Accounting For Crypto Assets

Welcome to Fundamentals of Accounting for Crypto Assets. This course is presented by Taylor Zork, CPA, MBA of CryptoCFOs.com To learn more and to become a member of our growing community visit www.CryptoCFOs.com

UPDATE: the CFTC announced on December 13, 2022 that some assets, including BTC, ETH, and USDT are commodities under US Law. The IRS has generally classified cryptocurrency as property and applies tax regulations in a similar fashion to stocks or real estate. For this reason, we will not discuss the tax treatment of fiat currency transactions here. Crypto assets can be held as capital assets or received as W-2 wages, self-employment income, or royalty income. Additionally, they may also be treated as inventory by traders and brokers in certain instances.As you can see, this asset class is extremely versatile and complex as it encompasses many different types of transactions and tax/ accounting treatments. Additionally, as explained by the U.S. Securities and Exchange Commission (SEC), a commodity falls under the classification of a property asset. According to the SEC, “A Bitcoin futures contract is a standardized agreement to buy or sell a specific quantity of Bitcoin at a specified price on a particular date in the future.In the United States, Bitcoin is a commodity, and commodity futures trading is required to take place on futures exchanges regulated and supervised by the Commodity Futures Trading Commission (CFTC).” As a result, we look more to the substance of each transaction to get a sense of what accounting treatment we use.When new decentralized applications (dAPPs) and protocols are introduced within the industry that have no official guidance tied to them, we rely on our knowledge of accounting theory and transactions of a similar nature in order to determine the proper accounting and tax treatment. In these cases, we tend toward the more conservative treatment to protect our clients and ourselves; however, the client is ultimately responsible for their tax filings (and we make adequate disclosures, such as an IRS Form 8275, to the taxing authority if required when taking a more aggressive tax position).

In the world of cryptocurrencies, wallets act as “bank accounts.” Cryptocurrency wallets consist of a private key and a public key. The private key secures access to your wallet, while the public key is the address that allows people and companies to send funds to your wallet.One of the major trade-offs with cryptocurrency wallets vs. traditional bank accounts is that since you are responsible for custody and security of your funds, no one can help you recover funds if you lose your account information. The private key secures access to your wallet; if this or the recovery phrase associated with it are lost, it will be impossible to recover the funds in your wallet.On the flip side, on a decentralized network, no person or government can freeze or seize your funds because they have no way to access or control this information. In addition to privacy protection, this benefit allows people and businesses that operate in legally conflicted industries (such as cannabis, which often runs into issues with the banking system), to process payments and securely store funds in a much more cost-effective and safe way. Laws enacted by governments may compel a person or entity to turn over private keys as part of a plea agreement or in a criminal case, but these situations require action from you rather than being subjected to seizure.A major difference between a traditional bank account and a crypto wallet is that, unlike a traditional bank account that can operate on a push/pull function, cryptocurrency wallets are push only. Every transaction must be approved and initiated by the person who holds access to the wallet via the private keys, so you can only send funds and cannot set up recurring pull transactions such as subscriptions that auto-debit your account.

Now that we have a better grasp of how wallets function for crypto assets, we need to understand the inextricable link between decentralization, self-custody, and security. In the world of blockchain and cryptocurrency, no bank holds and secures your funds. You are the bank. As a result, you rely on varied levels of security based on the context of the usage of funds.A real-world example of this concept is the difference between a wallet you carry in your pocket and a bank vault. Obviously, the money kept in a wallet is less secure than money stored in a bank vault, but the sacrificed security of funds is offset by increased convenience. To reduce the risk, a nominal amount of a person’s total wealth is carried in their pocket. The same principle applies to crypto assets.

Exchange wallets are funds held on centralized exchanges (CEXs). If a taxpayer purchases crypto assets on a CEX like Coinbase or Kraken, then the assets are in the exchange’s wallet. When investors leave funds on exchanges, they are relying on a third party to secure their assets. Exchanges have been hacked and bad actors inside an exchange have stolen and mismanaged funds; in the strange case of the Quadriga Ex exchange founder who suddenly died under suspicious circumstances, the private keys to $190 million of users’ funds vanished.Relying on exchanges to secure funds is only for active traders and those comfortable with the security vs. convenience tradeoff that this provides.Hot wallets are the next step up in security after exchange wallets because they allow the user better control over the protective measures they implement. The user can create complex passwords and cybersecurity features to reduce the chances of their funds being compromised.These wallets are “hot” because they live on your computer, generally as an app or as a plugin to a web browser. As they require an internet connection to use, malware, keyloggers, and other common hacking tools can be used to gain access to this type of wallet.Hot wallets are only as good as the security measures put in place to protect them. As a result, they should only be used with small balances of cryptocurrencies to reduce risk exposure.

A cold storage wallet is used for storing crypto assets where the private keys and access to the wallet are offline thereby protecting the funds from unauthorized access, hacks, and other vulnerabilities. There are physical devices, like Ledger’s Nano S or Trezor’s One, or simply something analog like a sheet or paper containing the private keys to the wallet. With the physical devices, the unit is connected to a computer to authorize transactions and generally has a passcode to gain access to the device itself. The security advantage of storing funds on a cold wallet is that they cannot be hacked unless someone either:Has access to your 12- or 24-word seed phrase (or written private key in the case of a paper wallet)Has access to your physical device and the device’s passcode

Multisig wallets require multiple signatures (multiple wallets approving the transaction) to sign or confirm transactions and can be secured with either a hot or cold storage wallet. This method provides for much greater security as there is no one single point of failure. A multisig wallet secured via cold storage is the gold standard for security with crypto assets, but this protection comes at the expense of convenience. This type of storage should be employed for large asset balances that are kept for longer time frames.

While seemingly counterintuitive to the ethos of blockchain and cryptocurrencies, enterprise custody solutions can serve a purpose for high-net-worth (HNW) individuals who prefer a third party to hold and maintain custody of their crypto assets.Companies like Ledger, Kraken, and Coinbase offer custody services for HNW and Ultra-HNW individuals, estates, and companies. These solutions are generally cost-prohibitive for the average investor.For many public figures within the crypto space, their mere participation in the industry can put a target on their back, as a would-be thief may assume that the individual has access to the location of their private keys or seed phrase. The main advantage of these services is similar to that of a multisig wallet, as it removes a single point of failure in the event of a robbery or if the holder is taken hostage, with the ransomers demanding they turn over the keys to their crypto. The disadvantage is that you are again relying on the security protocols of a third party. Also, if you’re a crypto “whale,” hire bodyguards!

Coins and tokens form two major types of cryptocurrencies.Coins are cryptocurrencies with their own native blockchain networks (Ether/ETH, Bitcoin/BTC, and Litecoin/LTC). These coins are the result of years of coding and building a robust and secure blockchain network that requires decentralized computing power to secure. As a result, coins are more difficult to create because they require entire networks to support their use and value proposition. Coins are rewarded to those who supply computing power for processing transactions and are generally used as the fuel for the transactions that are processed on that chain. For example, to execute a transaction on the Ethereum blockchain, you spend ETH as “gas” to fuel the transaction. The amount of gas required to execute the transaction depends on network congestion, the complexity of the action, and the speed necessary for confirmation. Tokens are cryptocurrencies that are created on top of existing blockchains. Since they do not require the infrastructure backing them, they are much easier to create; therefore, there are exponentially more cryptocurrency tokens than coins. One of the most common types of tokens are NFTS, which can be minted on a multitude of different blockchains including Ethereum, Solana, and Flow, just to name a few. NFTs can act as digital certificates of ownership that can be instantly verified and validated. Because tokens do not have the inherent utility of being gas on their native blockchains, they generally have a utility component that gives them value such as being a rare piece of art or music, gaining the holder access to discounts or events, or possessing a governance component.

What gives a cryptocurrency value?Market capitalization is the price of a crypto asset multiplied by the circulating supply; the calculation offers a sense of the overall growth potential of a project. As an example, for the popular meme coin Shiba Inu (SHIB) to grow from a price of 0.00002447 to $1.00, it would require a 40,866x (4,086,600%) increase in price. This move would take the market cap from approximately 13,500,000,000 to 551,691,000,000,000 USD (yes, $551 trillion, which is more than the total value of all of the world’s real estate). Excluding discussions of burn mechanisms and prior performance (SHIB is still up 43,718,959.3% from its all-time low), the likelihood of SHIB reaching $1.00 is slim. A common misconception in the world of crypto assets is the desire to find “bargain coins” that are priced at sub $1 with the idea that they have greater growth potential. This flawed practice leads to many retail investors loading up on coins like SHIB with the idea that if it just grew to $1, they could 1,000x their investment.Coins like ETH have value because they are the fuel used to transact on a secure and decentralized network. Since the network has a broad use and many dApps are built on Ethereum and require gas to operate, ETH benefits from high demand. While ETH grants the user the ability to process transactions on the Ethereum network, it also allows the user to put forward and/or vote on Ethereum Improvement Proposals (EIPs) that are intended to continually improve the Ethereum network. As a result, ETH has both an inherent utility and a governance component built into its economics.Tokens do not have this same inherent value, so they must rely on either their utility or the right to direct the project they are associated with in the form of governance rights. Some tokens have a combination of these two attributes.The utility of a cryptocurrency is a “use case,” which can come in the form of a discount for services provided by the project, act as an in-game currency, or help generate rewards in the case of crypto gaming. It can also unlock higher yields for staking or lending (more on this later). Governance tokens effectively grant voting rights and allow holders to guide the direction of a project either in the form of submitting improvement proposals or voting on a project’s milestones or roadmap. Uniswap and its native token UNI are one of the better-known governance tokens. UNI can be used to vote on existing proposals or generate new ones to help steer the direction of the project. These tokens have value because they allow users to influence the project. Since Uniswap is a DEX, users generate revenue by acting as liquidity providers (LPs). Users who generate revenue from this platform are incentivized to have a say in protocol evolution because it directly affects their profitability.Whether a cryptocurrency is considered a utility token, governance token, or a combination of both, from an accounting perspective, we treat it similarly to a stock for tax purposes.

Cost basis and holding period are the two inputs that determine the tax impact of a capital asset transaction, including crypto assets.Cost basis is an important concept as it determines your gain or loss when you arrive at a taxable crypto transaction. The automated tax software currently available for crypto accountants and investors is lacking in its ability to track basis across platforms. The software cannot know whether it has complete information or not, and sometimes comes to erroneous conclusions about basis in the face of DeFi transactions or users who interact with multiple exchanges or blockchains. Additionally, these programs will often pull in the data on pricing automatically, and it can be off by a significant margin. A prime example of this is when a user receives an airdrop of a coin that was traded on an exchange with low volume to artificially inflate the spot price. Since the software pulls in the best available data, it could think that a shitcoin airdrop you received was worth millions, when it was in fact effectively worthless. When the software can not automatically determine cost basis, it will default to a zero, a costly mistake. This is where much of the opportunity lies for practitioners serving the industry - accurately tracking basis.

Most income is taxed in three different ways, and taxpayers can make decisions that affect that classification. Understanding the tax classification of earned and asset-based income is essential to minimize taxes. Income is classified as:Long-term capital gains (capital assets held more than a year)Short-term capital gains (capital assets held one year or less)Ordinary income (income earned by wages, salaries, tips, commissions, interest, income earned from a business or through self-employment, and non-qualified dividends)Long-term capital gains (LTCGs) usually have the most favorable tax rates; tax brackets in 2022 for individual taxpayers and companies are 0%, 15%, or 20%. Short-term capital gains (STCGs) are subject to taxation as ordinary income at the marginal tax rate for individuals of as high as 37% and corporations of up to 21% in 2022. Gains and losses are also subject to netting by type. All short-term gains and losses are combined to determine the net short-term gain or loss, and all long-term gains and losses are combined to determine the taxpayer’s long-term gain or loss. The IRS allows individuals to deduct only $3,000 of any excess capital loss from your income each year (or up to $1,500 if you're married filing separately) with any remaining loss being carried forward to future years. Note that businesses may be able to carry Net Operating Losses (NOLs) forward to offset a portion of future business income. Also, if a significant portion of your income is from investment, you may be subject to an additional 3.8% Net Investment Income Tax as provided by IRC 1411. A great explanation of this may be found on the IRS’s website where they provide a Q&A related to NIIT: https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

Understanding Continuous Audits & Process Control NFTs

Understanding Triple Entry Accounting

When you buy cryptocurrencies with fiat dollars, you do not have a taxable transaction. The same can be said for buying an NFT with fiat money. Using other crypto or stablecoins to buy crypto will likely have tax consequences, as we discuss in this and future videos.

Many actions you’ll take with crypto are not taxable. Here’s a non-exhaustive list, and we’ll cover each in more detail in this course:– Buying crypto or NFTs with fiat currency– Transfers– Borrowing crypto– Gifting and donating crypto assets– Receiving crypto as a gift– Inheriting crypto– Soft forksIt is not always apparent whether a transaction involving crypto assets causes a taxable event or not. The IRS has shed some light on what does not facilitate a taxable transaction with respect to virtual currency. We can take this a step further and generally apply the same tax treatment to transactions involving other forms of crypto assets, including NFTs (although there may be exceptions).About three inches down from the top of the first page of your individual income tax return (Form 1040 pictured above), beginning in 2020, you will find a variation of the question:  “At any time during (insert tax year), did you receive, sell, exchange, or otherwise dispose of any financial interest in any virtual currency?”2022’s proposed Form 1040 language is more concise:“At any time during 2022, did you: (a) receive (as a reward, award, or payment for property or services); or (b) sell, exchange, gift, or otherwise dispose of a digital asset (or financial interest in a digital asset)? (See instructions.)”This message is the IRS prompting you to include your taxable crypto transactions in your tax return because Uncle Sam wants his cut. You must check either the “Yes” or “No” box as leaving it blank is not an option. This question on your 1040 also provides the breadcrumbs leading us to which crypto transactions are not taxable; deep in the form’s instructions, you find the following:“A transaction involving virtual currency does not include the holding of virtual currency in a wallet or account, or the transfer of virtual currency from one wallet or account you own or control to another that you own or control. If your only transactions involving virtual currency during 2021 were purchases of virtual currency for real currency, including the use of real currency electronic platforms such as PayPal and Venmo, you are not required to check the “Yes” box next to the virtual currency question.” The sole act of purchasing crypto assets at fair market value (FMV) would not require you to check “Yes” and would not cause a taxable event. Per the IRS, fair market value (FMV) is “the price that property would sell for on the open market. It is the price that would be agreed on between a willing buyer and a willing seller, with neither being required to act, and both having reasonable knowledge of the relevant facts.” We emphasize FMV because if you purchase crypto assets for less than FMV, you are likely receiving a discount in exchange for property, goods or services. To “receive” crypto is a condition to check “Yes” on the 1040 and is a taxable event (more on this later).

Transfers among commonly owned accounts (wallets/ addresses/ exchanges) are non-taxable events. For example, you may move your MATIC from Crypto.com to Binance Earn to get a better yield for staking it. A transfer such as this could trigger a reporting requirement for an exchange or other platform that results in the issuance of an “information return.” An information return, such as a 1099-K for example, is sent to the IRS and to you, but it would not cause a taxable event if it arose solely as the result of a transfer. Note that in the example of moving MATIC from Crypto.com to Binance, if you earned interest on either platform, it would be considered income and would be taxed at ordinary income tax rates.

Borrowing crypto assets is no different than borrowing from a traditional lender. The IRS does not consider a loan to be taxable income because it must be repaid. On the other hand, if a crypto loan with an initial USD value of over $600 is forgiven, you should receive a 1099-C for cancellation of debt (COD) income, which is taxable. If the loan provider requires an exchange of crypto for you to get the loan — for example, swapping ETH for cETH to get a loan in Compound (referring to https://compound.finance/) — a conservative approach would be to report the gain or loss, if any, that results from that transaction.

Gifting crypto assets to individuals generally will not have any tax implications unless you are super-rich; the inflation-adjusted lifetime exemption for federal gift tax (aka “death tax”) is $12.06 million per individual and $24.12 million per married couple in 2022. If you are receiving this much crypto as a gift, you should speak with an estate planning attorney. For the rest of us, gifts of more than the 2022 annual exclusion amount of $16,000 per individual and $32,000 per married couple create a reporting requirement with no financial impact. IRS Form 709 is used to disclose excess beyond the annual exclusion to the IRS, which is applied to your lifetime exclusion. For example, Brandon and Kendra are married and agreed to split a gift of BTC valued at $100,000 to their son Bentley in 2021. Bentley does not have a reporting requirement; however, Brandon and Kendra each have to file a separate Form 709 showing $35,000 ($50,000 gift, less $15,000 exclusion) toward their lifetime exclusion amounts. The FMV of Bentley’s BTC is established on the date of the gift, but Bentley inherits his parents’ holding period and tax basis. If Brandon and Kendra bought the BTC for $10,000 more than a year before gifting it, Bentley has an unrealized LTCG of $90,000. Because cryptocurrency is property (not currency), if Bentley immediately disposed of the BTC for $100,000 upon receipt, he would have to recognize a taxable gain of $90,000 upon sale. For this reason, it would have been much better for Bentley to have received fiat currency (USD) than property (BTC). Had Bentley received $100,000 in cash he would never owe tax, but on the disposition of the crypto asset (BTC) he pays tax on the disposal of a capital asset. Note also that Brandon and Kendra could jointly give $30,000 as a gift to an unlimited number of individuals and there would be no reporting requirement; as spouses, they can give unlimited gifts to each other (note that there is an annual exclusion limit of $164,000 in 2022 for spouses who are not U.S. citizens).If Brandon and Kendra decide instead to donate BTC valued at $100,000 to a charity under IRC Section 501(c)(3) or other eligible organization described in Section 170(c), let’s say Bentley University, cryptocurrency being treated as property instead of currency may be beneficial. Where the couple bought the BTC for $10,000 as property with a LTCG, they won’t have to recognize the $90,000 gain and may be able to deduct the entire gift. Generally, individual taxpayers who donate cryptocurrency and itemize the deduction on line 12 of Schedule A (Form 1040) can deduct property subject to capital gains in full up to 30 percent of their Adjusted Gross Income (AGI). This means that if Brandon and Kendra’s AGI is $333,333 or more, they just knocked their taxable income down by $100,000 through donating BTC they paid $10,000 for. Depending upon their overall taxable income, this action could save them anywhere from $15,000 to $23,800 in capital gains tax at the federal level (and more when you consider state taxes). If their AGI is less than $333,333, they can carry over the suspended charitable contributions to future tax years.Remember, the FMV of the crypto asset is determined on the date of the gift. Also note that cash donations and other non-capital gains property (cryptocurrency held for a year or less, for example) may be deducted in full up to 50 percent of their AGI to the extent of the lesser of the cost basis or FMV. For Brandon and Kendra this would only amount to a reduction in AGI of $5,000, so holding period is paramount.  These tax rules vary by tax year and percentages vary by type of charitable organization and the source of funds (i.e., originating from an IRA for someone over 70 ½ for example), so be sure to do your due diligence when planning gifts. Publication 526 explains how to claim a deduction for charitable contributions.It discusses:– Organizations qualified to receive contributions– The types of contributions you can deduct– How much you can deduct– What records to keep– How to report contributions