Accounting for Cryptocurrency Gains

****NOTE: This blog post assumes you have a working knowledge of Notice 2014-21.****

Earlier in this blog, I addressed financial audits of cryptocurrency companies, and that’s a work in progress. What about tax accounting?

I advise a lot of cryptocurrency companies about their regulatory compliance obligations. However, their income tax reporting is often quite simple. If they are earning income in cryptocurrencies, they choose a strategy for valuation, place on Schedule C or Form 1120 and then reduce by business expenses incurred throughout the year.

Many businesses and individuals, however, have a far more serious problem once the income hits Schedule D. Sales of capital assets are taxed on a net figure, the gain is reduced by “the” cost basis. There is a specific purchase price that must be applied, from a purchase that happened at a specific date and time. How do you find your cost basis in your records? This is a subject of many regulations related to stock trading. But we can find a rather simple solution built into the technology: new addresses can be used to create separate pools of cryptocurrency, to distinguish transactions and to otherwise derive a simple result.

This gives us two potential “best practices” for accounting records in cryptocurrencies:

  1. If you are receiving cryptocurrency in a few large transactions (investor/user), but spending it in many small transactions: Generate an exclusive sending address (for Multibit users this requires a new wallet) every time you accept cryptocurrency, and label each wallet with the market value of the cryptocurrency when you accept it. Every time you spend, you are using up a portion of that cost basis. Note that this is NOT the same as generating a new receiving address, due to the way common wallet software works – even if you generate a new receiving address, you might not be able to control the sending address.
  2. If you are receiving cryptocurrency in many small transactions (business), but spending it in a few large “cash out” transactions: If you are cashing out all of your cryptocurrency in one transaction, you can add up the value of every receipt transaction – there is no need to differentiate between them. You are not making pools of cryptocurrency by basis as recommended in 1. Instead, you are making pools of cryptocurrency based on your expected conversion to dollars schedule. These should be organized by blocks of time, if you intend to try to take advantage of capital gain rates and hold your income for a long time. However, if you aren’t, you can hold them according to your liquidation schedule. The “cash out” transaction has to empty the address each time for this to work.

Note that if you are dealing with truly micro-transactions, and your gain on the transaction is less than $0.50,  you may be permitted to round down on Form 8949 (which gives totals for Schedule D) to zero. So transactions resulting in capital gain under $0.50 may not even be listed (the accounting records should be maintained, however). This does not apply for your business income on Schedule C, because all income is listed together on one line. Please consult with your tax advisor about this question.

Software solutions would help people between these cases: Multibit, the biggest wallet client, does not allow you to specify which address you are sending bitcoins from. If your wallet provides this, or Multibit adds this service, it will be easier to do what I have described above. Again, a work in progress.