On the surface, being able to pay taxes with cryptocurrency seems like it would be a fantastic alternative. It would provide more legitimacy to the digital coins, which, in turn, would very likely help the markets grow. However, as good as it sounds on paper, there is still a sticky element that would have to be defined in clearer terms, or paying taxes with cryptocurrency could result in having to pay even more taxes.
The trouble is this: The U.S. Internal Revenue Service (IRS) doesn’t accept payments via cryptocurrency—yet. Meanwhile, the state of Arizona is exploring the possibility and a bill, Arizona Senate Bill 1091, has been submitted to address the issue. If passed, payments via virtual currencies authorized by the Arizona Department of Revenue would be accepted, beginning in 2020. This is where things get a little sticky.
According to the IRS, cryptocurrency is considered property—not currency. If a taxpayer settles up with cash, there’s no issue. But, if a payment is made with cryptocurrency, there are tax implications since now the payment is being made with property, not currency. The transaction would be considered a sale and, depending on when the coins were purchased, there could be gains associated with that property.
Let’s try and break it down further. If a taxpayer purchases cryptocurrency equal to the amount of the taxes owed, on the day the taxes are paid, there’s no gain. But if the cryptocurrency purchase was made, for example, a year ago and has increased in value, now there are gains on that purchase. Those gains, by law, would be taxable. Conversely, if the cryptocurrency doesn’t perform as expected, there would be a loss, and that loss should potentially be a deduction.
To complicate matters even more, it’s not possible to withhold taxes if a payment is made with property. It wouldn’t be possible to pay an employee in cryptocurrency, and then withhold some to send to the IRS. Nor could someone working as an independent contractor list a payment in the annual tax filing as cryptocurrency since, again, all taxes must be entered as U.S. dollars.
If someone receives a payment with digital currency, it must be included at its fair market value in income reporting. The fair market value equivalent in U.S. dollars it’s received must be reported. If that cryptocurrency is later sold, let’s say to make a payment for a work vehicle or invest in supplies, how is the basis of virtual currency received as payment for goods or services determined? It’s enough to make one’s head spin. Hopefully, Arizona’s move will help to clear some of this up, and the IRS will soon follow suit.