, Giancarlo was asked a series of questions by Democratic Senator from North Dakota Heidi Heitkamp: “Most of the trading and most of the work that’s being done on crypto-currency – whether it’s on bitcoin or other crypto-currencies – is really going under the tax radar. So, the disruption that may happen in other kinds of participation in markets may transition to a crypto-currency market because it is the new hot thing but also because if you think that you can gain 35% or 25%, or whatever your effective tax rate is, by moving over, that has some destabilizing effect.
“Can you comment about the tax consequences on crypto-currency and what you think you and the SEC could be doing to highlight that concern? After all, even Al Capone had to pay taxes.”
“I know that a lot of people in the crypto community may be watching this hearing,” Giancarlo responded speaking directly to crypto-currency traders. “So this is a very good opportunity to remind them that taxes are due on crypto currency transactions that may be taxable. So, this is not an off-the-grid-from-a-tax-point-of-view environment.”
“Tell me what the 1099 consequences are of crypto-currency transactions?” Heitkamp then asked.
“I’m not an expert in this, but it (IRS) treats it as an asset,” Giancarlo responded. “Appreciation of an asset means that a tax may be due for that appreciation for that capital gain.”
“Typically, how the IRS would know if I made a trade in the equity markets or your markets is I’d get a 1099, and then there would be accountability. Tell me whether or not you think 1099s are being enforced in the crypto-currency space,” Heitkamp asked next.
“I don’t have data to that; my suspicion is not to a great extent.” Giancarlo noted.
“That is a problem,” Heitkamp noted, bluntly.
This technical exchange has transformative consequences for crypto-currency trading; it means that crypto-currency fraudsters get away with something even Al Capone couldn’t get away with.
Crypto-Currency is an Outlaw Currency
From the very first white paper on Bitcoin, the most appealing idea behind crypto-currency was its outlaw characteristics.
Crypto-currencies cross borders, they aren’t beholden to the whims and spending habits of governments, and they are encrypted for maximum privacy.
It’s no coincidence that the most successful practical use of crypto-currency was by an outlaw, Ross William Ulbrecht, who created the Silk Road – the dark market place for things like illicit drugs. The Silk Road – first created in 2011 – transacted entirely by Bitcoin. And the reason for this is obvious: if you’re going to traffic in illegal goods, an anonymous form of currency transaction is best.
It’s also not coincidental that the Silk Road remains the most successful practical application of crypto-currency. In terms of the number of crypto-currency transactions, nothing else comes close to the Silk Road.
Al Capone, other Outlaws, and the IRS
The reference Heitkamp made to Al Capone is notorious in American history. The well-known gangster ordered the killing of seven people in the St. Valentine’s Day Massacre alone, but for a multitude of reasons he was never prosecuted for any violent crime; instead, he was convicted of tax evasion, a conviction which still ended his criminal career at the tender age of 32.
Though Hollywood gives credit to Elliott Ness for being principally responsible for bringing down Capone, it was actually an Internal Revenue Service (IRS) agent named Frank Wilson who led the investigation into Capone for tax evasion; Capone was convicted on three counts of tax evasion but sentenced to the maximum eleven-year sentence in 1931.
That take down has earned the IRS so-called street credibility even to this day as the go-to agency for taking down the bad guys.
Really shrewd outlaws could hide their illicit activity from everyone – even the FBI – except the tax man, the perception became.
Crypto-currencies present extra challenges for the IRS. By their very nature, profiting in them is difficult to track and their anonymous nature also makes them effective in laundering other illicit profits.
As Heitkamp implied, crypto-currencies present the IRS with challenges which give shrewd outlaws opportunities even Al Capone didn’t have.
It’s further important to note that while the IRS would have authority to investigate tax cheats, only the US Department of Justice can prosecute them criminally.
While Wilson headed his investigation, Capone was prosecuted by a prosecutor in the US Attorney’s Office named George Johnson.
It’s noteworthy that an IRS agent named Mike Malone was embedded in Capone’s organization. Ness, a prohibition agent, was responsible for investigating Capone’s illegal liquor empire, and while Capone was never convicted of this charge, Ness hurt his organization with his many raids and focused Capone’s energies on him, allowing Wilson to operate quietly.
The actual takedown of Capone was among the most sophisticated criminal investigations ever, and while Wilson headed the tax investigation, the credit should be shared among all involved.
Ulbricht, of Silk Road fame, was also taken down by a multi-agency task force – most sophisticated criminals using crypto-currency would be investigated by numerous agencies.
Crypto-currency trading and the IRS
As Chairman Giancarlo noted, the honest trader should view profits from crypto-currency trading as no different from profits made when trading in any other security.
Brian Crowley is a Certified Public Accountant and proprietor of Crowley Accounting and Consulting Services
He concurred, saying that crypto-currency profits can be taxed in one of two ways: at the capital gains tax rate or the ordinary income tax rate.
According to Crowley, the capital gains tax rate would occur when a security is held for a year or more before cashing in, while the ordinary income tax rate is for any profit which occurs in less than a year.
The calculation of each individual’s capital gains tax rate is quite complicated and dependent on their individual tax bracket, but the capital gains rate is lower.
The ordinary income tax rate was recently reduced across the board in the tax cuts passed late last year; the highest is currently at 39.6%.
Crypto-currency and the 1099
Crowley said that 1009 is an “Information return so that government knows how much each individual makes.”
In the US, Crowley noted, income generated by an employee of a company is documented by a W2 form, while many other sources of income, like interest income, dividend income, investment income, and income from contract work, are documented in a form 1099.
With traditional investments, the company holding the investment – be it E Trade, Goldman Sachs, Fidelity, or whoever – would send the taxpayer a 1099 for the year, which the taxpayer would use to file their taxes.
In the context of crypto-currency, the exchange or wallet which executed the trades would then be required to send 1099 forms to the trader. But, as Giancarlo noted, he does not believe many of them are complying.
That happens for several reasons. Exchanges and crypto-currency trading platforms like Bitfinex are totally out of the reach of US regulators like the CFTC and SEC, and they are often created overseas and thereby mostly out of the reach of the IRS.
That’s not to say that the IRS is helpless. After all, it wasn’t as though Al Capone’s gambling dens, brothels, and alcohol distribution networks were regulated; indeed, quite the opposite.
But unregulated exchanges and platforms dealing in crypto-currency designed for maximum anonymity and privacy present tax evasion challenges that provide outlaws with advantages that even Capone did not have.