Mike Villa guest hosts this week’s podcast where he discusses recent hot spots in IRS reporting and enforcement on digital assets and virtual currency with two experts in the field, Damon Rowe (former IRS Director of the Fraud Enforcement Office) and Stacey Ferris, a CPA and CFE who developed a college course on block chain and cryptocurrency that she teaches at the University of Maryland.
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Listen to the podcast here
Virtual Currency: IRS Reporting & Enforcement Developments from the Trenches by Tax Rep Network
Introducing Damon Rowe And Stacey Ferris
This is Mike Villa, serving as a guest host for the Tax Representation Network and sitting in for Eric Green as a moderator. I have two guests that you will enjoy tuning in to. We’re going to be discussing virtual currency, reporting, and enforcement developments from the trenches. I’ve got two guests that make me feel pretty inadequate. For those who don’t know me, I am a tax lawyer in Dallas who focuses on white-collar criminal defense and tax litigation. My two guests are highly accomplished tax professionals.
First, we have Stacey Ferris, who is going to tell us a little bit about the top-secret clearance that she gathered in her background. We also have Damon Rowe, who also has top-secret clearance from the Department of Defense. I’m the only speaker who does not have top-secret clearance, and therefore, I feel a little inadequate. Stacey is a CPA and certified fraud examiner with HKA, a multidisciplinary consulting firm, and has a bachelor’s degree in Accounting and a master’s in Forensic Accounting. How does that background get you to a minor in Chinese? How did that happen?
That’s a long story, but I’ve always had a passion for languages. Accounting was more the accident of ending up in a business course and going, “This isn’t that complicated.” My original plan for life was to be a diplomat. I wanted to work in China, work in Asia, and I moved to DC because I wanted to join the Department of State, but here I am, still in accounting.
With that top-secret clearance and a Chinese background, I think you might be hiding something from us, but she’s assured me she does not work for the CIA. I don’t know.
It’s a need-to-know basis. Sorry, Mike.
Need-to-know, that’s it. Stacey also has done some interesting work on our topic of virtual currency. As a professor at the University of Maryland, I understand that you have developed a blockchain and crypto course. What does it take to develop a course on blockchain and cryptocurrency? What have you done in that arena?
I started to get into the space around six years ago, as a personal investor and all that, and learning about it. I was attending every conference, every webinar, everything I could find, and that came out of a project that happened in 2017. My CPA firm at the time won a contract with NIST, the National Institute of Standards and Technology, to do an economic impact study of the Advanced Encryption Standard. That led me down the wormhole of studying encryption and reading about it. That’s how I got into this blockchain stuff and understanding it.
I met a lot of people who were developing and biddling, as they call it, in the space. I ultimately ended up working with a startup as their product manager for some audit products. It’s been a long and winding road. Ultimately, what happened is that at the University of Maryland, I knew some of the professors there, and they approached me and said, “We want our accounting students to understand what this crypto stuff is. Would you be open to developing a course?” I said, “I’ll take the challenge.” I took it. It’s been a lot of fun. You have to know something inside and out to teach it well.
You do have to know it inside and out. The other thing with virtual currency is you mentioned one word in there, biddling, I think?
Hodling or biddling.
It reminded me, and I hope the audience understands that the virtual currency world has its own dictionary. It’s got its own words. They have their own meanings. These are not words that we use in the regular world. This is in the virtual currency world. If an accountant or a tax professional wants to get involved in the virtual currency world, is it important for them to understand all the vocabulary that’s out there before diving into the virtual currency reporting world?
You can probably learn as you go. I don’t think it’s overly difficult. I don’t think it’s a barrier to entry. Learning the vocabulary is something that happens as you move along and you get more into the space.
They don’t need to buy your textbook to prepare a tax return on virtual currency.
It is not a textbook. There is no textbook.
You have to know something inside and out to teach it well. Share on X
It’s a virtual textbook.
I teach the course entirely from free materials online, from NIST, and other research documents. There is not a textbook. That was one of the big challenges of teaching this stuff, no textbook.
You’re like ChatGPT, you’re scraping other people’s data to pull it together for your own course book. It’s all in your brain. Thank you. We also have Damon Rowe with us. Damon is my law partner here at Meadows Collier in Dallas, Texas. Damon has an LLM in tax law and also a bachelor’s in Accounting. Damon worked for over twenty years with the IRS and the IRS Criminal Investigation Division. He didn’t work with the criminal division, he was the special agent in charge. For those who don’t know what that means, within the criminal division, Damon was the head cop for the criminal division in Dallas and then in Los Angeles. He was the guy with a gun and a badge trying to put the tax cheats in jail.
From there, he worked his way up to a couple of national roles, where he was the executive director of international operations for CI and the executive director of the Office of Fraud Enforcement for the IRS. I believe in those roles, you also had some virtual currency training from the IRS. Apparently, you also have top-secret clearance that, once again, I don’t have. Tell us a little bit about your roles with the IRS and how, maybe, some of that virtual currency training came to be and how you implemented it in your job there.
Certainly, going backward, the last spot, Office of Fraud Enforcement, when I was the executive director there, we wanted to roll out some training for the IRS. You talked about the biddling and the words that people use in the cryptocurrency world. We wanted our auditors, who were auditing the tax-paying American public, to be fluent in this area. Without fluency, they couldn’t understand the taxpayers’ problems or taxpayers’ needs.
Our whole issue at that time was trying to get people to the right answer. If our auditors were confused about what was happening, they might have been defaulting to some other thing that wasn’t the right answer. It was important to have that fluency. We didn’t have a book either, but we did develop some training through some outside third-party sources, and we were able to do that. They’ve come a long way in the last six years.
Different Types Of Digital Assets
It’s pretty interesting that to get the source material for all this training, it sounds like a lot of us are having to go to third-party sources to try to educate ourselves in this evolving world. That’s an interesting side note because where we’re at in this, timeline on virtual currency and tax reporting and enforcement is that we’re in a place that is now requiring us to teach ourselves about a new area, and yet it has real-world substantive impact and consequences. One of the things we wanted to talk about here is, within the virtual currency world, what are some of these substantive areas?
For example, Stacey has provided me with a chart that she’s put together with a group that she’s working with on digital assets. It’s like a hierarchy and a flowchart of different types of digital assets. I would submit to the audience, it’s a very easy-to-read chart. If anybody wants a copy of it, you can reach out to us, and we’ll happily send you a copy of Stacey’s chart on digital assets. Stacey, you can maybe walk us through, what are some of these basic types of digital assets that the audience might want to be thinking about if they’re first getting into the world of having to deal with tax reporting or information reporting related to these digital assets.
Digital assets for the IRS and taxes are all treated as property, regardless of whatever type you have on that hierarchy. The hierarchy is also going to be published in the Journal of Accountancy in the next few months. It’ll be available publicly soon, along with an article that will walk through each of the different categories on that chart. There are three main groups on that hierarchy, and this all came out of me trying to teach it. When you’re doing accounting, you have to identify what I am dealing with first. Although for taxation, you treat it as property, that doesn’t work very well in GAAP and accrual accounting. I realized I needed some way to break it down like here’s the landscape of the assets.
You’ve got three big categories, CBDCs, fungible crypto assets, and non-fungible tokens. Most of what you’re talking about with taxation is going to fall into fungible crypto assets. Within that group are private issuer tokens and the fully decentralized box, where I only put Bitcoin into the fully decentralized category. Virtually everything else falls into private issuer. The stuff that you think about is like coins and money. It’s not real money. It comes into private issuers, and it’s going to be, by and large, a lot of them are some utility token or stablecoin. Those are two huge categories of tokens that exist out there, and they’re popular for trade.
The purpose of that hierarchy is that if you know what you’re dealing with, it’s a lot easier to figure out how you treat it. For tax purposes, maybe it’s a little simpler because everything is property. You apply the capital gain and loss type rules, and it can be pretty straightforward. When you get into accrual accounting, based on the type of asset, you’re going to account for it differently, and it can get quite confusing. You’re not going to treat Bitcoin the same way you would treat NFTs.
If you’re into DeFi and you’re doing a bunch of DeFi activities, you’re going to have different types of assets that might require specialized derivative accounting. I was looking for a way to give the accounting community a standardized way of talking about the assets so that we could have conversations about how to treat this stuff and speak the same language about the types of assets.
How To Prepare Reports For Tax Purposes
As you move forward as a tax professional, one of the things we’re talking about here is how to help regular people who have invested in Bitcoin or NFTs, and maybe they’re trading in these types of virtual currencies or digital assets on a regular basis. How do we help them properly report it for tax purposes and then for information reporting purposes as well? You’re generally going to be dealing with a lot of individuals. If they’re in this space, they’re probably fast-moving, technology-loving types of people.
How do we get with those types of taxpayers in advance of them being fast-paced and moving things around a lot? How do we help them keep that organized to help you prepare a correct return or properly report these assets? Is there any guidance out there yet on how to sit down with a taxpayer at the beginning of the year to say, “You’re in this space, here’s what you need to be thinking about?” It’s more than just bringing me your bank statement. This is not the old days of bringing me your ledger from the shop. Have you all thought about that within these groups that you’re in, like how to deal with the people on the ground or within the space?
Digital assets for the IRS and taxes are treated as property regardless of whatever type you have on the hierarchy. Share on X
I’m part of the crypto CFO community, and we’ve had a lot of conversations about taxation issues. In particular, making sure your clients, the first thing that you’re going to be asked by a tax accountant is, I need a full list of every wallet you own. Do not hold back. Don’t hide any wallets from me. Don’t think, “This one isn’t important.” We need to know all the wallets you have because a lot of these transactions are on public blockchains. When we go and look in and try to follow the activity or confirm any activity or balances, we’re going to see who you sent money to and all the other wallets that were sent to.
Don’t try to hide it. If you’re doing relatively low-volume trading, a tool like Crypto Tax Calculator, I use it. I love it. It’s fantastic. You plug in your wallets. If it’s a public blockchain wallet, like an anonymous wallet, it’ll pull the data from the blockchain. If you have an account on an exchange like Coinbase or Binance, you can put in your login credentials, and it’ll pull down your activity. It organizes everything. You do have to go through and identify, what was this transaction, and whether you own the wallet that it was transferred to. Because if you’re transferring between two wallets you own, there’s no tax event happening there.
Keep good records. If you are doing a lot of activity, you’re a high-activity person, you’re making most of your money off of DeFi and trading and staking and other types of liquidity activity, keep great records and also potentially do a reconciliation of your activity and understand what’s happening on a more frequent basis, quarterly, maybe even monthly.
Understand, “Here’s my activity. Here’s my tax liability.” That might mean you involve a tax accountant to periodically work with you and keep up with stuff. Otherwise, you get to the end of the year, you’ve got 20,000 transactions, and you can’t remember what those transactions were eleven months ago when you were doing something in some DeFi pools. There’s no record of it outside of some transactions on a blockchain.
You mentioned two words that I think we all preach to our clients, even when you’re not in the virtual space, keeping great records. It’s easy advice to give, but it can be hard to implement for some of these taxpayers. I’ve been around, hypothetically, some folks who are younger, they’re in this space heavily. They don’t come into it with a lot of capital themselves, but they’ve built up some virtual currency. Before you know it, they’re trying to open businesses in the space.
What I have seen is there will be individuals who are trying to pay people with virtual currency, but they’re moving so fast. They don’t view this as, “How is this payment treated? What’s the employment tax due on giving someone virtual currency?” They think they’re moving into a space that is somehow beyond what a normal payment is, but they’re not. They’re still responsible for all the reporting of payment however they’re paying these individuals. I’ve seen this more than once, particularly with younger individuals, I’m talking teenagers and people in their early twenties, who have not hit it big yet, but they’re trying to enter the space.
They have a business that has employees or independent contractors who are happy to be paid in certain types of digital assets. Keeping great records of that type of activity for a young person makes it incumbent upon us as the more mature professionals to say, “You’re still trying to run a business. Here’s what a great record looks like. Here’s your checklist.”
We’ve developed a checklist in the crypto CFO community. We have onboarding checklists and client checklists. I would recommend that you get a tax accountant, and pay for it. Sit down with them and say, “What do you need from me?” Find someone you like who can handle this for you. It is overwhelming if you do not do accounting. If you don’t particularly like taxes, it is overwhelming to figure it out for yourself. I would say get a professional involved.
Damon, you were going to say?
There is one backstop that we have in this area that you don’t have in the fiat currency area, and that is the blockchain. It would be almost impossible, it’s not impossible, but almost impossible, to alter the transactions that are on there because of the way the blockchain is built and because of the cryptography. There are forensic firms that specialize in going back into each of your wallets and tracing each of your transactions through whichever blockchain you happen to find yourself on.
I wanted to say that because Mike mentioned there’s a businessman who brings two ledgers to an accountant. In my area, for the past 25 years, the businessman would pick which ledger he was going to bring to the accountant. There were two different ones. On the blockchain, it can’t be altered like that. That’s a great backstop for these new forensic firms that do this work to help out and make sure that the reporting is accurate.
That’s an interesting point. It’s almost ironic because, in the early days of virtual currencies, law enforcement often looked at some of these types of digital assets as purely the work of folks who wanted to hide their money, folks who wanted that anonymity, who maybe were involved in criminal activity. The ironic part now is that the way the blockchain operates, you can’t have two ledgers. It’s almost now a better way to track people to the extent that it becomes more in the light, as it is now.
Based on the research, the nefarious activity on the blockchain is under 2%. When we first started looking at it, back when I was in CI, we used to think that 80% to 90% of the activity would be money laundering. You’re buying pizza, you’re buying coffee, or you’re hearing senators talk about putting some laws and regulations around this. It’s totally different.
One other important point that has to be pointed out when it comes down to your records and how you’re doing this is that cost basis is a big issue. My understanding is the IRS and they call this out in their FAQ and their standards around or what they’ve issued around virtual currency. Consistency, pick a method and then stick to it. You’re going to draw more scrutiny if you suddenly change your method or you have a different method for different types of activity or different wallets.
Pick a consistent method for recording your finances. You will draw more scrutiny if you suddenly change your method or have different types of activity for different wallets. Share on X
You need to pick a method. When I say pick a method, LIFO, last in, first out, FIFO, first in, first out, FIFO is probably the default for most, HIFO, highest in, first out, or specific identification. HIFO and specific identification are difficult to do for high-volume people. They’re much easier for infrequent people who are buying a little here and there for the purpose of investment or value appreciation. Pick a method, stick to it, and keep your records. You’re going to be fine.
That’s good advice. Also, one of the things we worry about in this space is the eventuality of audits, possibly higher audit rates for an area that is still evolving. How do you plan to defend for an audit or an investigation, whether it’s civil or criminal? When you pick a method and give that uniformity, and when you have those records, it allows folks like me, who are on the litigation side and who handle audits of cases like this, to combat the IRS more easily. We can say, “We’ve picked one method. We’ve stuck with it. We can trace all these transactions.”
New Government Regulations And IRS Perspectives
It allows us to go back to the source records and combat the IRS when they challenge how we’ve reported some of these virtual currency transactions. Talking about the government’s regulations a little bit and some new guidance that’s out there, Damon, can you give us a little bit of an update from the IRS’s perspective? There are some new chief counsel memos out there as newly as last month of this year.
Certainly. The two latest ones we have are the advisories that came out on 1/13. They were released on 1/13, and they talked about the qualified appraisal requirements for charitable contributions. The threshold is if you want to take a deduction over $5,000, this CCA suggests that you have to get a qualified appraisal. The issue they asked was, if the taxpayer fails to get a qualified appraisal, does a reasonable cost exception apply? Could I now go to Coinbase and say, “I didn’t get a qualified appraisal, but can I go to Coinbase or any other reputable site and say, “My Bitcoin is worth $10 a Bitcoin, can I use that instead?”
This CCA says, “You can’t do that because of various reasons, but it won’t be deductible under 170A.” I was talking about this on a different show, and I was saying, “What if the charitable organization the next day turns your crypto into fiat currency for the very same amount that you gave it in? Do you still get the donation?” I think that’s up for debate. Do you still need a qualified appraisal? There’s some room in there.
A qualified appraisal is the same in all the areas you practice in, Mike. You have to have a professional designation in the area and regularly perform appraisals, and there are other requirements that the secretary might make. The government is tough on qualified appraisals, as you know, but this is one of the recommendations they’re making.
What Damon’s referring to is that there are other areas of the tax code, not just involved in virtual currency, where if you’re making charitable donations of property, now there’s a number of cases out there in the country related to syndicated conservation easements. We could have a separate week-long series of shows on those transactions, but they center on what that property is worth and valued at, and who the appraisers are that are coming up with the values that are related to the deduction that ultimately flows to the donor and/or the investors and entities that are making the donation. The appraiser and the appraisal process is a very important process in which I have to be dotted and T’s have to be crossed to make sure that you’re solidifying this potential contribution in the deduction. That’s a related field as to what we’re talking about. Was there another?
There was a second one. This one deals with the applicability of Section 165. It is if your cryptocurrency has a decline in value. In general, Section 165 provides for a deduction of losses sustained during a taxable year. All taxpayers want to take advantage of that. During this particular market, since cryptocurrency has gone down so much, the question has been arising, can taxpayers take advantage of 165 in this crypto market? The basic answer is no, but because it hasn’t been a terminal event if you still own the cryptocurrency.
It might go down to $0.01, but it still has some value. You might not like it. What it says is you might not like the value, but it still has some value. You don’t get to claim the loss in that. It doesn’t fall under this special provision under Section 67G, which suspends miscellaneous items from 2018 to 2025. This would have been considered a miscellaneous item. Here we are in 2023, it doesn’t fit. We’re not outside of the box yet.
Lessons From The FTX Collapse
That’s interesting. This is a very applicable concept. Maybe we can talk about our next topic for a couple of minutes anyway, with the FTX collapse. Here, we’re talking about when a virtual currency is potentially worthless. That’s what this advice is getting at, when can you take this deduction, if at all, in a market that’s so volatile? We’ve seen what the prices of virtual currencies have done in the last year and last couple of months.
Deeming something worthless could be a potentially big issue for some of these digital assets. Here, if you transition that discussion over to FTX, now you’ve got over a million investors who had virtual currency on this platform who may have lost money. Maybe they have something worthless. According to this, maybe you’re not getting a worthless deduction.
You might not. To add insult to injury, right before FTX, there was a Celsius decision. Celsius went into bankruptcy. It is because when you punch through that agreement, it says, “I agree to these terms and conditions.” Those terms and conditions were so vague that the bankruptcy judge said any interest that was on the Celsius platform was now owned by Celsius. Those people lost it.
They’re enforcing not your keys, not your crypto. There’s been a flight to DeFi and to hardware wallets for anyone who’s dedicated to the space of, like, “Let’s get off of centralized exchanges. Don’t hold a lot of money on a centralized exchange because you stand to lose it if that exchange hits problems.” Some of them are considered more trustworthy than others, but it’s got its risks.
That’s interesting, a flight to hard wallets because this ruling would say it may not be your interest at all. With FTX now, we have, again, a bankruptcy trustee working on a case, trying to essentially undo, and figure out what happened in this situation, number one. Number two, what, if anything, can be recovered for whoever the potential victims may be. There’s this trustee process. One thing to take away from it is it’s a long process. No one can access this stuff tomorrow and try to get their virtual currency off of this platform. This process that FTX is undergoing leaves a lot of investors asking questions about their personal positions and exposure.
Do not hold a lot of money on a centralized exchange because there is always the risk to lose it. Share on X
We could sit here and have a different episode on FTX for weeks upon weeks. There are so many issues involving potential allegations, at this point, just allegations. Remember, I’m a criminal defense lawyer. These are mere allegations. That’s what an indictment is. Aside from those allegations against the entity and the executives who worked at that company, what about all these investors? They’re going to call people like you at home who are reading in, who are accountants, or they’re going to call Stacey or me and say, “Can I take a deduction for this? This was stolen from me.”
He bought that house in the Bahamas with it, or whatever, allegedly. Whatever happened here, the people who are holding the bag, what are some of the things or issues they might consider? Stacey, have you ever taken a look at whether you can take losses on this type of activity, like a theft loss, for example? Is there an opportunity for any deduction yet? Any brainstorming on that front?
This has been a hot topic in the accounting space for the last couple of months, how are we supposed to treat this? What are we going to do? You can’t take a worthless securities deduction because, for once, crypto is not securities. The SEC has not yet proven their case that they’re securities. You can’t do that deduction. For a theft loss, you need a guilty verdict or some court ruling. That’s what I understand it to be. What I’m hearing from other crypto tax accountants is that this isn’t, the FDIC situation that isn’t going to meet the criteria to claim a theft loss. What you have is you’re stuck in a situation with only two options.
You can take a regular capital loss at this point. If you get anything from the bankruptcy settlement, it’ll be ordinary income. If you take that loss this year, then you’re going to have to recognize ordinary income if you ever get anything from that settlement payout. You’ll owe tax on that, your ordinary income tax. That sucks because you’re getting paid out with what you originally invested, which was after-tax money, and then you’re going to get it back and have to pay tax on it again. It sucks. It’s not great.
On the theft loss, you’ve mentioned it. One of the problems is you have to have some finality. You can’t unilaterally say, “I’m missing some money. I’m going to have a theft loss deduction.” You have to meet certain requirements under the code to claim a theft loss deduction. There’s a timing component to it. There’s also an issue of what other avenues you have that you potentially still have recourse to get this money back. Those are all issues.
Most people are saying, “At this point, just file extensions, file extensions, and keep filing and keep extending for as long as you can with the hope that something like this happens.” Either the IRS provides specific guidance and says, “This is how you can handle this,” there may be something that develops with the court case against Sam Bankman-Fried and theft loss becomes possible, or you extend until the settlement payout comes in and then you figure things out.
It’s going to be highly dependent on a person’s situation, how much they have invested, and what they view as the probability of getting a payout in that settlement. I wouldn’t take the extension option unless I’ve got a lot of cash on the line. There’s a high probability that I’m going to get something in that settlement because that’s a lot of extending and extending.
One of the messages to take away here is that if you’ve got a client out there who’s an investor, if you are an investor who has a question about this, you need to go to a tax professional who’s knowledgeable in the space to understand the different options of how you potentially move forward while you’re waiting for this legal process to unfold.
Understanding “John Doe” Summonses
We are nearing the end of our time here. Damon, did you want to touch for one minute on any other enforcement initiatives? One thing that comes to mind is there were John Doe summonses that went out. For those who don’t know, maybe touch on what this John Doe summons is and how it got names of people who invest in virtual currency.
Certainly. There have been some very large ones that a lot of people have probably heard about in the news, Circle, Kraken, sFOX. A John Doe summons for the government is an invaluable tool because it’s an ex-parte order. The government goes to a judge by themselves. They generally have to prove three elements, that they were investigating a particular person or an ascertainable class or group, that the class or group failed to comply in some manner against the IRS. Lastly, there is no other way for them to get the information but this order.
The latest, the judges have started coming down and saying that now, with all those three requirements, it also has to be narrowly tailored. Generally, without speaking to anyone specifically, Kraken, Circle, or S-Fox, they were looking at people who had transacted over $20,000 in cryptocurrency during certain periods of time. What they were going to do was match that with violence.
On the 1040, there’s a line that says, “Do you have cryptocurrency?” If you check “No,” and then your name pops up in a John Doe summons and you have over $20,000 in transactions, then you’re going to be tagged. That’s what those are about. There’s a lot of information out there from the IRS. If you look at the 2022 criminal investigation annual report, the chief of CI said he’s hiring 500 more agents this year. He expects hundreds of more cryptocurrency cases. Those will be criminal cryptocurrency cases.
That’s an important message to end. If you’ve got taxpayers who are not reporting virtual currency, if you were tuning in closely to what Damon just said, there’s a line on the 1040 that says, “Do you own virtual currency?” It’s not asking if you owe tax on it. It’s for information reporting. The IRS is now utilizing tools to catch people who are lying about owning virtual currency. That can become the basis for yet another question, which could lead to, “Did you have unreported tax on virtual currency?” It’s a separate question. These are potential criminal questions in the virtual currency world.
We’re getting to the end of our time here. I want to thank our guests for joining us. I would remind our readers that if they have any comments or questions, you are more than welcome to reach out to us. Myself, Mike Villa with Meadows Collier, Stacey Ferris with HKA, and Damon Rowe. We’re happy to talk to you. Let my friend Eric Green know if you’ve got questions or comments or if you’d like an additional episode on this topic. Thank you for your time.
Thank you all.
