Do you need to report your cryptocurrency on a Foreign Bank Account Report (FBAR) (aka FinCEN Report 114)? The IRS recently released an email exchange posing this question. And the American Institute of CPAs (AICPA) just released its own set of comments on the tax treatment of virtual currency that includes commentary on FBAR reporting. The answer all depends on the details, although there’s no downside in erring on the side of caution.
Cryptocurrency is Taxed Like Property
In Notice 2014-21, the IRS announced that convertible virtual currency such as Bitcoin is taxed like property and not currency. Just as with other types of property, the tax treatment of cryptocurrency is based on the specific situation. A day trader in Bitcoin won’t be taxed the same way as a café selling coffee for Ether.
For example, an individual miner that acquires cryptocurrency will have ordinary income. Similarly, an independent contractor who gets paid in Bitcoin will have self-employment income. In contrast, an investor selling Ether at a gain will have capital gain. But the Notice left many questions unanswered, including the reporting rules for virtual currency.
Reporting Requirements for Foreign Assets
Taxpayers must report all their foreign bank accounts on the FBAR. Does this extend to accounts on foreign cryptocurrency exchanges or wallets with cryptocurrency? The stakes are high given the potential FBAR penalties.
Civil penalties for non-willful violations may amount to $12,459 (inflation-adjusted) per violation. For willful violations, FBAR penalties can be the greater of $124,588 (inflation adjusted) or 50% of the account balance at the time of the violation, for each violation. Each year of failing to report amounts to a separate violation, so the amounts can add up very quickly.
Taxpayers file FBARs with FinCEN, not with the IRS. But you may also have to report your bank account on your tax return on IRS Form 8938. Yes, that’s right, Congress has decided you have to report your foreign bank account on two separate forms filed with two separate agencies.
If that wasn’t confusing enough, taxpayers report certain types of accounts and assets only on the FBAR, while others only belong on Form 8938. You can find a summary of the differences on the IRS website. Most importantly, taxpayers have to report equity interests in foreign entities on IRS Form 8938, but not the FBAR. For 10% or greater shareholders of foreign corporations, you also have to file IRS Form 5471.
That means you have to report stock in foreign corporations, interests in foreign hedge funds, partnership interests in foreign partnerships and interests in foreign mutual funds on Form 8938. (But you don’t have to report foreign real estate as long as you hold it directly instead of through an entity.) Even cash-value foreign life insurance contracts are reportable on both forms.
Voluntary Disclosure for Non-compliance
Before the disclosure from a host of Swiss banks, the world of international tax reporting was arcane and often ignored. After all, reasoned many taxpayers, how can a simple individual of relatively modest means be expected to understand such complexity? That all changed with Bradley Birkenfeld. In 2007, Birkenfeld, a private banks who worked in UBS wealth management, provided the IRS with extensive information about U.S. taxpayers who were hiding assets in UBS offshore accounts.
According to the IRS, U.S. taxpayers held as much as $20 billion in undeclared UBS bank accounts. In 2009, one month after UBS agreed to pay an unprecedented fine of $780 million to the U.S. government, the IRS announced the creation of an offshore voluntary disclosure program (OVDP).
Taxpayers who entered the OVDP first paid all the income tax due on their unreported income (plus interest and penalties). On top of that, they paid a penalty equal to 20% of the highest balance in their offshore account. (This OVDP penalty was in lieu of the FBAR penalty and a variety of other tax penalties for failure to report foreign accounts, assets and income.)
In later years, the 20% penalty increased to 27.5%. However, taxpayers who voluntarily came into compliance before the OVDP began may have avoided the offshore penalty altogether. In the end, the OVDP has been a resounding success for the IRS, bringing taxpayers into compliance and increasing revenue. In 2015, the IRS announced that it had received more than 54,000 disclosures through the OVDP, resulting in more than $8 billion of revenue.
The OVDP has existed in one form or another for nearly 10 years. But the IRS recently announced that the OVDP is coming to an end, and it will be officially closed on September 28, 2018. Interestingly, the end of the OVDP marks the beginning of a new chapter in tax compliance: cryptocurrency.
The first salvo in cryptocurrency tax compliance was launched with the IRS litigation against Coinbase, a topic I’ve addressed earlier. In 2016, the IRS served a “John Doe” summon on Coinbase to obtain information on noncompliance by Coinbase accountholders.
The IRS was borrowing a page from their experience obtaining information on accountholders from Swiss banks. The IRS went after the Swiss banks not only because they provided information on noncompliant taxpayers, but also because it provided a powerful incentive for taxpayers to voluntarily enter the OVDP. Once the IRS got information from a bank, accountholders in the bank were no longer eligible for the OVDP. If the IRS discovered a taxpayer based on information garnered from a bank, the taxpayer faced the spectre of much higher penalties compared to the OVDP. This made the OVDP seem relatively attractive and pushed many taxpayers to come forward voluntarily.
The IRS may be deploying a similar strategy with Coinbase. By going after a cryptocurrency exchange, the IRS is showing that it’s trying to mine data efficiently. Of course, owning a Coinbase account is not a criminal. But you have to report income from the account. As Novogratz quipped in a recent New Yorker article as advice to crypto traders, “Pay your taxes!” (Perhaps he should have said “File your FBAR!”)
In the Coinbase litigation, the court ordered Coinbase to release information on transactions (buy, sell, send or receive) that totaled at least $20,000 during the 2013-2015 period. The limitation on the scope of information signaled a partial victory for Coinbase. But it brought little comfort to big accountholders who failed to report.
If history is any lesson, the IRS is not likely to stop with the Coinbase subpoena. They will likely seek information from other cryptocurrency exchanges and seek to develop other sources of information to identify non-compliant taxpayers. The lesson from the OVDP is that early movers who come into compliance earlier rather than later seem to be better off.
Will Cryptocurrency Require a New OVDP?
As the value of cryptocurrency has increased, the government has taken note. The Treasury issued a report in 2016 recommending more action to encourage tax compliance. The IRS has had a contract with an organization that specializes in tracing transactions on the blockchain since 2015. Over the past year or so, the IRS and Department of Justice have been sending criminal tax experts to speak about cryptocurrency with tax professionals and other professional advisors.
At the time of the Coinbase litigation, the IRS apparently considered whether noncompliant Coinbase accountholders should enter the OVDP. But the IRS apparently viewed Coinbase accounts as domestic accounts, not as foreign assets requiring disclosure on FBARs. According to the AICPA report cited above, at least one IRS representative stated that Bitcoin doesn’t belong on an FBAR. But that was back in 2014, and much has changed since then.
The IRS has not yet issued any formal guidance on these issues. The IRS will likely issue a more coordinated and comprehensive set of guidelines for cryptocurrency compliance. One of the biggest issues is whether they will require reporting of accounts held in cryptocurrency exchanges and wallet addresses. For example, what about cryptocurrency held through a foreign exchange?
AICPA recommends requiring taxpayers to report their accounts held through foreign cryptocurrency exchanges, but not on domestic exchanges or wallets. This recommendation makes a great deal of sense, but should there be a blanket exemption for domestic exchanges and wallets? If the IRS requires all domestic exchanges to report transactions on IRS Form 1099 (such as Coinbase is already embracing), then it may make sense to exempt domestic exchanges.
Will the IRS require reporting wallets? It’s hard to imagine a blanket exemption for wallets if domestic exchanges report transactions on 1099s and taxpayers report foreign exchanges on FBARs. Alas, reporting of wallets raises further questions. For example, what about a taxpayer that controls a wallet that is beneficially owned by an entity?
After repeatedly extending the due date, the IRS and FinCEN require individuals with signature authority over foreign bank accounts to report their accounts on an FBAR. Even if the accountholder does not beneficially own the account, mere signature authority is enough to require reporting. Would the IRS require similar reporting for individuals with control over wallets for entities? What about reporting for multi-sig wallets?
Historically, tax policy often evolves by application of existing rules to new situations. This doesn’t always lead to the most coordinated or sensible set of policies as the IRS creates new rules and standards based on applying existing rules to new situations rather than crafting a new set of rules that provide a comprehensive framework. It’s likely the IRS will take a similar approach for cryptocurrency, creating reporting rules based on analogy to existing financial assets or commodities. One way or another, new rules are likely to arrive. Investors would be well advised to take note of the signs of movement in this area and take steps to get into compliance today.