Introduction
Taxpayers are required to report their cryptocurrency transactions on their tax returns. The Internal Revenue Service (“IRS”) has made clear that income generated from mining activities qualifies as taxable income. Mining cryptocurrency is a taxable event and must be reported to the IRS at the fair market value of the mined coins at the time they are received and is also a taxable event when the mined cryptocurrencies are sold/disposed. The IRS views crypto mining income as ordinary income, which is taxed as ordinary income at tax rates from 10% to 37% and the disposition of mined crypto as capital gains/losses.
The tax forms that mined incomes are to be reported upon depend on whether the cryptocurrencies were mined as a hobby or as a part of regular business activities. It is incumbent upon taxpayers to not only stay compliant with evolving IRS guidance on mining activities but also to keep detailed records of the cryptocurrency mined coins, fair market values at the time earned, and so on. Filing a false return or evading the obligation to report all mining activities on your tax return could lead to serious criminal fines and penalties, charges of contempt and perjury, and possibly jail time. Retaining an attorney experienced in mining reporting obligations and new IRS tax guidances is the first step to your defense.
The Blockchain and Crypto Mining
The blockchain is the distributed and decentralized public ledger where all transactions are stored. It provides for a secure, permanent record of transactions that are verified via peer-to-peer networks. Cryptocurrency mining is the process of verifying cryptocurrency transactions by using computers to solve complex mathematical equations. The first miner to “solve” the algorithm will often receive an award in the form of cryptocurrencies for solving the equation. Once the transaction is verified by the “winning” miner, all miners will be able to quickly verify that the solution solves the problem.
Validated transactions form a “block” containing transaction details and are then transferred to the blockchain. Every transaction is public, but the individual parties involved in the transaction are not identified—making cryptocurrency transactions not anonymous but pseudonymous. Mining uses substantial computing power and is very expensive. Also important, it creates many tax implications and can involve reporting on separate IRS forms.
“Mining cryptocurrency produces numerous tax implications that must be reported on separate forms. These obligations can differ depending on whether the cryptocurrency was mined as a hobby or as a business. As mining activities are becoming more prevalent, taxpayers should be aware of the triggering events that require income recognition. The IRS has increased its scrutiny regarding taxpayer mining activities. Failing to report these mining activities or reporting inaccurate earnings amounts on your tax forms could lead to IRS audits as well as criminal penalties and jail time in extreme cases. If a criminal prosecution is initiated, possible charges include tax evasion, filing false returns, contempt, perjury, etc. A criminal defense attorney will vigorously defend you against these charges.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.
Crypto Mining Activities as Taxable Events
Two Taxable Events
Mining cryptocurrencies could be subject to two different tax recognition events. The first tax event occurs when the taxpayer “mines” cryptocurrencies and receives new cryptocurrency as a reward. The second tax event occurs when the taxpayer disposes of their new cryptocurrency at a later date. The former transaction is taxed as ordinary income, while the latter is taxed at capital gains rates.
- First taxable event: The first tax trigger for mining activities takes place when cryptocurrency is deposited into the taxpayer’s wallet as a result of successfully verifying or “mining” transactions. The taxpayer will therefore owe taxes on the mined income at the time it is earned. This is true even if the value of the mined crypto creates a loss or a gain the year after.
- Second taxable event: The second tax trigger for mining activities takes place when the taxpayer sells, exchanges, or otherwise disposes of the mined cryptocurrency. The taxpayer will have a capital gain or capital loss from the sale/disposition. If the cryptocurrency was held for one year or less, there is a short-term capital gain/loss. If the cryptocurrency was held for over one year, there is a long-term capital gain/loss.
IRS Guidance
Taxpayers earn taxable income from mining activities when they receive a reward for successfully verifying a new block that is transferred to the blockchain. IRS Notice 2014-21 provides that the virtual currency received from mining activities must be included in gross income at fair market value at the time of receipt. It helps to keep detailed mining records of when cryptocurrency is created (mined), how much was created, and what the fair market value was when received. The income recognized becomes the taxpayer’s cost basis in the mined cryptocurrency. Once the cryptocurrency is sold, the capital gains or losses recognized is the fair market value at the time of the sale/disposition minus the cost basis. In other words, if there is a capital gain, the capital gains tax is incurred only on the capital gains amount—the increase in value.
Example
Suppose the taxpayer earns 0.5 Bitcoin from mining activities. If Bitcoin is valued at $40,000 (fair market value), the taxpayer would have a realized income of $20,000. This is ordinary income. It is also the taxpayer’s cost basis in the mined cryptocurrency. The taxpayer holds on to the 0.5 Bitcoin for two years and then sells. At the end of the second tax year, Bitcoin is valued at $60,000, meaning the value of taxpayer’s 0.5 Bitcoin is worth $30,000. The taxpayer would therefore realize a long-term capital gain of $10,000 ($30,000 fair market value at time of disposition minus $10,000 cost basis at the time the cryptocurrency was mined). The $10,000 capital gain is taxed at preferential long-term capital gains tax rates.
Mining as a Hobby versus Mining as a Business
Many taxpayers are unaware or are just starting to realize that cryptocurrency mining could lead to taxes. Those who understand this may not know where or on what form to report their mined cryptocurrency.
Hobby
If crypto was mined as the taxpayer’s hobby, the crypto earned is reported as income on Schedule 1 (Form 1040) as “other income.” It is taxed at the tax rate of the taxpayer’s income bracket. While mining as a hobby is quick and easy to report on the taxpayer’s tax forms, a disadvantage is that hobby income is not eligible for the usual business deductions.
Business
Mining is a unique activity because there is generally no employer to issue a W-2 to their employees. Mining companies also do not generally issue Forms 1099-MISC to their independent contractors. IRS Notice 2014-21 provides that the taxpayer may be subject to self-employment tax as a result of their mining activities. For instance, if the taxpayer’s mining activities were a part of a trade or business and the mining by the taxpayer was not undertaken as an employee, the net earnings amount (minus allowable deductions) of those mining activities is self-employment income and subject to self-employment tax. If mining was conducted as a business, the earnings are reported as income on Schedule C.
Business Deductions for Mining Cryptocurrency
There may be several mining deductions available for a business, not for mining as a hobby. Section 162 of the Internal Revenue Code allows for a deduction of “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Examples of deductions include electricity, repairs, rental unit, and equipment for mining. Also, if the mining business loses money within the tax year, it may be eligible to offset those losses against other income.
Conclusion
Crypto mining is a novel activity that involves the verification of virtual currency transactions by solving a complex mathematical equation. The first miner to solve the problem is often given a reward in the form of new coins. The receipt of coins from mining is subject to two tax recognition events: one when the coins are earned and the other when the taxpayer eventually, if ever, sells or otherwise disposes the coin. The IRS deems the first taxable event as ordinary income and the second as capital gains/losses. As a result, because these obligations are mandatory, the IRS will waste no time investigating and prosecuting their violation. Tax evasion and filing false returns are criminal offenses and could subject you to substantial criminal penalties and jail time. Accurate reporting, retaining an experienced defense attorney, and detailed recordkeeping are the keys to full IRS tax compliance. Contact Oberheiden P.C. today.
As a seasoned tax professional deeply entrenched in the cryptocurrency space, I have a comprehensive understanding of the intricate taxation regulations surrounding crypto mining. My expertise in this domain stems from extensive hands-on experience navigating the complexities of cryptocurrency transactions, combined with a continuous vigilance regarding IRS guidelines and evolving legal frameworks.
Cryptocurrency mining, the process of validating transactions through complex computations, is a key element in the blockchain network. It involves receiving rewards in the form of newly minted coins for successfully solving these mathematical problems. The taxation of these rewards is a critical aspect that taxpayers must understand and adhere to, as highlighted by the Internal Revenue Service (IRS).
The IRS, through Notice 2014-21, clarified that income generated from mining activities is taxable. It categorizes the income earned from mining as ordinary income, taxed at rates varying from 10% to 37%. The fair market value of mined coins at the time of receipt serves as the basis for determining this taxable income. Additionally, when these mined cryptocurrencies are sold or disposed of, they are subjected to capital gains or losses, taxed at preferential rates based on the holding period.
One significant aspect to note is the differentiation between mining as a hobby and mining as a business. The reporting requirements and tax treatments vary based on this distinction. Hobbyist miners report their income on Schedule 1 (Form 1040) as "other income," while business miners must report their earnings on Schedule C, potentially subjecting them to self-employment tax obligations.
Detailed record-keeping is crucial in ensuring compliance with IRS guidelines. Maintaining records of mined coins, their fair market values at the time of acquisition, and subsequent transactions is imperative to accurately report income and capital gains/losses.
Moreover, the IRS's strict stance on compliance underscores the importance of accurate reporting. Failure to comply or reporting inaccurate earnings can lead to audits, substantial fines, and, in extreme cases, criminal charges such as tax evasion, filing false returns, contempt, and perjury.
For effective defense against potential IRS investigations or legal ramifications, seeking counsel from experienced attorneys well-versed in cryptocurrency mining reporting obligations, such as those at Oberheiden P.C., is highly advisable. These professionals can guide individuals through the complex tax landscape and provide a robust defense strategy in case of any legal scrutiny.
In summary, staying abreast of IRS regulations, meticulous record-keeping, accurate reporting, and seeking expert legal counsel are fundamental in ensuring full compliance with tax obligations related to cryptocurrency mining.
