Questions to ask clients about digital asset activities

In this episode two members of the AICPA Virtual Currency and Digital Assets Tax Task Force (VCDATTF), Nik Fahrer, CPA, Senior Manager, National Tax Professional Standards Group — FORVIS, and Robert Tobey, CPA, Partner — REID CPAs, LLP, share their expertise with April Walker, CPA, CGMA, Lead Manager — Tax Practice & Ethics, AICPA & CIMA, on how to vet potential clients with digital asset activities, including questions to ask, as well as how to gain more expertise in this evolving field.

What you’ll learn in this episode

• Expertise tax practitioners need to be proficient in the digital asset field (0:55)
• Best places and ways to gain digital asset tax expertise (3:00)
• Examples of processes and procedures to set in place before accepting a client with digital asset activities (5:59)
• Record keeping responsibilities (14:05)
• Red flags (15:04)
• Highlights from Rev. Rul. 2023-14 (16:41)
• Current projects of the VCDATTF (18:36)
• Final thoughts (20:48)

Related resources

• Frequently asked questions on virtual currency transactions — IRS webpage explaining virtual currency questions and answers.

AICPA resources

• Digital assets and virtual currency tax guidance and resources — Sharpen your tax knowledge on digital assets and understand the tax complexities and strategies involved with virtual currency and cryptocurrency. This hub is your go-to library for AICPA guidance and resources as well as current legislative and IRS initiatives and projects the VCDATTF is monitoring.
• Crypto Loss Tax Reporting: Fact or Fiction — With the prevalence of recent virtual currency exchange bankruptcies and digital asset volatility, taxpayers may have misconceptions on reporting tax losses.
• Rev. Rul. 2023-14 — The ruling provides that cash-method taxpayers who stake cryptocurrency native to a proof-of-stake blockchain and receive additional units of cryptocurrency when validation occurs (i.e., validation rewards) must include the fair market value (FMV) of proof-of-stake validation rewards in their gross income for the tax year in which they gain dominion and control over the validation rewards.
• AICPA Comments on the IRS Draft 2023 Forms 1040, 1065, 1120, and 1120-S Digital Asset Question — The AICPA submitted comments on the digital asset question that is first appearing on the draft 2023 Forms 1065, U.S. Return of Partnership Income (version dated June 23, 2023); 1120, U.S. Corporation Income Tax Return (version dated June 2, 2023); and 1120-S, U.S. Income Tax Return for an S Corporation (version dated June 22, 2023). The AICPA also commented on the draft 2023 Form 1040, U.S. Individual Income Tax Return (version dated June 22, 2023), digital asset question.
• AICPA Comments on Non-Fungible Tokens – Notice 2023-27 — The AICPA submitted comments on Notice 2023-27 on the treatment of certain non-fungible tokens (NFTs) as collectibles. The AICPA is requesting that Treasury and the IRS provide further guidance on the issues suggested in our comments.

Transcript

April Walker: Hello everyone and welcome to the AICPA's Tax Section Odyssey podcast, where we offer thought leadership on all things tax facing the profession. I'm April Walker, a Lead Manager from the Tax Section, and I'm here today with Robert Tobey and Nik Fahrer to delve into how to interact with clients and potential clients that may have digital asset activity.

Nik and Robert are on the AICPA's Virtual Currency and Digital Assets Tax Taskforce so I thought they would be perfect to share some thoughts with us today.

Digital assets, virtual currency, there's so many different terms of art here. Cryptocurrency. It is such a unique and fast-moving field. Kick us off with what kind of expertise is needed to be able to be proficient in this area. Proficient is maybe a hard word, but at least to be able to practice in this area.

Robert Tobey: First of all, you have to have a general understanding of the different types of digital assets that are out there. Right now, in particular, practitioners are probably dealing mostly with cryptocurrency, miners, traders, stakers, and non-fungible tokens which indicate a specific ownership interest (it's like a derivative of some type of underlying asset).

You need to have an understanding of what each type of these assets are. Since the tax code treats them as property from each one of these activities. If you are a miner, that's generally self-employment income. If you're an investor, that is just buying and selling, that's long or short-term capital gains.

If it's NFTs, that's treated generally as a collectible and that's taxed at 28% if it has a gain. That is ordinary income also, but the timing of recognizing that is still up for debate.

Really unless you have an understanding, my feeling is if a client comes to you or if you have these types of assets, you should seek out council, an accountant, a lawyer that understands these types of assets.

If you're a practitioner and a client comes to you and you're unsure, you should seek out help from the digital asset task force where we can answer some of your questions.

But this is one of those areas because the rules are so different and the different types of assets have different attributes to them. If you're unsure, don't practice in this area unless you really know what you're doing.

Walker: We're going to talk a little bit more about some of those questions a little bit later, but I like to think about it. It's a whole new vocabulary. It's a whole new vocabulary for understanding — what even is staking? You have to understand that stuff so that's a great way to kick us off.

Nik, as you're trying to think about learning this, where have you found to be the best place to gain expertise in this area?

Nik Fahrer: First of all, thank you April for having me on here today.

Walker: Yes. Thank you for joining me.

Fahrer: The first piece of advice that I would recommend is just dabble in this on your own. Find some insignificant amount of money, and just go out there and play around with it.

I think the best way that you can learn something and the mechanics of how these things actually work is to sign up for an account on a centralized exchange, just to name a few in the US would be Coinbase, Kraken or Gemini. Put an insignificant amount of money in there. Buy, sell, but then take it even further.

Don't just buy and sell on a decentralized exchange, send it to a non-custodial wallet and connect it to a decentralized application, like a decentralized exchange and play around with it on there. Stake some of your crypto to see how that works and just generally figure out the mechanics.

I think that's generally the best way to understand what some of these words mean. It really feels like there's a entirely new vocabulary when you get into the space.

When a client comes to you and they're like, “Hey, I just staked some Ethereum and earned X amount of dollars through staking.” You're probably wondering what the heck is staking? Doing it on your own with an insignificant amount of money is a really easy way to learn how this stuff works.

But taking it a step further, if you want to learn how these applications within this new technology actually apply within the Internal Revenue Code, the AICPA has a really good webpage.

IRS has an FAQ webpage. They also have a web page dedicated specifically to digital assets where you can go out and see all of their guidance that they've previously issued, both binding and unbinding guidance that they've issued out there. That's a really good resource as well. I would start there with those two things and then just be a critical thinker.

Try to understand as you're working with your clients in this space, where are the risks and then also, what's the cost versus benefit analysis? If a client comes to you and says, “Hey, I did all these hundreds of thousands of transactions in crypto,” and they tried to turn over an Excel document to you to go through and calculate all of their basis and proceeds. That's going to be a huge time suck.

Is that really worth the cost versus what may actually be captured on the client's tax return could end up being an overall net $1,000 gain? Use some common sense as well and just try to understand what are the risks, but also what's the cost versus benefit analysis here?

Walker: I like that and thank you for bringing up the AICPA's page. We'll put a link to that in our show notes and as well as the IRS page.

Robert, you are a partner at Reed Accountants and Advisers. Talk to us a little bit about is there any specific processes or procedures in place that you guys have before you either accept a client that has digital asset activities or how you're dealing with a client that might start dabbling in it? Also while you're at it, just talk to us a about advice you might have for those with smaller practices.

Tobey: It's interesting if someone comes to us and is just a trader. Like they have a Merrill Lynch account for cryptocurrency. There's not a lot of risk in that type of account and it's easier for us to accept and understand because they're trading — it's like they’re trading stock. If they hold it, they can be a trader in the securities which allows them to deduct their expenses differently then if they're an investor.

If they are an investor, they may be holding it for long-term gains, [but the trader is] going to have short-term capital gains and losses. That's easier to understand.

If somebody comes to me and says, I'm a miner, and I'm working with a client right now, that's a miner. I go fine. What do you mean by you are a miner? What do you do? Where do you do it? What currencies are you working with? Where is your mining rig located? Because that has some state income tax implications with respect to it.

This guy lives in Connecticut and his mining rig is in a facility that hosts it in Texas. When you mine, it's like you're self-employed and you're earning income. What do you do with that income once you earn it? You recognize it as ordinary income, you deduct your Sec. 162 ordinary necessary business expenses against this.

But now you have cryptocurrency, that once you hold it in your hands, it is an investing type of asset. What do you do with it once you have it? Are you staking with it? Are you trading it? Are you holding it for investment? Because of the complexities of the subject matter, I go through a lot of questions.

I have a checklist of questions I go through to ask people who were more than merely investors (like they hold stocks) in cryptocurrency before we choose to accept them.

You [have] to make sure that there's not any risk with respect to this. Are they doing things offshore? Are they doing them in a manner where there's some subterfuge about what they're owning because they want to potentially hide their assets offshore? There's also firm risk that we have to take into consideration.

Then once I talk to them, I determined what a fee might be because this is generally complicated stuff [more than for a] regular tax return. Our firm is really trying to get away from just doing standalone 1040, so we're talking to a lot of businesses. I'm talking to a cryptocurrency venture fund to figure out what they're doing and how I might be able to help them. That brings another level of complexity.

I lived in Charlottesville, Virginia for 25 years and there are a lot of small practitioners down there that serve the community. They're more likely to see someone who's a trader.

They really need to go to either the AICPA website or the IRS's website and become familiar with the rules regarding cryptocurrency of recognizing gains and losses and what types of gains and losses are there. Also they need to understand the fact that sometimes regular security rules don't come into play here because investing in cryptocurrency is not subject to the wash sale [rules].

There are some unique aspects to it that they really need to understand. Again if I'll go back and say what I said before. If you're unsure of it, don't put your toe in the water. If you're going to work in this area, at least get up to your knee, so you understand what's going on and you have some technical background with respect to it.

Walker: I think that's great advice. Also, it's more than just asking the very simple question that you have to ask to be able to check the box on the 1040. I like that. You need to think about and ask what those different levels of deeper engagement questions are.

Nik, what about you? You're at FORVIS, so a bigger firm. [Do you have] additional steps, or additional recommendations you have about when you're dealing with clients with digital asset activities?

Fahrer: Absolutely. I can speak to that. The best piece of advice that I would say is, let's start with the basics first. Let's not complicate things before we get too far down the road, but let's first ask those basic questions of, one, do you have the competency to serve this client, or does someone in your firm have the competency to serve this client?

Two, what is the reputation of the client and is this a client that you want to be connected with and work with? Maybe one that is not so obvious is can they pay your bill? Robert alluded to this a little bit earlier, but these are complex issues. Maybe the fees are a little bit higher than normal.

Is this something where you need to be concerned about the volatility in the market and the client may be underwater in their investments and not as liquid in their cash position. Let's ask those basic questions first and then we can start to move into the more digital asset specific questions that need to be asked in that client acceptance.

This isn't fully inclusive, but some of those could be how clean are their records? That's probably the biggest one that you want to ask is where are you keeping track of all your records, especially if the client gets off of a centralized exchange.

I alluded to this earlier whenever I was talking about how to get expertise, or some experience and doing it on your own. Don't just stick to a centralized exchange. Send your crypto to a non-custodial wallet, play around with on-chain transactions, because more than likely that's what your clients are going to be doing that need your help. Then now that you have this experience on your own, you can relate to them and know what to look for when they come to you, and know what to expect in the recordkeeping as well.

[For] on-chain transactions, there's a record of all of them on the blockchain, but there's no standard 1099 reporting, at least as of yet. We're waiting for some more guidance from the IRS here, or Treasury, one of the two, to understand what the standardized reporting is going to look like in the future.

Because of that, there are software companies out there and I'll just name a few that can help automate the on-chain transaction reporting. [For example] CoinTracker, or Ledgible, or Cryptio, or a Bitwave are several of them out there. That's not all inclusive. There is more than just those.

But they can basically connect their software to the clients wallets and exchanges and it will automate a vast majority of the transactions, and a lot of them will even raise red flags if they are unable to match cost basis, based on all of the wallets and exchanges that they've connected into that software. That's another thing that helps you as a practitioner know, hey, the client hasn't given me all their information. They say they've connected to all of their wallets, they say they connected all of their exchanges, but we're missing information for a lot of the cost basis of these transactions. It's a tool that you can have in your tool belt that'll really help you take this to the next level.

Walker: I'm glad you brought up recordkeeping. That was actually one of my questions, but that's great. Thank you for the recommendations.

I'll ask Robert if he has any also, because I feel like this could become a fire drill situation. When you got somebody coming in and they have all these crypto transactions, and then you have to go back and try to figure it out. Hopefully this is a proactive conversation. What do you recommend to your clients to help with recordkeeping, Robert?

Tobey: I'm not recordkeeping for [them].

Walker: Absolutely.

Tobey: Here's the deal. This isn't looking at a [Form] 1099-B where the column 15 [has all the information]. Most of the people that I deal with that are investing in, or dealing with crypto, have thousands of transactions. Unless they use Coinbase or some other [tracking software].

Fahrer: [Some options are] Ledgible, CoinTracker, Cryptio, Bitwave. Those are all just a few, just to name some.

Tobey: Unless they use those and they bring us the records and we can tie them out, or they have a spreadsheet that they've done themselves.

Our firm will not do that. We're running out of people just to do regular work and to sit there and to try to keep track of somebody's 10,000 crypto transactions in any one year that are not large dollar amounts in and of themselves. We just can't do that. It's a client responsibility and they wouldn't want to pay me to do it frankly.

Walker: Absolutely. That's a red flag if you've got somebody coming in and they are just like, I got crypto transactions and I haven't done [anything with] it. That's a red flag. What are some other red flags that should send a signal up that this is may be not the best client for you?

Fahrer: One question that we generally like to ask is, how did you acquire your digital assets? If they don't have a good answer to that question, that's generally a red flag.

Tobey: And where are you holding it? Are you holding it in the U.S., outside of the U.S.?

I'm really interested in the risk I'm going to have with somebody that's dealing with exchanges that are not U.S. exchanges and they should be reporting it, but they shouldn't necessarily be transacting on the exchange. I agree that if they can explain where they got it, if they can explain ins and outs of the transactions and they tell me that they're doing stuff offshore. The offshore ones have stopped me dead in the water.

Fahrer: I think one thing that you can do as a practitioner to protect yourself and your firm is to get some sort of representation from your client that says, hey, I've provided you with all of my wallets, exchanges and transactions, and that there are no other ones out there that I haven't already provided to you. That protects you that the client is saying that they've given you everything.

Tobey: We have that in general in our engagement letters. That we've told you everything, we've provided you everything you needed to prepare our tax return. Now that you say that, I actually might put an extra sentence in there about cryptocurrencies.

Walker: We're all learning. We're going switch gears just a little bit and I want to talk about guidance the IRS recently released. Revenue Ruling 2023-14, talking about cryptocurrency, staking, and rewards. Robert, you want to give us a very high-level overview of that. I know that it can get really complicated, really fast. Just tell us what we need to know about that guidance.

Tobey: This is a timing is everything revenue ruling. It was issued while a couple named the Jarretts are in the Sixth Circuit Court of Appeals, having their case heard with respect to a refund and that the IRS gave them with respect to how they reported their staking activities.

The long and the short of it is the Jarretts take the position that staking activity is nothing more than a baker putting ingredients together, baking a cake and doesn't recognize the income from baking the cake until he sells the cake. That's the simple discussion of it.

The IRS says okay if you stake, once you earn the income or have dominion and control over the rewards from staking, you need to recognize it as income. It's a very big deal. The IRS came out with this to put the stake in the sand with their position regarding the Jarretts. You got to follow it because it's a revenue ruling.

If people have a feeling that they want to take the position that the Jarretts do, you're going to have to file a disclosure form with the IRS stating that you've taken a position contrary to the law. You can do that, but it'll give you the free pass to the IRS audit auditors.

Walker: Yes, it will, okay, that's great. We'll link that in there so you can read it, and learn more and make sure that you're following that guidance. I mentioned that both of you were on the Virtual Currency Digital Asset Task Force. I want to say thank you for that. Thank you for your volunteer service.

Nik, could you give us a quick rundown on just a few of your top priorities for the group or that the group is working on?

Fahrer: Yeah, absolutely. Maybe I'll touch on a few that we just completed too.

We actually just released a resource that is basically questions to ask your clients if they invest in crypto.

We also recently released an FAQ on taxpayers taking losses. Specifically, taxpayers that may have had crypto tied up in a centralized exchange like FTX. Can they capture those losses in 2022 tax year? If not, how did they capture those in the future?

We also, recently sent a letter on the new virtual currency question that's being added to our 1120-S, 1120-C corp, and then also, 1065 partnership returns. It's very similar to the 1040 question. We sent a letter to the IRS about that.

Also sent a recent letter to the IRS about Notice 2023-27, which is guidance on NFTs as collectibles. As you can tell, we've been really busy, this year sending a lot of letters and working a lot of resources for you all.

Upcoming, we're looking at responding to the Senate Finance Committee letter, that asks basically nine or ten different questions of, how does the ambiguity in the tax law apply to digital assets?

Senators Lummis and Gillibrand also recently proposed a bill in the Senate [Lummis-Gillibrand Responsible Financial Innovation Act to create a comprehensive regulatory framework for crypto assets], and we're going to respond to that as well. Then this [ruling], 2023-[14], which talks about the timing of when to pick up staking income in gross income.

Walker: Perfect. Yes, as you said, you've been very busy, and I'm sure will continue to be as there's seems like to me, as we learn more about virtual currency and digital assets, there's more to learn, is the way I feel about it. Thanks for helping get that guidance out there.

Robert, as we're wrapping up just any final thoughts you want to share on this topic, or with our listeners about digital assets?

Tobey: The loss issue with respect to FTX and some of the other digital exchanges is really problematic. It's a timing issue. A lot of times losses can only be taken as miscellaneous itemized deductions which are no longer allowed after the Tax Cuts and Jobs Act. It could be interesting to see what the IRS comes out or whether they come out with guidance that will allow some of these losses.

There's a vibrant market today in the bankruptcy claims from FTX. How were those treated for tax purposes? Are there two different property rights there? Is there a bankruptcy claim property and there's a claim, but the underlying cryptocurrency? Even though you sell your bankruptcy claim, do you still own the underlying right to the cryptocurrency? I don't know. Neither does the IRS. We've asked for guidance from the IRS on this.

Can you take a bad debt deduction with respect to cryptocurrency and I don't believe that's allowed because bad debts are only allowed with respect to cash. That's another area that we need some guidance from. When it [comes] from bankrupt exchanges and other things, it's unclear of when you can and whether you can claim any loss at all. The IRS is going to have to deal with this because, I read that there was another exchange that was near bankruptcy this week. This isn't going away.

I will tell any practitioner that's listening to this. If you have someone who comes to you and says, here's the facts and circumstances of my losses with things. You need to stop and really look at several things. What was the underlying investment? What was the underlying cryptocurrency? When did the event occur? Claiming it currently in 2022, I think in a lot of cases would be problematic.

Walker: That's super helpful. Thanks for bringing that really important topic. What about you, Nik, what [are] some final thoughts you have as we're wrapping up.

Fahrer: One thing that I'll say is that I think this technology is really polarizing. We seem to have people on both sides of the aisle. We have people that just really love this new technology. We have people that, just haven't really bought into it and they don't see the benefit to it.

The question I would pose though is, given the IRS is issuing a lot of new guidance on this new technology, given that it is a hot topic in DC, why would they regulate it if it's something that's going to go away?

My personal opinion is, they probably wouldn't. I think it's going to be here to stay. It's probably going to be around for awhile and to just completely brush it off and ignore it completely is maybe a mistake as this continues to grow in adoption.

Tobey: I'll tell you that they'll be some upheaval in it this year.

The recent administrative law judgement decision that cryptocurrency that was bought by individuals on an exchange, is not a security where crypto assets bought by institutional investors are securities. That it'll be interesting and that's going to go, if it was by administrative law judge, I can see that going to the regular court system now because, I don't see how you can say it's a security for one type of investor and not for another.

There's another court case, that the Supreme Court is going to hear next term. Similarly, about rulemaking by the SEC in general, that will have an effect on this. Because one thing, when you're dealing with crypto and dealing with all these other assets — for the IRS, its property. For the SEC, it's a security. For the CFTC, it's a commodity and in some countries, it's a currency. We're dealing with US tax law. We know what property is, but you've got to take into consideration,what it is in other jurisdictions and what it is to other rule-making bodies within the United States.

Walker: Thank you so much, Robert and Nik. This is definitely not be the last time we talk on this podcast about virtual currency. But I think this gave our listeners, a lot of good topics to dig into and think about as you're dealing with your clients.

Again, this is April Walker from the AICPA Tax Section. This community is your go-to source for technical guidance and resources designed especially for CPA practitioners like you in mind. This is a podcast from AICPA and CIMA together as the Association of International Certified Professional Accountants. You can find this wherever you listen to your podcast and please follow us so you don't miss an episode. If you already follow us, thank you so much and please feel free to share with other like-minded friends. You can also find this in aicpa-cima.com/tax to check out our other Odyssey episodes and also to get access to all the resources that were mentioned during this episode. Thank you so much for listening.

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