Cryptocurrency Taxes: Know What You Don’t Know – 3 Rules of Three
Part 1: Three Sources of Income
Winning in sports means scoring more points than your opponent. It’s a zero-sum game…one winner and one loser. Winning in the business world is different. There are many winners and many losers. You don’t earn points, rather the goal is to make sure your revenues are greater than your expenses…to generate profits.
This is Kelly Coughlin, CPA and CEO of EveryDayCPA. I like to play sports and I love business. And in both cases, I play to win. If you to want to win in the virtual currency business, you need to manage your BIGGEST expense… if you win…and this is taxes. This five-part series will show you how to win this game!
This is a five-part series, “Cryptocurrency Taxes: Know What You Don’t Know – 3 Rules of Three”. I will help you see why three is your magic number. Let’s get right into it.
Cryptocurrency: 3 Rules of Three
There are 3 sources of revenue. There are 3 types of accounts. And there are 3 types of entities you need to use to minimize your taxes.
Let’s start with Part 1: 3 sources of revenues and hopefully profits from these revenues. I don’t need to tell you here that financial profits are being generated from cryptocurrency. So are losses. In this series, I am only going to focus on minimizing cryptocurrency taxes on PROFITS. Did you know that the IRS and other tax agencies frankly don’t give a rip about whether your revenues and profits come from “legitimate” business activities? I don’t know if virtual currencies are the next tulip bulb ready to burst or the next generation of currency to replace traditional currencies. But for now, I don’t care if it is legitimate or not. The IRS and other tax agencies don’t care if it is legitimate. They care if it is profitable. Al Capone and other Organized Crime bosses, frequently get in the crosshairs of the IRS when they match the income on their tax returns with the income required to sustain their lifestyles. Let’s just stipulate one thing now. If you are earning profits, the IRS wants its share of these profits. The key is to make these profits AND minimize your tax… LEGALLY. Not reporting is certainly an option…but a very bad idea. This puts you in prison. Ignorance of when an activity is taxable is also not an option…this MIGHT not put you in prison…but it will physically destroy your financial statement…not some theoretical virtual loss or charge, but an asset seizure, wage garnishment, and/or tax lien. One of my favorite quotes about the IRS is their urban myth motto on their desk: “We have what it takes; to take what is yours.”
My goal here is to help you understand how to structure your crypto profit generation in ways that minimize cryptocurrency taxes – expenses and liabilities – in the event you generate profits.
Crypto: Three Ways to Generate Profits
The first thing I want to cover is to define the different ways you can generate profits from Crypto business activities. For simplicity, I am frequently going to refer to the crypto business as Bitcoin, since this is the most recognizable digital currency.
1) Speculation: The most common way to generate a profit in bitcoin is to buy low and sell high. Just like a real estate investment or a stock investment that might appreciate in value, you haven’t recognized a gain or profit on that house or a stock or that currency until you sell it. The profits from this activity are taxable. In the virtual currency world, even if you sell your bitcoin and purchase, for example, Ethereum, you are still subject to cryptocurrency taxes.
2) Exchanging for Other Goods and Services: This leads to the second most common way to generate a profit in bitcoin is to exchange for other goods and services or other currencies including other virtual currencies…this is also taxable. The gain is the difference between the cost of the bitcoin you exchanged and the value of the goods or services or virtual currency you received. This also is taxable. These are not considered earned income and are not subject to social security tax and other types of earning taxes, rather they are passive gains and losses subject to short-term or long-term gains or losses.
3) Currency Mining: Finally, the third most common way to generate a profit in bitcoin is to mine this currency. At its core Mining is similar to providing tech computing or consulting services to clients for a fee. You might earn a fee to run excel spreadsheets or Access database or SEO analytics. You need hardware, software, electricity, and labor to deliver these services. And when you do this work, you get paid normally in USD…but if you got paid in crypto to do this work, you would also generate revenues. And of course, since you had expenses related to this, your gain would be the net profit between your revenue earned and expenses paid. These profits are considered EARNED income and are subject to payroll tax and other types of earnings taxes that go on your Schedule C of your 1040 tax return.
In the crypto mining business, it’s the same. You have the hardware, software, electricity, and labor costs to solve mathematical equations related to previous bitcoin transactions to help create a new cryptographic block of code that can be connected or linked like a chain to the previous cryptographic block of code. Thus, the term blockchain. There are about a thousand bitcoin miners who are more or less enabling the free exchange and use of the currency they are mining and, for this, they are being paid in the new currency. And just like an Excel spreadsheet consultant who gets paid for that work; the bitcoin miner gets paid for his work. And both are taxable.
So that covers the three ways to generate revenues and profits in your virtual currency business activities. Two are passive activities; subject to short and long-term capital gains and losses; the 3rd, mining, is considered earned income and is subject not to capital gains tax, rather self-employment tax AND income tax.
Next Time: 3 Types of Cryptocurrency Accounts
Next episode we will cover the three types of accounts to operate your virtual currency business activities: a taxable account; a pre-tax account (like a 401k or an IRA); and a POST-tax account (Roth IRA). Which type of account you use for your virtual currency business has a HUGE impact on your current and future tax liability. This is Kelly Coughlin at EVERYDAYCPA and thanks for watching.
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