Last Updated: September 25, 2020
This article was originally published on Forbes by Shehan Chandrasekera on January 28, 2020
Over the past few weeks, I have been breaking down the new “cryptocurrency question” on IRS Schedule 1. In this final post of the series (part 6 of 6), we will take a deep dive into the “financial interest” category of this question. This is an extremely ambiguous category which is open to interpretation and some professional judgement. (The IRS has not defined the term, “financial interest”, for the purposes of Schedule 1 question)
In my opinion, the “financial interest” category is an all inclusive category; it is intended to capture anything which is not directly covered by “receive”, “sell”, “send” or “exchange” categories. Below are some interesting situations where you will likely have “financial interest” in virtual currencies and have to check “yes” on Schedule 1 cryptocurrency question.
Just Holding Cryptocurrency
For the tax years prior to 2019, you would not have to do anything on your tax returns, if you only held cryptocurrencies during the year. However, starting 2019 tax year, for the first time, you have to disclose to the IRS you hold crypto assets because holding means having “financial interest” in cryptocurrencies. Holding cryptocurrencies is clearly not a taxable event so you will not owe any taxes for holding. But, now you have to disclose your ownership/affiliation to the IRS by checking “yes” on cryptocurrency question.
From the enforcement perspective, the inclusion of “financial interest” category is the only way the IRS can police certain cryptocurrency holders. For example, if you hold virtual currencies in decentralized exchanges, hardware/offline wallets or foreign exchanges, the IRS may not have any visibility to those transactions because those platforms do not typically report to the IRS (How The IRS Knows You Have Crypto). Therefore, making the taxpayer disclose these activities on Schedule 1 is the only way the regulators can get some knowledge about those holdings.
On a side note, the question about financial interest in cryptocurrencies closely resembles the question on Part III of Schedule B regarding foreign financial accounts. So, asking such a broad question is nothing new to the IRS. According to the IRS chief counsel, Michael Desmond, the Schedule B question has been very successful and the service expects to see the same success with Schedule 1 cryptocurrency question.
Owning Crypto Through a Pass-Through Entity
Here is an interesting situation where you may have to check “yes” for the cryptocurrency question as a result of owning an entity which has financial interest in cryptocurrencies. Let’s assume Jennet, Andrew & Sam pool money together and start a small bitcoin mining operation. The mining operation is registered as a LLC and taxed as a partnership. Let’s call this entity, BTC LLC. Also, each partner contributes $5,000 worth of capital and therefore owns 33.33% of interest in the entity. BTC LLC mines bitcoin throughout the year. At the end of the year, BTC LLC files a Form 1065 (U.S. Return of Partnership Income) and distributes Schedule K-1ns to Jennet, Andrew and Sam, showing their 33.33% share of income or loss. Now, here is a situation where each partner may have a “financial interest” in virtual currency through the ownership of BTC LLC. The IRS has not been explicit about whether you have to check “yes” on Schedule 1 in such situations. However, as a conservative taxpayer, it would not hurt to check “yes”.
This scenario leads to another area where practitioners need to be proactive. Going with the example above, imagine BTC LLC has 100 partners. BTC LLC tax return (Form 1065) is prepared by one accountant and the personal returns (Form 1040) are prepared by different accountants for each partner. In this case, as a best practice, it is suitable to include a footnote in each K-1 indicating that the partnership deals with virtual currencies. This way the partners and their accountants know to answer the cryptocurrency question on Form 1040 Schedule 1 accurately.
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Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.