Cryptocurrency Business Taxes: Know What You Don’t Know – 3 Rules of Three

Part 3: Three Legal Entities


Picking the INCORRECT type of legal entity to do your cryptocurrency business could have a devastating impact on the taxes you pay in that activity. Similarly, if you do it the right way, it can have a huge benefit to you in your after-tax returns.  Stay tuned and you will see how you can utilize the correct business formation structure to maximize your after-tax crypto returns.  


This is Kelly Coughlin, CPA and CEO of EverydayCPA. You saw in part 1 the three ways to generate profits and potentially taxes in the cryptocurrency market: 1) buy, hold and sell; 2) buy other goods and services or other currency; and 3) perform mathematical equations for a fee to build the Blockchain.


In part 2 you saw the three types of accounts you can utilize for your crypto business, a regular cash taxable investment account; a 401k or traditional IRA; or a Roth IRA. 


Now, in Part 3 of our five-part series “Cryptocurrency Taxes: Know What You Don’t Know – 3 Rules of Three,” we will cover the THIRD rule of 3…the 3 types of legal entities in which you can implement your crypto business…and this connects directly to the 3 TYPES of crypto income you intend to generate.


Cryptocurrency Busines: 3 Types of Legal Entities


There are three types of legal entities you will need to potentially utilize depending on the type of cryptocurrency business you intend to operate. This does not include you, yourself as an individual. You are not a legal person or entity, thankfully, you are a natural person or natural entity. Natural persons, as you well know, have to pay taxes. US citizens have to pay taxes on worldwide income no matter where they live. But here we are talking about legal entities. Some legal entities pay tax. Some legal entities do not pay taxes themselves but pass on the taxable income and related tax liability to the owners of the entity. Some legal entities are exempt from taxes…but the exemption is granted for certain and specific types of income. If you intend to make significant income in the crypto market, you will want to be aware of these three types of legal entities.


Simple Buy and Sell of Cryptocurrency 


If you are simply buying and selling cryptocurrency and exchanging it for either US dollars or other currencies that you spend for living expenses, you can do this in your natural entity account. I hear that PayPal and Venmo now allow you to make purchases and sales in Bitcoin. You don’t want these funds to be in a tax-exempt account, because frequently there will be penalties and taxes to pay if you pull out funds from this account. And to be clear, paying for goods and services or loans or gifts from your pre-tax tax-exempt account is considered a distribution and is subject to income tax. You can spend the profits or use the losses to offset the other gains, and if the losses are great enough, to reduce your taxable income by $3,000 maximum. 


Your natural entity taxable account will work for this. I don’t recommend it, but it works for this purpose.


Crypto for Long-term Savings


If you are getting into the crypto market for long-term savings…to supplement and POTENTIALLY juice up your 401k (which is most likely loaded up with mutual funds) then you can do this in either your traditional IRA or 401k or a Roth IRA. Buying, holding, and selling cryptocurrency is a permitted activity in these tax-exempt entities. Recall, however, that the third type of income from crypto activities, crypto mining (see Part 1 of this series) is NOT a permitted activity in a tax-exempt account. 


This leads to the tax-exempt organization. These include your traditional IRA, your 401k, and your ROTH IRA. These are tax-exempt organizations with a specific exempt purpose: to provide for the retirement of the owner of the IRA or Roth or 401k account. It’s important to note they are NOT exempt from tax for all types of income.


Tax-exempt Cryptocurrency Business?


Tax-exempt status, whether for your IRAs or a charity such as a 501c3 exemption or the 401k exemption for retirement accounts, is limited to the income that is earned for the purpose defined in that tax exemption. The idea is that you can’t use a tax-exempt organization that gets a tax exemption for certain sources and types of income, to apply that exemption for all sources and types of income. For IRAs, Roths, and 401ks this includes income exemption that is limited to passive income from, for example, interest, dividends, rents, royalties, and capital gains. It does NOT include EARNED income from solving mathematical equations for a fee and creating the blockchain. This type of earned income was not allowed exempt status. 


Recall, in addition to income tax, earned income creates payroll-related taxes. Social Security, FICA etc. All the funds in IRAs and 401ks and ROTHs have already paid payroll taxes. So, when these funds get pulled out, they do not have to pay these taxes twice? They only have to pay INCOME taxes, which were deferred until the funds were distributed. If earned income were allowed in these tax-exempt entities, you would be able to avoid having to pay payroll taxes on earned income. That sounds great to me…but not to the US Treasury.


What’s the relevance here? Put simply, crypto mining is NOT a passive investment activity. It is an activity that creates EARNED income. It is NOT permitted, neither in your traditional IRA, 401k, or your Roth IRA. HOWEVER, investment dividends from a separate crypto mining company that is owned by an LLC company which is 100% owned by your Roth, is a permitted tax-exempt activity. 


And this is the subject of Part 4’s discussion, so stay tuned! This is Kelly Coughlin at EverydayCPA.  Thanks for watching.

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