Section 988(e)(2) Would Never Have Applied

…or at least, would have been so strenuously fought by the IRS that you wouldn’t want to bother with it anyway.

When Notice 2014-21 came out two weeks ago, there was much wailing and gnashing of teeth because the IRS didn’t say cryptocurrencies should get currency treatment under Section 988. But what exactly did we lose?

  1. Most of Section 988 is about ordinary income tax treatment for businesses that have foreign currency gains. These gains can arise from outright ownership in the course of conducting business, hedging derivatives, debt denominated in foreign currency, and several other activities. Businesses generally like this, because the losses are ordinary income losses rather than useless capital losses.
  2. Section 988 also gives ordinary income tax treatment for individuals with foreign currency gains that relate to their business. The way the code defines that category is by saying “If you would take business deductions from the income, it’s ordinary income.” Simple enough, right? Again, this is good because when it’s related to business activity we want to be able to deduct ordinary losses. It goes a little further, though, and even include foreign currency gain that relates to investment activity. It’s determined by the income for which investment deductions are permitted under Section 212. (Section 988(e)(3)).
  3. Section 988 applies to a third category: individuals earning foreign currency gains that neither relate to business nor investment. These gains benefit from two very favorable provisions: First, they are taxed as capital gain. Second, and this is the source of the wailing and gnashing of teeth, there is no tax on gain of less than $200 per transaction. So when you buy your drink & drown on the Juarez strip with your old stash of pesos, you don’t have to pay tax on the change in value against the dollar. (Section 988(e)(1) and (2)).

So, it looks like there are three beneficial categories of gain under Section 988 that we do not get to benefit from after Notice 2014-21. However, category 3 is an empty set.

Why is Category 3 an Empty Set for Cryptocurrencies?

I’m going to paint a picture of what would have happened to all the cryptocurrency users that tried to take advantage of category 3.

Treasury Regulation 1.212-1 defines investment activity for the purposes of 212 deductions, which are taxed under category 2. This is a weird set of mechanics occasionally seen in the tax code – in order to understand what investment income is, we have to look at what income the deductions may be related to. Essentially we are reverse-engineering the difference between categories 2 and 3 of Section 988 income based on the difference between category 2 and category 3 deductions.

This is where it gets ugly. The income is investment income under parts (b) and (c) of that regulation if over time, or within the overall market, people tend to earn capital gain on that income. No one cares about your own intentions.  The prescient KPMG piece published in January mentions this as well: we need to be wary of the fact that cryptocurrencies GENERALLY result in capital gain, and GENERALLY is better held as investment property than spent as a medium of exchanges:

Can Bitcoin serve primarily as a medium of exchange rather than for an investment or speculative purpose? Some have argued that Bitcoin ultimately fails as a medium of exchange because of its inelasticity of supply. The incentive to retain Bitcoin for investment or speculative purposes outweighs and ultimately dooms its function as a medium of exchange. (citing Krugman, MIT Tech Review)

Essentially, as KPMG notes, currencies are defined by their inflationary tendencies. Special tax provisions for currencies anticipate an inflationary, rather than deflationary, environment. Section 988(e)(2) most of all anticipates an inflationary environment.

This is not a totally dispositive point – you could sit and argue that you (and about 20 other people on the planet) are paid for your work entirely in cryptocurrencies, and you pay for your daily expenses in cryptocurrencies and oh by the way, your 401k and IRA are invested in stock indexes and other traditional investments – so you use cryptocurrency in personal transactions exempt under 988(e)(2). If Section 988 had applied, I welcome those 20 people to take that position and argue it – but if they lose, over the course of the four years of litigation, they would have incurred hefty penalties and interest.

In reality, the line would be too blurry for people to take the 988(e)(2) position on their tax return.

Incidentally, a de minimus rule may apply to Schedule D anyway: if 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.  Please consult with your tax advisor about this question.