Navigating The Challenges Of IRS Policy

IRS policy makes sense for Bitcoin investments, but not transactions

The taxation of any capital asset requires two measurements: a cost basis and a gain. The cost basis is the cost to you of obtaining the asset, and the gain or loss is the change in the value of your investment on sale. If you buy a share of Apple stock for $100 and sell it for $150, your cost basis is $100 and your gain is $50 (or 50%), on which you are subject to the capital gains tax. That tax depends on when you sold either short-term (less than a year) or long-term (greater than a year). The government sets lower tax rates on long-term investments to discourage short-term trading relative to long-term holding.

Today, Bitcoin taxation follows this same framework. If you buy one bitcoin in January for $10,000 and sell it in June for $15,000 your cost basis is $10,000, and your gain is $5,000 on which you will pay taxes. This mental model makes sense when considering Bitcoin as an investment. This is a straightforward application of the taxation of capital assets, which is why the IRS uses it today.

One wrinkle in this story is that taxation of investments requires your broker to report to the IRS the gains and losses of their clients through a 1099 form. You might notice this if you have a brokerage account (say, Vanguard), which supplies these forms to the IRS and also to you when you file your annual taxes.

The problem with this framework for Bitcoin is that it requires brokers or other third-party custodians to gather this data, possibly requiring compliance with onerous KYC regulations. And it chafes against the decentralized peer-to-peer ethos of Bitcoin, where there is often no third-party broker between two individuals exchanging value. But by law today all such transactions are taxable events, even if your bitcoin wallet does not report those transactions to the IRS.

Small Transactions

This framework then really breaks down when you begin to use bitcoin as a medium of exchange and not just a store of value. Imagine instead of selling your bitcoin for USD in June at $15,000 a coin, you instead use some of that bitcoin to buy a T-shirt that costs $15, or 0.001 BTC. Because you are exchanging bitcoin for the T-shirt, you technically are selling bitcoin, and therefore, this is a taxable event. Remember, your bitcoin appreciated by 50% from January, and so 50% of your cost basis from January is subject to tax. That means that the $15 T-shirt includes a $5 capital gain from the appreciation of bitcoin, so you would have to pay tax on the $5 gain embedded inside of the bitcoin used to pay for the t-shirt.

Clearly this is ridiculous. For the IRS to execute this, all vendors in the economy would need to report all transactions to the IRS. That transactions are publicly available on the blockchain doesn’t help much because you still cannot connect Bitcoin addresses to taxpayer IDs, which are social security numbers. To make that connection, vendors would need to harvest KYC information like SSNs for any Bitcoin transaction, no matter how small. This is not only a gross violation of privacy, but impractical with today’s technology. And I’m skeptical that such technology would develop, since it chafes against the ethos of Bitcoin.

The best solution today for this problem is the “de-minimis exception,” which the Coin Center in Washington DC is advocating. The genesis of this exception comes from foreign currency. If you buy euros with dollars in the US, spend those euros in Europe, and the euro has appreciated against the dollar in the interim, then technically you owe tax on the gain from that appreciation. Today, the IRS grants a de minimis exception, which makes small FX transactions exempt from this tax computation. So there already is precedent for this in the current tax law.

Absent a smarter policy like this, the IRS has no hope of collecting any of these taxes, and the tax law itself is antithetical to Bitcoin. It’s an open question whether a nonsensical law like this is better because it is so hard to enforce, or whether it’s better to have a more realistic law using the de minimis exception that will surely increase the taxation of Bitcoin. I am no fan of taxation, but slightly prefer the latter because it will provide more legitimacy to Bitcoin in the tax code and over time create a clearer path for adoption.

Lightning Transactions

If small transactions do in fact move to Lightning, then tracking these transactions is even more difficult, if not impossible. Lightning interfaces with Bitcoin by opening and closing a channel which has a representation on the Bitcoin blockchain. Think of opening a bar tab where you continually buy drinks, but only report the final bill rather than the entire…