Cryptocurrencies & State Tax: Transactions with Virtual Currency
To date, limited guidance on the taxation of cryptocurrencies has been released by tax authorities. Usage of cryptocurrencies in transactions creates significant ramifications concerning the determination of federal and state and local tax liabilities. While questions surround the tax treatment of the purchase and sale of cryptocurrencies for US dollars or other government-backed currencies, this article focuses on the state tax treatment of transactions where cryptocurrencies are used to pay for goods and services.
Recently, there has been much discussion regarding cryptocurrencies, particularly given their significant fluctuations in value and the increased level of governmental scrutiny. Uncertainties notwithstanding, usage of cryptocurrencies in transactions creates significant ramifications concerning the determination of federal and state and local tax liabilities. While questions surround the tax treatment of the purchase and sale of cryptocurrencies for US dollars or other government-backed currencies, this article focuses on the state tax treatment of transactions where cryptocurrencies are used to pay for goods and services.
To date, limited guidance on the taxation of cryptocurrencies has been released by tax authorities. At the federal level, the IRS published a six-page Notice in March 2014 (Notice 2014-21). The Notice generally provides that cryptocurrencies that are designed to be used as a means of exchange are treated as property and not “currency” for US federal income tax purposes. The significant consequence of this treatment is that the use of cryptocurrency in purchasing an item is treated as a sale or exchange of the cryptocurrency, resulting in taxable gain or loss to the purchaser. This article does not discuss whether pre-Tax Cuts and Jobs Act, exchanges of cryptocurrency for another cryptocurrency could potentially be treated as tax-free like-kind exchanges under Code section 1031.
In addition to the IRS guidance that has been issued, several states have opined on the sales tax treatment of cryptocurrencies. For instance, in March 2014, New York State (NYS) declared that purchases of taxable goods and services using cryptocurrencies should be treated as barter transactions, with the cryptocurrencies considered intangible property (New York Technical Service Bureau Memorandum No. TSB-M-14(5)C, 12/05/2014).
Ordinarily, for NYS sales tax purposes a barter transaction between two parties is treated as two separate sale transactions. Each party is considered a seller and required to collect sales tax from the counterparty—who is considered a buyer—based on the value of the property or services received from the counterparty. However, a seller is not required to collect sales tax on the provision of intangible property to a counterparty (20 NYCRR 526.7(d)). Because NYS considers cryptocurrencies to be intangible property, there would be no sales tax collection requirement from the party exchanging cryptocurrencies in exchange for goods or services.
Consider this example. Suppose an individual provides a pen to an associate, in exchange for which the associate provides a notebook to the individual. NYS considers the initiating individual to have sold the pen to his associate and requires the individual to collect sales tax on the “sale” of the pen. NYS also considers the associate to have sold the notebook to the individual and requires him to collect sales tax on the “sale” of the notebook. (In a traditional buyer-seller relationship where goods or services are exchanged for cash, only the seller of goods or services is required to collect sales tax; the cash-paying buyer has no requirement to collect sales tax on the money provided to the seller).
In a deemed barter transaction, however, if the associate were to provide cryptocurrency to the seller in exchange for the seller’s pen, only the seller and not the associate would be required to collect and remit sales tax on the transaction because the sale of the cryptocurrency would be considered the sale of an intangible asset that is not subject to sales tax.
Considering the issue from a sales tax compliance perspective, NYS requires a seller that makes sales in NYS and accepts cryptocurrencies in lieu of cash to:
• Register for sales tax purposes;
• Record the value of the cryptocurrency accepted at the time of each transaction, in US dollars;
• Record the amount of sales tax collected at the time of each transaction, in US dollars; and
• Report such sales and remit any sales tax due in US dollars when filing its periodic sales tax returns
While the federal income tax and state sales tax consequences described above appear to be relatively straightforward, there remain many tax-related concerns regarding transactions involving cryptocurrencies.
First, a business that decides to accept cryptocurrencies as payment for products will likely need to review its sales and use tax collection procedures and processes. In a typical cash-based transaction, sales and use tax is collected as cash and deposited into a bank account from which it is later withdrawn and remitted to the state or locality.
Where cryptocurrency is accepted in a transaction, the seller must consider the intermediate step of converting the cryptocurrency to cash (or making sure that the company has enough cash to cover its tax liabilities if there is no conversion or if conversion cannot happen quickly enough) to enable it to remit the sales tax. Sellers must be able to assess the value of the cryptocurrency at the time of the transaction for sales and income tax purposes. Sellers must also maintain records reflecting the dollar value of the amount of tax collected for purposes of determining the appropriate amount of tax remitted. It is important to note that conversion of a cryptocurrency into cash in order to pay sales taxes would be viewed as a sale of the cryptocurrency for income tax purposes, producing taxable gain or loss. The passage of time between a sale and the remittance of the tax due could cause significant financial implications to sellers if the value of that cryptocurrency fluctuates during that time period.
Second, businesses that accept cryptocurrencies as payment will need to determine how to refund purchase amounts to customers. Presumably, refunds would be expected to be based on the dollar value of the cryptocurrencies as of the time of the initial sale. But if refunds are expected to be given in cryptocurrency, is the refund treated as a new barter transaction resulting in additional tax consequences?
Third, companies generating receipts from holding or transacting in cryptocurrency will need to review how to characterize those receipts for state income tax purposes, as business or non-business receipts. Similar issues have been raised in other industries where assets have been held to hedge against fluctuations in materials used in the business (See General Mills, Inc. et. al. v. Franchise Tax Board, 1st District Appellate Court, Dkt. A 131477, August 31, 2012).
Finally, outside of the tax arena, businesses that accept and retain cryptocurrencies as payment should review any obligations that they may have as money transmitters, or as businesses engaged in the business of buying and selling cryptocurrencies, in addition to other legal or regulatory requirements.