The cryptocurrency ecosystem is revolutionizing the world of finance and growing at a rapid clip that shows little signs of slowing. However, navigating this new frontier and ensuring tax compliance can prove challenging, as many tax clients are unaware of their obligations for reporting and paying taxes on cryptocurrency transactions. This is presenting a host of growth opportunities for those accounting firms that are equipped with the right resources and expertise.
“Cryptocurrency and digital assets is still a young asset class. Some would say the asset class, and the larger industry, are still in their infancy. So cryptocurrency comes with all of the challenges of a new emerging technology, or nascent asset class, and yes, that includes some fraud or bad actors. However, I see real innovation in financial technology, which will persist and change finance and capital markets as we know them today,” said Noah Buxton, managing director at San Ramon-based Top 100 Firm Armanino LLP.
Said Marianne Fisher, product marketing manager for sales and use tax at CPA.com, “With the continued shift to digital payments, global networks and decentralized systems, virtual currencies are anything but a fad. We’re seeing large corporations and lenders expressing interest in this space — a sign of increased activity ahead.”
There’s no doubt that cryptocurrency, perhaps once viewed as just a buzzword or fad, is here to stay. Consider this: A recent study by Cornerstone Advisors found that 15 percent of American adults currently own some form of cryptocurrency — and more than half of these investors are first-timers who invested during the first six months of 2020.
Furthermore, in early April of this year the cryptocurrency market capitalization hit an all-time high of $2 trillion as both retail and institutional investors continue to jump aboard. The record-setting surge was led by Bitcoin, the biggest digital currency, followed by Ethereum, which is the second largest cryptocurrency in terms of market cap.
The growth of cryptocurrencies has caught the attention of more and more tax and accounting professionals for more than one reason. In fact, a survey conducted by Blox, a crypto accounting platform, found there are three main reasons why professionals are entering this niche market:
- They discovered a need from existing traditional clients, associates or colleagues;
- They are naturally interested in blockchain and cryptocurrencies; and,
- They noticed an opportunity after the 2017 global crypto hype.
Unfortunately, with this rapid growth and innovation also comes confusion and murky regulatory guidance, which can prove challenging for accounting professionals who work with crypto-related businesses and investors.
“The opportunity set includes more crypto in the individual and high-net-worth portfolio, more crypto and digital assets on the corporate balance sheet, as well as investment funds continuing and increasing allocations in this space. So that creates tax structuring and compliance opportunities across the board,” said Buxton. “It also comes with incredible challenges because there’s frankly a lack of clarity from the IRS, and also very few practitioners with the technical understanding required to assess these unique assets and transactions.”
Underscoring this point, the Blox survey found that 97 percent of surveyed professionals noticed a major gap in guidance and CPA support for crypto tax, tax prep and compliance. Furthermore, most respondents said they believe the biggest mistakes, errors or issues with crypto accounting are:
- Missing or inaccurate data from clients (98 percent);
- Lacking disclosure of assets and transactions for tax reporting, from both businesses and individual clients (95 percent);
- Miscalculations of capital gain for the P&L when analyzing transactions without the proper methods (92 percent); and,
- Manual tracking of user or business data/account information (87 percent).
In light of a more proactive effort to tackle crypto accounting and tax concerns, 84 percent of respondents indicated that the services they most often provide to clients are: calculating cost basis, reconciling transactions and reporting tax returns. Other business needs include providing confidential reviews for clients and reconciling their crypto-related transactions or activity, the survey found.
As the crypto market continues to grow and a clearer framework for crypto regulation takes hold, the demand for firms to provide crypto-related services is poised to sharply rise.
“From a tax perspective, I can say some definitive ways how we know [cryptocurrency] is definitely not a fad and that’s when the government and the IRS is addressing it formally,” said Amy Miller, senior manager for tax policy and advocacy at the American Institute of CPAs. Miller cited several examples, including the fact that, in early April, a federal court authorized the IRS’s request to issue a “John Doe” summons on all Circle and Poloniex customers who transacted $20,000 or more in crypto deals between 2016 and 2020.
Navigating the challenges
As noted, there are a host of complexities facing tax and accounting professionals when serving clients in the crypto space. First of all, recognizing transactions that are tax-reportable can prove tricky.
“There’s a variety of transactions happening out there and you want to make sure you understand the nuances of transactions. Because crypto is taxed when you dispose of the asset, it is important to understand … when the crypto is being disposed of, because obviously the date and the amount that is associated with that ‘when’ is what goes into calculating gains and loss in crypto. So [you really need to] understand the ins and outs of the transaction,” said Wendy Walker, a solution principal for tax software provider Sovos.
Said Howard Krieger, managing director for CBIZ Valuation Group, in New York, “Every time you sell or move the cryptocurrency you have a taxable transaction. And so part of the challenge is keeping track of all of the activity. One of the ways this challenge manifests itself is in the existence of multiple wallets. Cryptocurrencies are held in wallets. Well, you may have a company that organizes its expenses by maintaining different wallets. … Throughout the course of ordinary business you might have money leaving those wallets to settle an expense that was charged in crypto, or you might have a sale of your token from that wallet just because it was opportunistic, or you might have a transfer between two wallets in order to clean up your books. So all of the sudden, you get the worst of all worlds, cash- and commodity-related, because the accountant has to then trace all of the movement of value between wallets and determine: Was this a sale? Was this an expense? Was this housekeeping? Because not all of those are taxable events.”
Echoing the sentiment, Buxton of Armanino said, “In most cases, crypto are capital assets, except where the digital asset represents a security interest, so investors have capital gain tax implications for the purchase and sale of cryptocurrencies. That all sounds relatively straightforward; however, complexities arise quickly from the use of crypto in decentralized finance protocols, as well as from basis tracking for the sheer volume of transactions by some investors.”
He added, “I think some of the emerging uses of cryptocurrency today really present the biggest challenges.” These include the following:
- Wrapped token protocols. With wrapped tokens, the idea is that you can port value across blockchains by wrapping tokens. Wrapping tokens increases interoperability between different blockchains, but can also present some potential tax issues — a taxable event for gain, and potential income tax implications for the way a client uses it downstream.
- Token swaps. This involves the trade of one cryptocurrency for another. While token swaps almost certainly lead to a taxable event, the challenge here lies in tracking the data.
- Automated market-maker protocols.People are essentially lending, or market-making, with tokens. This is an emerging area presenting a host of tax implications. For instance, those who lend their cryptocurrency out likely receive the same or different tokens in return, which is likely to be categorized as income. However, if the “decentralized finance,” or DeFi, platform gives a user an “IOU” token in return for two or more capital assets that are provided for liquidity purposes, is there a capital gain event?
- Staking income.Staking is the idea that you can receive a crypto incentive by participating in validating transactions or contributing to a blockchain network. Staking income is subject to ordinary income taxes. When tokens earned from staking are sold, the gains will be taxed as capital gains. That may sound straightforward, but it can present data challenges given market price fluctuations and volume of income events.
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Complexifying factors
Client reporting can also prove challenging and there are various factors that can contribute to the complexity.
Said Fisher of CPA.com, “Crypto assets are traded across hundreds of independent exchanges, with few standards on data formats or ticker symbols. These assets are by their nature decentralized, so data streams are, too. That makes it difficult to collect, standardize and reconcile information to accurately calculate cost basis, fair market value and fees, among other things.”
Taking a closer look at fair market value, this can be problematic given the trading on multiple exchanges and the fact that crypto markets never sleep.
“How you apply [fair value] is very tricky, particularly when you’re dealing with an asset that’s traded on multiple exchanges. If you think about a normal equity security or a company stock, they are usually just listed on one exchange and you can go to that exchange and get the price, but here you have assets that are exchanged or traded on multiple exchanges. So coming up with sometimes the true accounting fair value can be challenging if the company needs to identify what their principal market is, and that value may be different than maybe the value they need to report from a tax perspective,” said Amy Park, an audit and assurance, blockchain and digital assets partner with Big Four firm Deloitte.
Park noted that — given the inability to “write-up” the value of a company’s digital asset holdings when and if the price goes up or a previously written-down asset subsequently recovers — providing additional disclosures that a company believes are meaningful to its investors is important.
“I think what a lot of companies are struggling with is, ‘What I have to report on my financial statements is not actually what I feel like is the economic value of my assets.’ So what we’ve been encouraging is really providing additional disclosures and being able to explain: What is your strategy? What’s your business? Why is the amount that’s reported on your financial statement the amount that is reported and how is that different from what you feel it is? What is the volatility of the exposure? The impact to your cash flow? etc.,” said Park. “We are seeing more and more companies are providing that additional information … to really help deal with some of the challenges that, I think, being forced into the existing accounting model results in.”
Added Rob Massey, partner and global tax leader for blockchain and cryptocurrency at Deloitte, “In tax … you need to establish an accounting method which is systematic and rational when it comes to valuation. The thing with digital assets is, again, these markets don’t close and transactions happen with great frequency and, since the value moves, should you be held accountable for evaluating the value at each transaction moment and across what?”
Continued Massey, “Best practice is to look across many valuation data points using block explorer-type tools. … Then if you have a lot of transaction volume and you don’t want to look at the value every three seconds, can you aggregate some data points into something more like hourly or even daily? And the answer is ‘maybe’ as long as you have an approach which fits the business model and is rational because you establish accounting methods for tax very early on, including your valuation methodologies.”
Have the right tools, resources
The complexities mentioned above are just some of the issues that tax and accounting professionals may face when it comes to working with crypto-related businesses and investors.
The good news is that vendors are increasingly developing software that is intelligent and automated to help tax and accounting professionals and the clients they serve.
Take, for instance, Lukka’s LukkaTax for Professionals, a virtual currency tax preparation tool built specifically for accountants that was developed in partnership with CPA.com. Features of this offering include:
- The ability to efficiently collect a complete and accurate record of crypto asset transactions;
- Automatic standardizing of crypto tickers to eliminate data inconsistencies;
- Application of an appropriate fair-market-value-based valuation methodology, not index pricing;
- Accurate accounting of mining income, spot and margin trades, transfers and fees;
- Transaction matching at a global level, not an exchange level;
- Use of multiple accounting methodologies for managing tax liability; and,
- Easily stored and generated tax lot and Form 8949 outputs and reports.
“Really, what it does is it creates the data that is required to be included in an 8949 or, very often, also in your other income bucket on your Schedule 1. Then that information can be used in a downstream tool like ProConnect, or ProSeries, or Drake Tax, or whatever [tax preparation] system you would traditionally use,” said Robert Materazzi, CEO of Lukka.
Added Materazzi, “Do not assume that your traditional technology or infrastructure will meet your needs when it comes to handling crypto assets. Maybe take this opportunity to upgrade all of those processes and those technology stacks by assessing new solutions.”
Also serving the tax and accounting profession is Verady, with the recent launch of its Ledgible Tax Pro, which is designed for tax professionals with clients who will answer “yes” to the IRS Form 1040 question around virtual currency.
For tax year 2020, the IRS moved the declaration of virtual currency question from Schedule 1 to the first page of Form 1040, further reinforcing the agency’s enforcement focus on crypto.
Ledgible Tax Pro is designed for crypto assets and produces the IRS Form 8949 and other reporting formats that are directly importable to filing systems used by tax professionals. Features include:
- Matching transfers from wallets to exchanges automatically;
- Real-time client collaboration;
- Fee calculations for both wallets and exchanges in cost basis to reduce tax;
- Categorization for taxable income, gifts and capital gains; and,
- The ability for professionals to include tax advisory and planning views for their clients.
“With respect to cryptocurrency or digital assets as a whole, a lot of the infrastructure that makes reporting for accountants and tax professionals doesn’t exist. There’s no bank statements for crypto; there’s no brokerage statements for crypto; there’s no 1099 forms that give people what they need when they’re dealing with crypto,” said John Wandrisco, chief commercial officer at Verady. “There weren’t any accounting packages that could handle crypto and the crazy challenges that it creates and provides. So, having those basic tools to help professionals to serve their clients, [and] integrate those into their practice, was really kind of a fundamental opportunity that we saw.”
Verady also developed the Ledgible Crypto Partner Program, which is designed to help traditional accounting professionals open a profitable new market segment for their firm.
Serving the source
Leveraging modern technology and having the right expertise is critical when serving not just investors, but also cryptocurrency companies. Armanino, for example, has a team of digital experts and offers clients a full suite of digital asset services including TrustExplorer, a proprietary real-time attest application. Utilizing blockchain technology to connect on-chain data with off-chain data, TrustExplorer provides downloadable attest reporting at the push of a button.
With real-time attestation services, Armanino can collect and preserve evidence continuously, conduct risk assessments, and ensure ongoing accuracy through automated controls supported by periodic manual procedures. Instead of relying on “point-in-time” reports that are stale as soon as they are distributed, real-time attestations ensure that information is current and relevant.
Furthermore, Armanino announced in 2020 the launch of a proof-of-reserves service for digital asset exchanges, custodians and crypto-lending platforms, enabled through the TrustExplorer platform.
Going forward, the shifting crypto landscape will continue to present both challenges and opportunities for the tax and accounting profession. Given this, Miller at the AICPA encourages professionals to further educate themselves and their clients, and, if they haven’t done so already, to invest in some crypto just to gain more familiarity.
“If you’re a firm, and you have the resources, have someone be dedicated to being up to date on the latest IRS guidance on this issue — keeping up to date on what is coming out of IRS, what is coming out of Treasury, what is coming out of SEC,” said Miller, “And then … consider trying it out for themselves, if they haven’t already done so. … There are some very small currencies that are worth just a few cents just to see what it’s like, what the platform is like, what the reporting could look like. So you really fully understand what’s lacking, what your clients are confused by, and what kind of information you can ask them for.”
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