What is Operation Hidden Treasure?

In early March 2021, the IRS has issued directives to address taxable transactions, sales, and exchanges regarding virtual currency in the upcoming tax years in an attempt to get ahead of individuals and businesses utilizing cryptocurrencies.

More specifically, with this directive, the IRS is moving to identify individuals who own and regularly transact virtual currency within the scope of “tax evasion signatures” including “structuring” virtual currency transactions in increments of less than $10,000 to avoid certain income reporting requirements.

According to numerous news articles released after the IRS public announcement, the IRS is actively (and has previously been) coordinating with sophisticated (third party) vendors to identify and subsequently investigate potential tax evasion signatures related to virtual currency and the potential unreported virtual currency transactions. Damon Rowe, the Director of the Office of Fraud Enforcement at the Internal Revenue Service, announced at a Federal Bar Association presentation on fraud enforcement priorities that the office has “added some crown jewels,” including a dedicated team of IRS Criminal Investigation professionals who are working on “Operation Hidden Treasure.”

Operation Hidden Treasure is comprised of agents who are trained in cryptocurrency and virtual currency tracking, and who are focused on taxpayers who omit cryptocurrency income from their tax returns. Operation Hidden Treasure is a partnership between the civil (IRS) office of fraud enforcement and the IRS Criminal Investigation Unit to root out tax evasion from cryptocurrency owners.

So, what is virtual currency (VC) anyways?

In the simplest of terms, according to the IRS FAQ definition(s), virtual currency is “a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.  Some virtual currencies are “convertible,” which means that they have an equivalent value in real currency or act as a substitute for real currency. In summary, virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the United States dollar or a foreign currency, per IRS Rev. Rul. 2019-24. For reference, there is about 3,000 different, active cryptocurrencies and an estimate of more than 6,000 in total since 2018. Additionally, the IRS has issued more than 10,000 notification letters (Notice CP-2000) to individuals whom the Services has concluded did not report taxable virtual currency transactions since 2018. So the IRS knows if you have cryptocurrency! You can find the IRS FAQ’s regarding virtual currency here: https://www.irs.gov/individuals/international-taxpayers/frequently-asked-questions-on-virtual-currency-transactions. Additional VC definitions and terms can be found on the IRS web-site link here: https://www.irs.gov/businesses/small-businesses-self-employed/virtual-currencies. 

Taxable events

What is a deemed taxable VC event?

• Convert Bitcoin to a flat sale.
• Exchange Bitcoin for another virtual currency.
• Make a purchase with Bitcoin or other virtual currency.
• Use Bitcoin to pay for goods and/or services.

Then you may have to report a taxable transaction on your federal tax return with ordinary and capital income or loss dependent on the type of transaction you undertake. For example, if you sell or exchange Bitcoin for another virtual currency, then you would report a capital gain or loss of Bitcoin on your Schedule D via Form 8949 to report that virtual currency transaction. Additionally, for example, if you use Bitcoin to pay for labor services or you receive virtual currency for payment for services rendered, then you would a taxable income event for receipt of that virtual currency subject to income and/or self-employment tax(es).

But what about nontaxable VC events?

Won’t we have some nontaxable transactions with virtual currencies? Yes.  In summary, non- taxable events include but are not limited to the following: purchases of coin with fiat – any currency secured by a government, transferring fiat out of an exchange, moving coin(s) from one exchange to another exchange, and lastly, moving coin(s) from exchange to your electronic wallet, for example. Additionally, given IRS Revenue Ruling 2019-24, a taxpayer does not have gross income under Section 61 as a result of a “hard fork of a cryptocurrency” the taxpayer owns if the taxpayer does not receive units of a/the new cryptocurrency. Contrastingly, a taxpayer has gross income, ordinary in character, under Section 61 as a result of an “airdrop” of a new cryptocurrency following a “hard fork” if the taxpayer receives unites of (the) new cryptocurrency. A hard fork is when a new cryptocurrency is created on the cryptocurrency’s Blockchain effectively digitally splitting the cryptocurrency creating a new cryptocurrency. IRS Sec.61 summarizes “all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion, are included in gross income, Comm. v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955); moreover, income is ordinary unless it is gain from the sale or exchange of a capital assets or a special rule applies. So, are you holding Bitcoin as an investment, a payment source or both? Answers to those questions should be asked because the reporting will change based on the answers. 

Operation Hidden Treasure Finds Non-Filers

With this newly unveiled initiative, the IRS is actively working – and has been for years – towards finding, and identifying particular American taxpayers, more specifically non-filers, who they now know own, regularly transact, exchange and/or barter with virtual currency that are now deemed taxable transactions required to be reported by the IRS. Additionally, with this new IRS directive, the IRS is now more actively tracing cryptocurrency transactions in an attempt to identify American taxpayers who are omitting higher dollar crypto-related transactions based on improved virtual currency tracking diagnostics that may or may elicit taxable transactions resulting in additional income taxes to the Treasury. In all of this, the IRS, in my humble opinion, is clearly further attempting to identify a new taxpayer base involving taxable virtual currency transactions in an attempt to derive increased tax revenues into the Treasury. 

Of note, as of April 2021, the IRS does not have a voluntary disclosure program for virtual currency nor does it appear the IRS is so inclined to initiate a voluntary disclosure program. 

If you have involved yourself with any virtual currencies, transactions, purchases, sales, exchanges, etc. it is best practice to confer with your CPA, or tax return preparer and/or a local tax attorney whom may have a virtual currency team or specialist to further assist you with your virtual currency concerns. In response to this initiative announced, all American taxpayers should take reasonable, responsible steps in reporting virtual currency activity within their US federal income tax returns by checking the box “yes” regarding VC activity as well as report any sales, purchases, transactions, exchanges or bartering of VC to your CPA for tax year(s) in which those VC transactions, activity occurred. At this point, you would rather be on the right side of tax law just in case the IRS comes knocking at your door years from now. Next month, we will explore virtual currency mining and the related tax effects.

Now let’s develop and address the tax consequences related to the mining of virtual currencies such as Bitcoin, Ethereum, etc. as well as related tax issues, reporting surrounding charitable donations of your virtual currency.

Recently, a client asked for a meeting to address certain virtual currency activities including (data) mining for virtual currency that they had undertaken vigorously in 2020. This piqued my interest, to say the least, especially after writing the article linked above. In summary, this particular client has undertaken (data) mining of the virtual currency, Ethereum, as well as participating in other virtual currency ideas and transactions with tax consequences. 

As a reminder, per the IRS, virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency. For more information on the tax treatment of virtual currencies, see Notice 2014-21. On top of that, you must report income, gain, or loss from all taxable transactions involving virtual currency on your Federal income tax return for the taxable year of the transaction, regardless of the amount or whether you receive a payee statement or information return.

Let’s explore simpler transactions and reporting, and then move to more detailed transactions.

First question: What are the tax consequences if I mine virtual currency and/or receive digital compensation for the mining of virtual currency? In all, once you successfully mine in full or in part (a) virtual currency, the IRS has deemed that a taxable transaction for which ordinary income to the “holder”, the owner of the mined virtual currency, should be reported to the IRS by the “holder”. If these virtual “monies” are received in part(s) or in full during the taxable year, it would be best for the “holder”, the owner of the virtual currency, to catalogue and track the exact amount of virtual currency, bitcoin, ethereum, etc. mined as well as the value as of the receipt date of the specific virtual currency so that those amounts can be presented to your CPA or local tax representative who prepares your tax returns. With this information, your CPA and or local tax rep should check the box required for virtual currency activity on Form 1040, pg.1, and then outline the taxable transactions, to what extent is deemed ordinary taxable income via Form 1040, Schedule 1, Other Income, for the amounts of those mining transactions in total. 

Second question: What if I sell some or all of the virtual currency I mined and/or purchased previously? As a reminder, per the IRS, when you sell (a) virtual currency, you must recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of the capital loss(es). For more information on capital assets, gains, and losses, see Publication 544, Sales and Other Dispositions of Assets. Additionally, your gross sales price will be what you sold the virtual currency for on the date of sale given the specific virtual currency index and your cost basis will be the previously recognized FMV (fair market value) of said virtual currency on the date of receipt, as previously recognized in ordinary income from mining prior. Therefore, you would have a recognized capital gain or loss from your sale of virtual currency reported on Schedule D, and if capital loss(es) recognized, that capital loss(es) would be further limited to $3,000 given the capital loss limit requirements. These transactions, sales, dispositions, etc. should be reported with Form 1040 via Form 8949 and/or Schedule D to the extent required with an additional classification of short-term, less than a year, and long-term, more than a year.

Third question: What if I received cryptocurrency as a bona fide gift? Do I have taxable income? Generally, no. if you receive cryptocurrency as a bona fide gift – not for performed services, or other income producing activities – then, you will not be required to recognize income until you sell, exchange, or otherwise dispose of the gifted virtual currency. Additionally, your basis in that virtual currency received as a bona fide gift will depend on whether or not you have held said gifted virtual currency for a year or less.  If recognizable gain required, your basis is the donor’s basis, plus any gift tax paid; however, if you sell for a loss, then our basis in the virtual currency will be the lesser of the donor’s basis (or) the fair market value of the virtual currency at time you received the gift. Lastly, the IRS states, if you do not have documentation to verify donor’s basis, then your basis will be deemed to be zero. For more information on basis of property received as a gift, see Publication 551, Basis of Assets.

Fourth question: What if I donate some or all of my virtual currency I mined and/or purchased previously? What do I report? Very interesting question for which more details will be needed on an individual basis. For reference, per the IRS, virtual currency is property and treated for capital gain and loss as well as charitable contribution deductions similarly as stock – a noncash contribution. Therefore, what if you were to donate stock and/or virtual currency to your church or another charitable organization? What happens then? In summary, if you donate virtual currency to a charitable organization as described in the Internal Revenue Code Section 170(c), you will not be required to recognize taxable income, or (a) gain or loss from that charitable contribution donation similarly to how no income, gain or loss would be required if you donated stock as a noncash charitable contribution. For more information on charitable contributions, see Publication 526, Charitable Contributions.

Fifth question: What is my charitable contribution deduction if I donate virtual currency to my church or another valid charitable organization? In general, your charitable contribution deduction will be equal to the fair market value of the virtual currency at the specific date and time of the (virtual currency) donation if you have held the virtual currency for more than one year.  If you have held the virtual currency for one year or less at the specific date and time of the donation, your deduction is the lesser of your basis in the virtual currency or the virtual currency’s fair market value at the time of the contribution. Presuming the cryptocurrency continues to increase in value, as Bitcoin and Ethereum have, it’s likely best to hold for one year before you donate so you’re able to take advantage of claiming the FMV on the date of the gift. Additionally, if the donated virtual currency is worth more than $250 and under $5,000 at the date and time of gift, you and the charitable organization should execute Form 8283 – Noncash Charitable Contributions, to acknowledge receipt of the charitable donated property. Moreover, if the cryptocurrency donation is worth more than $5,000, along with Form 8283 and both parties signature acknowledgements it would be best to attach the indexed value for the date of the gift.

Additional information can be found here: IRS Virtual Currencies, as well as Notice 2014-21 and Rev. Rul. 2019-24. Moreover, if you have any other virtual currency questions, concerns, etc. you can submit an inquiry on the “Contact Us” page of our website. Our team would be happy to help, wherever we can.