Investment

Turning Crypto Users into Felons

We frequently comment on the almost uniquely American practice of “criminalization”—the conversion of our daily activities into crimes. For instance, we recently discussed how a Google search for the wrong term could lead to a possible prison sentence.

The $1.2 trillion infrastructure bill President Biden signed on November 15 is the latest example of this trend. It contains two poison pills for anyone who buys or sells cryptocurrencies—what the bill refers to as “digital assets” —that could easily turn them into felons.

The provision that’s received the most publicity requires “brokers” of digital assets to report information for transactions above $10,000 to the IRS. Conceptually, this is similar to the rules requiring that financial institutions that pay interest or dividends to investors should report these payments on Form 1099 to the agency. To comply with this rule, federal law requires brokers to obtain the name, address, and Social Security number of their customers.

This sounds simple enough, but in the context of cryptocurrencies, it’s not. To begin with, the law defines a “broker” as “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” This definition is obviously intended to cover crypto exchanges like Coinbase—but many crypto transactions don’t occur on an exchange.

What’s more, the definition is so broad that crypto miners, and even software developers might need to report crypto transactions above $10,000 to the IRS. This poses a particular risk to miners, who generate income by using computers to perform complex mathematical calculations that verify transactions on a blockchain. In effect, for a decentralized blockchain like bitcoin, all current bitcoin owners jointly pay the miner. Compliance with the law in this situation is obviously impossible.

Another problem is that it’s not possible for an exchange to report accurate information to the IRS unless the same exchange is used for both sides of the transaction. For instance, if you buy crypto on one exchange and sell it on a different one, the value of the entire transaction will show up as a capital gain on the Form 1099 the second exchange sends to the IRS.

A similar issue arises for crypto traders who keep their coins offline, in a “cold wallet.” This is an excellent security strategy to avoid online theft. As a simple example, let’s say you own one bitcoin you purchased several years ago for $20,000. You store it in a Trezor cold wallet. In 2021, you decide to take profits and upload the bitcoin to Coinbase, where you sell it for $60,000. Coinbase has no way of knowing your cost basis, so again the entire value shows up as a capital gain on Form 1099.

Also keep in mind that most domestic crypto exchanges don’t actually issue Form 1099-B, although they will presumably develop this capability before the law goes into effect in 2023. For instance, Coinbase currently issues Form 1099-MISC to its US customers. That form only lists the rewards or fees you’ve earned on Coinbase, not your trading profits or losses. To calculate those, you’ll need a third-party tool like CoinTracker.

But there’s another worrisome part of the bill that’s not as well known, at least not yet. And it’s even worse. It defines all “digital assets” as the equivalent of cash and applies the anti-money-laundering rules that apply to cash transactions to them. That means anyone who receives the equivalent of $10,000 or more in a digital asset must report the transaction to the Treasury’s Financial Crimes Enforcement Network (FinCEN) on Form 8300. If the buyer is purchasing a digital asset (e.g., using bitcoin to purchase Ethereum), they must also file Form 8300.

Failure to comply with these requirements is a felony punishable by a civil penalty not smaller than $25,000 or a criminal penalty ranging from $250,000-$500,000 and a five-year prison sentence. Presumably, it will also be illegal for someone to make a series of smaller but related crypto transactions that if summed up would equal or exceed $10,000 to avoid this reporting obligation. That crime is called “structuring” and is subject to the same penalties.

The problem is that the Form 8300 rules date back to 1984 and are set up to cover the physical receipt of cash. They simply don’t translate to the digital world. For instance, the instructions require the person filing it to “furnish the correct [taxpayer identification number] of the person or persons from whom you receive the cash, and if applicable, the person or persons on whose behalf the transaction is being conducted. You may be subject to penalties for an incorrect or missing TIN.”

This is an impossible burden for crypto traders to overcome. Crypto payments are made to a digital address like “1BvBMSEYstWetqTFn5Au4m4GFg7xJaNVN2.” Most traders don’t know the beneficial owner of the digital address when they send or receive crypto to or from it. The address could be owned by an individual, a business, or have multiple owners. One person can own several different addresses with no personal information available linking them together. What’s more, if the person or company you’re receiving crypto from isn’t US-based, they won’t have a TIN.

This provision is the single biggest reason why many crypto traders will likely become felons in the years ahead.

The good news, if there is any, is that both of these provisions won’t come into effect until 2023. There are already efforts underway in Congress to narrow the definition of “broker.” We can only hope that Congress also revisits the extension of Form 8300 filing requirements to digital assets.

There are no easy solutions here. Calculating capital gains and losses is feasible using third-party software and we recommend you use it to avoid the IRS’s crypto dragnet. However, it seems likely that the gains and losses tracked by such software won’t necessarily match the 1099-B forms crypto exchanges receive from the IRS. If there’s a mismatch, you could start receiving threatening letters from the IRS, which can be time consuming and expensive to resolve.

Perhaps the easiest solution is to conduct all your crypto transactions on a single exchange, so that the Form 1099 it sends to the IRS reflects an accurate picture of your actual capital gains.

The Form 8300 dilemma is even more difficult to resolve. Barring an amendment that strips this reporting obligation from the law, we don’t see any good solutions. However, we think it’s likely that the regulations interpreting the law will be written so that if you buy or sell digital assets through a financial institution, the filing requirement would be waived. Instead, the financial institution would file its own version of the form; a Currency Transaction Report.

And if you’re not willing to comply with the new rules? In that event, you have two options.

  • Option #1 is to risk heavy fines and a possible prison term if you’re caught.

  • Option #2 is to drop out of the system altogether by finding a more crypto-friendly country to live in, acquiring a second citizenship, and subsequently giving up your US citizenship and passport. It may sound like a radical solution, but over the years, we’ve helped dozens of people execute it.

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