In a launch shrouded in mystery, Bitcoin emerged in 2009 and changed the face of the global economy. As a new asset class, cryptocurrency presented a unique investment opportunity for individuals and organizations. However, along with the excitement of this emerging currency came myriad questions surrounding cryptocurrency’s financial regulations and tax implications. Thirteen years later, there has been some progress in defining crypto tax laws. Still, financial professionals such as accountants and auditors must work to account for cryptocurrencies as their organizations and clients use them to conduct business.
Before diving into the complexities involved with crypto transactions and investments, it might be helpful to understand what cryptocurrency is and who uses it.
What is cryptocurrency and how does it work?
Essentially, cryptocurrency is a digital form of currency. However, many details prevent it from being treated like fiat currency for accounting purposes:
- Cryptocurrency is considered property, not legal tender: This is an area where crypto tax laws can get complicated. In the eyes of the IRS, purchasing and then holding cryptocurrencies is not a tax event in and of itself. However, any crypto transactions resulting in capital gains or losses are considered taxable events that must be reported. Further, any crypto payments received for services performed need to be declared as taxable income and are, as such, subject to withholding.
- A peer-to-peer network decentralizes cryptocurrency: Another of the more salient factors distinguishing cryptocurrency from fiat currency is that cryptocurrency is not beholden to the rules, regulations and fees enforced by a centralized financial institution or government. Because of this, unlike fiat currency, which has a valuation directly related to the fluctuating market, cryptocurrency’s value is driven by supply and demand. Finally, because most cryptocurrency supplies are capped, no governing agency can affect their value via inflation.
- Blockchain technology provides a secure, anonymous and permanent method of record-keeping: The peer-to-peer network that works to confirm and record each crypto transaction consists of computers, or nodes, that are essential to the blockchain infrastructure. With no central node or administrator to act as a higher authority with more rights or responsibilities, these nodes operate as a regulatory system for the digital ledger. As a crypto transaction is initiated, each node digitally mines for proof of crypto ownership to permit and document the exchange. An explanation of receipt, called a hash, identifies each crypto transaction and ensures it has been validated by the nodes and attached to the blockchain. Once added to the public ledger, these blocks cannot be removed or altered.
- Crypto exchanges: The entities that facilitate crypto transactions are called exchanges. Doing your homework on the different exchanges and their various features is critical in executing safe crypto transactions. Investopedia has a solid base of criteria it uses to judge the legitimacy and quality of the many exchanges currently available today. Factors such as security, currency support, payment methods and fees associated with transactions are all features that need to be considered when choosing an exchange. Accountants and auditors would be wise to know the ins and outs of the exchanges used by their clients so they can best advise them on the tax implications presented by each one.
- Digital wallets: A digital wallet is an encrypted application that stores cryptocurrency. Services like PayPal can offer crypto storage as well, but it is recommended that anyone looking to increase their crypto investments acquire a digital wallet. Hot wallets are defined as those that require an internet connection to use and access crypto. A cold wallet refers to digital wallets that do not require a connection and are usually external devices, much like thumb drives.
Who is using cryptocurrency?
Despite the rapid and massive fluctuations in value, crypto investments have the potential for immense profit in both the short and long term. This makes crypto an enticing investment opportunity for investors of all types. From beginners with little to no knowledge of crypto to seasoned investors with a keen eye constantly on the market, crypto appeals to a range of individuals.
Many people have a growing distrust of both the banking industry and governments, which can be the driving force behind many crypto investments. In the absence of a governing body, the fees that accompany these institutions are also eliminated, making crypto all the more attractive. Crypto transactions are faster and more cost-effective than traditional banking methods as well. This is important to investors with efficiency in mind. Without a centralized entity, crypto companies can operate without the lengthy protocols and fees associated with banking systems.
Investors with an interest in keeping their portfolios diverse have a keen interest in crypto. Not only can you spread your investments into a new asset class, but within that class, there are also multiple diversification opportunities. Because they are not required to operate in the same way, there are different projections for each crypto exchange.
Financial reporting requirements
While these financial reporting requirements are subject to change, these are the current standards that some countries must abide by:
- United States: As mentioned above, cryptocurrencies are not considered legal U.S. tender, and investors must report all capital gains and losses regarding cryptocurrency on their federal income tax returns for the year of the transaction. At the time of this article, regulations for exchanges are imposed at the state level and vary from state to state, with all exchange companies required to register with FinCEN. To prevent criminal acts within the crypto environment, the U.S. Treasury is attempting to enforce local and global cryptocurrency regulations that require exchanges to report any suspicious activity over $10,000, with anonymity being off the table for single transactions over $3,000.
- Canada: Like the U.S. government, the Canadian government does not recognize cryptocurrency as legal tender, and all exchanges are required to register with FinTRAC. Both Canada and the U.S. consider crypto holdings as securities and treat them as such in their respective tax filing laws. Canada is known to be very proactive with its crypto regulations, and no significant changes are expected in the near future.
- United Kingdom: Cryptocurrencies are not considered legal tender in the U.K., which has no specific cryptocurrency laws. Exchanges have requirements for registration. A capital gains tax is applied to gains or losses on cryptocurrencies.
- Europe: Crypto is not a legal tender in Europe, and member-states regulate exchanges. Taxation laws vary by member-states, with many requiring tax reporting on capital gains. For member-states such as Germany, France, and Italy, exchanges are required to register with their respective regulatory agencies. In the future, the European Central Bank has indicated an interest in issuing cryptocurrency.
Opportunities for accountants and auditors
The rapidly evolving and volatile nature of this field makes the rules around reporting tax on cryptocurrency a mystery to most investors and corporate leaders. Because of this, there is a great need for tax professionals with knowledge of this ever-growing space, and it is only expected to increase. To stay relevant and in demand in this current financial climate, accountants and auditors must stay abreast of the new tax rules and regulations pertaining to cryptocurrency. By expanding your services to include crypto, you can leverage your broadening expertise to fill the current need, while increasing your influence and client base.
As a digitally-based currency, crypto offers a host of advantages for accountants and auditors seeking to stay at the forefront of the market. By design, blockchain in accounting provides the advantage of overseeing a transparent and secure ledger. Subsequently, the costs associated with maintaining historical records, reconciling ledgers and providing proof of asset ownership are drastically reduced. This will promote a healthier profit margin and free up time otherwise spent on these tasks. The time saved can be used to solve complex problems that a computer cannot tackle for your clients.
The technology that crypto presents to financial professionals can also eliminate the bias and error that can inadvertently happen on the human level. Accounting software can also help with this by implementing automation within processes such as data entry and reporting. Additionally, with everyone posting to one public ledger, the need for costly, time-consuming and stressful third-party audits could become a thing of the past.
Risks of cryptocurrency
No investment is without risk, and crypto investments are no different. However, the risks associated with crypto are unique to its volatility, decentralization and recent emergence in the industry.:
- With crypto, there are zero guarantees: One of the most significant risks of cryptocurrency is its ever-fluctuating value. Crypto’s public perception, the ever-growing fear of pending regulations, its early association with the dark web and the sheer novelty of a new asset class can all influence the demand for crypto in significant ways. This demand can be swayed quickly and dramatically without warning. In short, crypto’s reputation for being a high-risk, high-reward investment has been well-earned.
- Cryptocurrency is not backed or regulated by a financial entity: While one of the most attractive aspects of crypto is that it is not tied to a governing financial institution, this can also present a significant risk factor. The protection that banks and governments provide against theft, fraud or improper management does not apply to crypto investments and transactions. Because of this, the burden of determining the legitimacy of a crypto investment rests solely on the investor, with no possible recourse if they choose incorrectly.
- Regulations for cryptocurrency and accounting are still being developed: Because crypto cannot be pigeonholed into any currently established tax rules, crypto accounting can be a tricky business rife with confusion and inadvertent misreporting. This only adds to the uncertainty that a crypto investment carries and can make even the most fearless investors wary of entering the cryptocurrency space. To add to this uncertainty, Forbes reports that the Financial Accounting Standards Board (FASB) has only just begun to add a project pertaining to digital assets to its technical agenda.
- Incorrectly recording crypto can have negative tax implications: As with all tax events, crypto activity needs to be appropriately recorded to maintain good standing with the IRS. Failure to do so can have negative tax implications that can be costly and can even result in legal recourse. The excuse that an investor is ignorant of the evolving laws surrounding crypto is unlikely to garner any sympathy from the IRS.
- Not all crypto companies are the same: When a new class of assets emerges, the bustle surrounding its growth can cause investors to make hasty decisions regarding the crypto company they partner with. Some might assume that if they worked successfully with one company, they could do so with another. However, because the crypto space is unregulated, its companies are not beholden to any rules or laws that would be enforced within a regulated industry. Inexperienced investors without the proper guidance are vulnerable to scams, misleading claims and identity theft.
Tips for accountants and auditors
Probably the most valuable piece of advice finance professionals can receive regarding cryptocurrency and accounting is to keep up with the changes as they are presented. Your clients and reputation depend on you being as knowledgeable and experienced as possible in this dynamic space. Having a solid understanding of the basics of crypto is an essential start for emerging as a leader in the industry. Before getting bogged down in its countless details, you must first grasp the fundamentals. If you are uncertain where to begin, listening to your clients’ concerns can help point you in the right direction.
Because staying on top of industry standards is vital to any business with a focus on future growth, it is essential to recognize the tools that can help you on the way. By partnering with an established accounting software company, you can be sure to provide top-notch financial services to your clients. The right software can help guide you through the nuances of any complex tax situation, optimizing your time so you can give each of your clients the attention and accuracy they deserve. Reputable accounting software can also help streamline your firm’s workflows, maximizing productivity and efficiency.
For more than 30 years, Caseware’s advanced solutions have continually anticipated the future needs of accountants and auditors, enabling them to create positive impacts for both themselves and their clients. Learn how Caseware can help your organization prepare for any future challenges and opportunities.