Should You Be Reporting Cryptocurrency Held in a Foreign Exchange on the FBAR and Form 8938?

August 5th, 2019

It’s been assumed that the answer to the question I posed as the title to this post is “Yes”, that you should be reporting cryptocurrency held in foreign cryptocurrency exchanges on the FBAR. However, the AICPA Virtual Currency Task Force asked this question to FINCEN and was surprised to find the answer is no:

FinCEN responded that regulations (31 C.F.R. §1010.350(c)) do not define virtual currency held in an offshore account as a type of reportable account. Therefore, virtual currency is not reportable on the FBAR, at least for now. This may change in the future, especially considering the influx of stable coins, so practitioners should stay abreast on this topic. FinCEN did tell the task force that it, “in consultation with the IRS, continue[s] to evaluate the value of incorporating virtual currency held offshore into the FBAR regulatory reporting requirements.” Absent this clarity, the conservative approach would be filing the FBAR.

I think the conservative approach is best, and we can look back at the Hom decision at a parallel situation. Years ago, online gambling accounts were not reportable. Then FINCEN said to tax professionals, you do not have to report these accounts on the FBAR. However, a court then ruled in United States v Hom that these accounts were reportable. Nothing today prevents the identical situation from occurring with regards to cryptocurrency.

Indeed, let’s say John Smith has $1,000,000 worth of Bitcoin on some foreign cryptocurrency exchange. He doesn’t file the FBAR. He sells his cryptocurrency and the IRS discovers this when no tax return (or FBAR) is received. The matter is referred for criminal prosecution, and not only are charges filed for failing to file a tax return, the Department of Justice adds charges for not filing the FBAR.

There is no penalty for overreporting accounts on the FBAR, just underreporting. Thus, the mantra, “When in doubt, file the FBAR,” definitely applies. I strongly suggest you file the FBAR for foreign cryptocurrency exchanges (assuming you have an FBAR filing requirement).

But what about Form 8938 (Statement of Specified Foreign Financial Assets), the FATCA reporting statement that’s required with certain tax returns? Nothing has changed with regard to this form. Thus, even if you elect not to report your foreign cryptocurrency exchange holdings on the FBAR, you are still required to report them on Form 8938 (assuming you meet the Form 8938 filing threshold).

Again, there’s no penalty for overreporting and lots of penalties for underreporting. The conclusion I draw is the only logical conclusion given the current situation.

We’ve Moving, and We’re on Vacation

July 28th, 2019

Our offices are moving (conveniently while we’re on vacation). Our new address is:

Clayton Financial and Tax
222 S Rainbow Blvd, Ste 205
Las Vegas, NV 89145-5356

And we’re going to enjoy a vacation. If something earth-shattering in the tax world happens while I’m relaxing, I’ll take time out to post on it. Otherwise, enjoy the fine bloggers listed in the blogroll on the right.

I’ll be back on Tuesday, August 6th.

IRS Sending Letters Based on Coinbase Summons

July 26th, 2019

In 2017 the IRS won its fight with Coinbase, and received information from that cryptocurrency exchange on customers who traded cryptocurrency. Today, the IRS announced that they’re sending letters to individuals who may need to file or amend their returns to report cryptocurrency transactions.

The IRS notice states:

The Internal Revenue Service has begun sending letters to taxpayers with virtual currency transactions that potentially failed to report income and pay the resulting tax from virtual currency transactions or did not report their transactions properly.

“Taxpayers should take these letters very seriously by reviewing their tax filings and when appropriate, amend past returns and pay back taxes, interest and penalties,” said IRS Commissioner Chuck Rettig. “The IRS is expanding our efforts involving virtual currency, including increased use of data analytics. We are focused on enforcing the law and helping taxpayers fully understand and meet their obligations.”

The IRS started sending the educational letters to taxpayers last week. By the end of August, more than 10,000 taxpayers will receive these letters. The names of these taxpayers were obtained through various ongoing IRS compliance efforts.

For taxpayers receiving an educational letter, there are three variations: Letter 6173, Letter 6174 or Letter 6174-A, all three versions strive to help taxpayers understand their tax and filing obligations and how to correct past errors.

Two of my clients received Letter 6174-A today. They had both included their cryptocurrency sales on their tax returns for all years, so they can ignore the letter. My suspicion is that Letter 6174-A is sent to taxpayers the IRS believes are in compliance.

The more serious letter is Letter 6173. This letter states, “For one or more of tax years 2013 through 2017, we haven’t received either a federal income tax return or an applicable form or schedule reporting your virtual currency transactions.” That’s potential trouble for recipients. If you receive (or received) Letter 6173, you should consult a tax professional immediately. This letter requires a response, and it means the IRS thinks you’ve erred on your taxes. Having said that, remember that it’s entirely possible you did include your cryptocurrency transactions on your return and the IRS simply erred.

I should point out that it’s my conclusion that these letters are the result of the Coinbase summons. The IRS notice states only they used “data analytics” and that “[t]he names of these taxpayers were obtained through various ongoing IRS compliance efforts.” It could be something else, but I’m not aware of any other ongoing compliance efforts related to cryptocurrency.

Location, Location, Location: The Real Winners of the 2019 World Series of Poker

July 17th, 2019

This year was the 50th anniversary of the World Series of Poker (WSOP). And by all accounts, this year’s series of tournaments was highly successful. Attendance was up across the board. The Main Event, which concluded early this morning, was no exception. 8,569 entrants paid $10,000 each for their chance to win $10 million, the second-most entrants all time.

One important note: I do need to point out that many of the players in the tournament were “backed.” Poker tournaments have a high variance (luck factor). Thus, many tournament players sell portions of their action to investors to lower their risk (and/or “swap” action with other entrants). It is quite likely that most (if not all) of the winners were backed (or had swaps) and will, in the end, only enjoy a portion of their winnings. I ignore backing and swaps in this analysis (because the full details are rarely publicized). Now, on to the winners.

Congratulations to Hossein Ensan of Munster, Germany. Mr. Ensan beat second place winner Dario Sammartino when Mr. Sammartino’s two-way draw (he had both a flush and straight draw) did not catch up to Mr. Ensan’s pocket kings. Mr. Ensan’s German Wikipedia page notes that he emigrated from Iran in 1990 and is listed as a professional poker player. Whether he’s a professional or an amateur makes a huge difference for taxes. In 2017, the Federal Fiscal Court (Germany’s highest court dealing with tax issues) ruled that professional gamblers must pay income tax on their net gambling winnings (less expenses); amateur gamblers do not have to pay income tax on gambling winnings. The US-Germany Tax Treaty exempts his winnings from US taxation.

This is a huge issue for Mr. Ensan; the classification is the difference between earning $10 million and earning $5,393,531. Assuming Mr. Ensan is subject to income tax, he’ll lose $4,606,469 to the Bundeszentralamt für Steuern (BZSt). That’s a reason why many German professional poker players reside in the United Kingdom: They avoid the high German taxes.

Finishing in second place and winning $6,000,000 was the aforementioned Dario Sammartino. The native of Naples, Italy now resides in Florence, Italy after a stay in Slovenia. Italy does tax gambling winnings: Mr. Sammartino will owe an estimated $2,572,350 to Italy’s Agenzia delle Entrate (42.87%)

In third place was Alex Livingston. The resident of Halifax, Nova Scotia, Canada benefits from Canadian law on gambling: His winnings will not be subject to tax in Canada. However, he will lose a flat 30% of his $4,000,000 ($1,200,000) to the IRS per the US-Canada Tax Treaty. (He can file a Form 1040NR return for the 2019 tax year to recover a portion of his tax based on any taxes US gambling losses he had during the year.)

Garry Gates of nearby Henderson ended in fourth place. Mr. Gates, who has worked in the poker industry for years, earned $3,000,000 for his finish. An amateur gambler, he avoids self-employment tax. As a Nevada resident, he also avoids state income tax. I estimate he will owe $1,050,813 (35.03%) of his income to tax.

Another amateur gambler, Kevin Maahs of Chicago, finished in fifth place. Mr. Maahs won $2,200,000 before taxes for his finish. He owes both federal and Illinois income taxes on his winnings; he’ll likely lose $870,729 (39.58%) to tax.

Finishing in sixth place was Zhen Cai. Mr. Cai, a professional gambler residing in Lake Worth, Florida earned $1,850,000 for his efforts. One of two American professional gamblers at the final table, he must pay self-employment tax and federal income tax (as a Floridian, he avoids state income tax). I estimate he will lose $706,679 (38.20%) to tax.

Nick Marchington from London, England finished in seventh place for $1,525,000. Mr. Marchington, a professional gambler, gets to keep all of his winnings. The US-UK Tax Treaty exempts gambling winnings of UK residents from tax. And the United Kingdom doesn’t tax gambling winnings. As my mother says, location, location, location.

In eighth place was Timothy Su of Boston. Mr. Su, a software engineer, does avoid self-employment tax. He does have to pay federal and Massachusetts income taxes. There’s a slight bit of good news for Mr. Su: Massachusetts’s income tax rate dropped for 2019 from 5.15% to 5.05%. That’s not a huge change, but when you win $1,250,000 and will have to pay an estimated $491,150 in tax, saving $1,250 is still better than nothing.

The ninth place finisher was Milos Skrbtic. Mr. Skrbtic, a professional gambler, was born and raised in Serbia, but currently resides in San Diego. Had he remained in Serbia he would lose 50% of the $1,000,000 he won to tax. The US and Serbia don’t have a Tax Treaty, so 30% would be withheld by the IRS. Serbia does give a tax credit on their income tax, but only for taxes paid to a country which Serbia has an income tax treaty for. Since the US and Serbia do not have such a treaty, he would have been liable for Serbia’s 20% tax on gambling winnings. Unfortunately, Mr. Skrbtic lives in California; the Golden State is anything but a low tax environment. I estimate he faces the highest tax burden of any of the final table participants: He will owe an estimated $474,463 in tax (47.45%).

Here’s a table summarizing the tax bite:

Amount won at Final Table $30,825,000
Tax to BZSt (Germany) $4,606,469
Tax to IRS $3,313,395
Tax to Agenzia delle Entrate (Italy) $2,572,350
Tax to Illinois Department of Revenue $108,900
Tax To Franchise Tax Board (California) $108,414
Tax to Massachusetts Dept. of Revenue $63,125
Total Tax $11,972,653

That means 38.84% of the winnings at the final table goes toward taxes.

Here’s a second table with the winners sorted by their estimated take-home winnings:

Winner Before-Tax Prize After-Tax Prize
1. Hossein Ensan $10,000,000 $5,393,531
2. Dario Sammartino $6,000,000 $3,427,650
3. Alex Livingston $4,000,000 $2,800,000
4. Garry Gates $3,000,000 $1,949,187
7. Nick Marchington $1,525,000 $1,525,000
5. Kevin Maahs $2,200,000 $1,329,271
6. Zhen Cai $1,850,000 $1,143,321
8. Timothy Su $1,250,000 $758,850
9. Milos Skrbtic $1,000,000 $525,537
Totals $30,825,000 $18,852,347

Mr. Marchington finished in seventh place but ended up in fifth based on after-tax income. As my mother says, it’s location, location, location.

The Internal Revenue Service didn’t end up as the biggest winner at the final table this year. Thanks to two of the top three winners being exempt from US taxation, the IRS had to be content with earning just a bit more than fourth place money. The German Tax Agency, Bundeszentralamt für Steuern, is the biggest winner among tax agencies. As usual, the house–the tax agencies–ended up with more than first place money. The house always wins.

It Looks Just Like the L.A. Freeway System!

July 14th, 2019

One of the things I love about living in Las Vegas is not dealing with the Southern California traffic. I remember running into a horrendous traffic jam at 2 a.m. I remember the ten mile drive that took two hours. I don’t miss that in the least. Yes, there’s some traffic here in Las Vegas–I complain when my commute home takes twenty minutes instead of the usual twelve minutes–but it’s really benign when compared to Los Angeles.

I bring this up because the Taxpayer Advocate released a “roadmap” of what happens with a tax return. Here it is:

TAS_Roadmap

There are some comments I’d like to make about this:

1. Yes, our tax system is that convoluted. We should have a simple, straightforward system. Our current Tax Code reminds me of differential equations (and yes, I took that in college).

2. There are important steps that are left out of the roadmap. One of the items listed in “Tax Return Processing” is IRS Issues Math Error Notice. When I think of a math error, I think of 2 + 2 = 5. Those kinds of math errors are appropriate for a math error notice. However, one of my clients just received a math error notice where the IRS inserted a $300 penalty for no particular reason. That’s not appropriate for a math error notice (at least, I don’t think it is), yet if my client didn’t write the IRS within 30 days of receiving that notice it would be next to impossible to have that corrected. Indeed, the Taxpayer Advocate has, in the past, complained about math error notices.

3. The equivalent of traffic jams do occur. One of the current issues taxpayers and practitioners face is slow response time on the IRS reading its mail. Consider my client’s response to the math error notice. She received the notice on July 10th, and on July 11th mailed the response (using certified mail, return receipt requested). It was received on July 13th. The average IRS response time for reading correspondence is 14 weeks. That means it will likely be November 1st before my client receives a response to the erroneous penalty on a math error notice. And suppose a second letter is needed (which happens). The lack of timely responses by the IRS negatively impacts all taxpayers (and the IRS). I have a second client who received a late filing penalty for filing a tax return without an extension. The extension was filed, but it wasn’t processed until after the tax return was processed! That client had to file a request for abatement for the penalty. Here’s a situation where the IRS’s internal systems should have automatically abated the penalty, yet my client must mail another piece of paper to the IRS, wait 14 weeks for it to be read, and hope that the agent who reads it understands that this was an IRS error.

4. The IRS’s automated systems hurts “edge-case” taxpayers. My mother is not that computer literate. Yet she is supposed to pay her taxes (like all of us). Now, she happens to have a son who is a tax professional, but what if she didn’t? Would she really be able to determine how much of her social security is taxable? Or how to compute the new Section 199A deduction on her dividends that qualify for that deduction?

5. Did I mention that the Tax Code (and how it works) is far too complex? I’m pretty sure I did.

Most of the blame does not fall to the IRS; it falls to Congress, which enacts the laws that have resulted in this mess. Additionally, Congress has not adequately funded the IRS. These are issues that need to be resolved, but cannot be resolved by the IRS.

The Check Is in the Mail, Really!

July 14th, 2019

One of the more interesting aspects of being a tax professional is the reliance on the mail, the Post Office. When you timely mail a tax return, it’s considered filed on the date of mailing. There are, as always, some caveats: You should mail the return (or payment) using certified mail. That means going to the Post Office, waiting in line, and using one of those green certified mail receipts. But if you do that your return will be considered timely filed even if it takes a while to get to its destination. It also helps resolve issues if your return gets lost in the mail (that’s happened a couple times to my clients), or if the mail truck makes a right turn while on a bridge over San Francisco Bay (there’s a reason there’s a bridge), or the mail truck goes up in flames.

This morning I received a notice from California’s Franchise Tax Board (the state’s income tax agency):

Due to a significant delay at the Post Office, some June payments arrived via mail up to a month late at the Franchise Tax Board.

However, these payments will be posted with a timely date of June 15, 2019. No action is needed by taxpayers or their representatives.

On Tuesday July 9, FTB received approximately 115,000 estimate and other payments with dates mostly between June 5 and June 20.

If a taxpayer or representative contacts FTB regarding a payment sent in June that has not yet posted, FTB customer service representatives will use all available resources to locate the payment.

FTB is asking taxpayers and representatives to allow some additional time to process and post their payment. It is not necessary to stop payment on a check that was delayed. MyFTB users may log in to their MyFTB account to verify payment.

Kudos to the FTB for being proactive on this issue and letting the public (and the tax professional community) know of the problem, and for taking the appropriate steps to resolve the issue. If you are one of the impacted taxpayers, give the FTB one month to resolve this. Unfortunately, this is clearly something that’s going to be a manual fix, and there are 115,000 fixes to be done.

If your payment posts and isn’t corrected to the June 15th date, then it will be time for you (or your tax professional) to contact the FTB.

Nevada Wises Up on Exempt Commerce Tax Companies

June 25th, 2019

Nevada has a tax on businesses called the “Commerce Tax.” This tax impacts businesses with gross receipts of $4 million or more. If your Nevada business makes less than that, you don’t owe the tax. However, you still had to file a return stating that you didn’t owe the tax.

The state legislature wised up on this:

The 80th (2019) Nevada Legislative session has changed the filing requirement for Commerce Tax. Pursuant to Senate Bill 497, businesses whose Nevada gross revenue for the 2018-2019 taxable year is $4,000,000 or less, are no longer required to file a commerce tax return.

Businesses whose Nevada gross revenue for the 2018-2019 taxable year is over $4,000,000 are still required to file a commerce tax return by August 14, 2019.

I received an email notifying me of this:

This e-mail is to inform you that the filing requirement for Commerce Tax has been changed. If the Nevada gross revenue of your business from July 1, 2018 through June 30, 2019 was $4,000,000 or less, your business is no longer required to file a Commerce Tax return and your Commerce Tax Account will be automatically closed, effective June 30, 2019.

If the Nevada gross revenue for your business from July 1, 2018 through June 30, 2019 was over $4,000,000, your business is still required to file a Commerce Tax return on or before August 14th, 2019.

In the event your Nevada gross revenue exceeds the $4,000,000 threshold in a future year, it is your responsibility to file a return for the year. Failure to do so may result in the assessment of penalty and interest.

It had to cost something for the Department of Taxation to process the $0 returns (which is what most businesses file); Nevada will now save that processing cost. And that’s one less form I have to file. This is a win-win for Nevada and its businesses.

Arizona v. California Update

June 24th, 2019

The State of Arizona has asked the US Supreme Court to stop California’s illegal (in Arizona’s view) scheme of requiring indirect passive owners of LLCs who happen to own other LLCs that invest in California from paying California’s minimum $800 franchise tax. Because this is a dispute between the states, the proper venue for Arizona to challenge this is an original action at the Supreme Court.

Today, the Supreme Court had a one-line order on the case:

The Solicitor General is invited to file a brief in this case expressing the views of the United States.

This can be expected in the next few months. Once that brief is filed, the Supreme Court will again consider whether to hear the case; it’s probable that decision will be late this year. If the case is heard, it would likely be sometime next Spring.

Should a Taxpayer be Liable for Tax on Income She Didn’t Receive?

June 22nd, 2019

Not even the IRS could go after someone for income they didn’t receive, right? Well, wrong. And when the taxpayer filed a lawsuit to reverse the result, she lost. She appealed to the Eleventh Circuit where the Court had a slightly different view of taxes than the government.

The story begins when her ex-husband is subject of a lawsuit (they were married at the time). It became clear the lawsuit would last longer than the marriage, and the couple agreed that they’d be equally liable for the judgment (if any). The couple divorced; later, the ex-husband settled the lawsuit for $600,000. He paid that to the plaintiff; he also filed a claim on his tax return for the $300,000 he paid. The IRS had no problem with that.

Per the divorce agreement, she reimbursed him $300,000. She also took a deduction under Section 1341 of the Internal Revenue Code. The IRS said no you don’t. She asked for relief in court. The district court granted summary judgment to the IRS. She appealed.

The Appellate Court looked at what’s necessary for relief: To obtain relief under § 1341, a taxpayer must satisfy four requirements.

First, an item of income must have been included in a prior year’s gross income “because it appeared that the taxpayer had an unrestricted right to such item.” § 1341 (a)(1). Second, the taxpayer must have later learned that she actually “did not have an unrestricted right” to that income. See § 1341(a)(2). Third and fourth, the amount the taxpayer did not have an unrestricted right to must have exceeded $3,000 and be deductible under another provision of the tax code. Fla. Progress, 348 F.3d at 957, 959. If the taxpayer can demonstrate these elements, then she has a choice between two options: “[s]he can deduct the item from the current year’s taxes, or [s]he can claim a tax credit for the amount [her] tax was increased in the prior year by including that item.”

The government disputed whether the taxpayer had an unrestricted right to the income. The lawsuit claimed that there was misappropriation of funds. “But here, the record lacks any proof that [the ex-husband] knowingly misappropriated income, since his settlement agreement with [B] expressly disclaimed any wrongdoing.” The government also claimed that she had no presumptive right to the ex-husband’s income. “First, even if the government’s assertion were correct, it makes no difference to the § 1341 analysis. What matters is whether [she] sincerely believed she had a right to [his] income, not the correctness of her belief.”

The next part of Section 1341 is for the taxpayer to establish that “after the close of a taxable year, ‘the taxpayer did not have an unrestricted right’ to some amount she initially reported as taxable income. To make this showing, the taxpayer must demonstrate that she involuntarily gave away the relevant income because of some obligation, and the obligation had a substantive nexus to the original receipt of the income.” The government said that she voluntarily gave away the income. The Court disagreed.

[Her] situation is materially indistinguishable. As with Barrett, her obligation to pay arose not from a final judgment, but from an agreement she entered in good-faith to avoid litigation. And it would be equally as “ludicrous”—as it was in Barrett to say that Barrett voluntarily paid his $54,000—to conclude that [she] voluntarily paid $300,000 of her income without regard to any legal obligation.

Indeed, she initially opposed paying [her ex-husband] for any liability arising from the…lawsuit. Only after [the plaintiff in the lawsuit] threatened her with litigation did she agree to be bound to do so and enter into Article 5 of her separation agreement…

[She] also paid an attorney to advise her of her rights, and that attorney told her that she had an “obligation” to pay [the plaintiff]. Under these circumstances—and particularly in light of the desirability of fostering settlements without litigation—[she] did not need to wait to be sued before settling and paying for her payment to be considered involuntary. Because the record reflects [she] reasonably anticipated litigation and settled in good faith in the shadow of litigation, her $300,000 payment was involuntary for purposes of § 1341.

The Court also noted that the obligation to pay must relate to the original receipt of income, and that she clearly established that.

There’s one more element that must be met:

Finally, to qualify for § 1341 relief, Mihelick must show that her $300,000 payment is deductible under another provision of the tax code. Fla. Progress, 348 F.3d at 958-59. Mihelick can meet this element, as she can deduct her payment under 26 U.S.C. § 165(c)(1), which allows deductions for an individual’s uncompensated “losses incurred in a trade or business” during the taxable year.

Given that the ex-husband was the CEO and majority shareholder, and that the lawsuit alleged that he breached his fiduciary duty while acting as CEO, the lawsuit related to the income and can be deducted.

The Court began the decision as follows:

Inscribed above the main entrance of the Internal Revenue Service office in Washington, D.C., is a quotation from Supreme Court Justice Oliver Wendell Holmes Jr.: “Taxes are what we pay for a civilized society.”…An admirable outlook, yet even Justice Holmes would likely agree that it is uncivilized to impose taxes on citizens for income they did not ultimately receive. But that is precisely the result the government asks us to uphold today. [citation omitted]

The Court rightly chastised the IRS and US government for being uncivilized.

Case: Mihelick v. United States

IRS To New York, New Jersey, and California: We Weren’t Kidding

June 11th, 2019

Today the IRS issued rules and guidance on charitable contributions as a workaround to the new limits on state and local taxes. Unsurprisingly, the IRS said exactly what I thought they would: both substance over form and quid pro quo apply.

There’s a fundamental rule in tax: The substance of a transaction determines how it’s taxed, not what it’s labeled. Suppose I pay you to perform services for me, but I send you a Form 1099-INT (for interest income). What I pay you is service income, not interest income, no matter how it’s labeled. Consider state taxes. Suppose a state (say, New York) offers you the ability to contribute to the “Support New York Fund” instead of state taxes. Well, the substance is that you’re paying state taxes by contributing to that fund.

Another issue is “quid pro quo;” that’s Latin for ‘something for something.’ And if you get something for a charitable contribution, that portion isn’t charity. Consider a donation to some foundation for $50 and you receive a blanket worth $10; your charitable contribution (that you can take) is $40. This rule has been around for some time. It applies to these workarounds, too.

Put bluntly, the IRS isn’t amused with the workarounds. The Tax Code is law; until Congress changes it, federal deductions for state and local taxes are limited.