Bitcoin and Fred

I am going to dedicate this post to Fred.

Fred likes to talk about Bitcoin. He is a believer. He may as well be on the payroll.

I do not want to talk about blockchain or cryptocurrencies or any of that.

Let’s talk about the taxation of the thing, in case Fred has gotten to you.

As I write this Bitcoin is selling for around $15 grand.

On January 1, 2017 – less than a year ago – it sold for around $1 grand.

COMMENT: There is a reason why we are still working, folks.

There are even Bitcoin ATMs. I understand there around 70 or so locations around Miami alone. You can tap into one if you are going to the Orange Bowl at the end of this month.

Mind you, if you withdraw dollars-for-Bitcoins you probably have a tax consequence.

You see, the IRS has said (in 2014) that Bitcoin is not a currency. Given this thing’s propensity to swing hundreds if not thousands of dollars of day, it makes sense that it is not a currency. Currencies are supposed to have some stable value, at least until politicians run them into the ground.

No, Bitcoins are property, like stocks or a mutual fund. Like a stock or mutual fund, you have a tax consequence on the sale.

Let’s use the following numbers for the sake of discussion:

          Bought on 1/1/17                    $1,000

          Cashed-in on 12/31/17           $16,500

Let’s say you cash-in a Bitcoin while you are at the Orange Bowl. What have you got?

Way I see it, you have ...

    $16,500 (proceeds) - $1,000 (cost) = $15,500 gain

You are supposed to report $15,500 as income on your tax return.

What type of income is it?

I see a buy. I see a sell. I would argue this is capital gain. It would be short-term, as you did not own it for a year.

Let’s throw a curve ball.

Let’s say that you did some work for somebody in 2016. The paid you with that Bitcoin on January 1, 2017 – the one worth $1,000 at the time.

What are your tax consequences now?

You got paid with a Bitcoin worth $1,000. You have $1,000 of ordinary income. If you got paid for work, it is also subject to self-employment tax.

Then you sell it.

I see the following …

   $1,000 (ordinary) + $15,500 (capital gain) = $16,500   

This is what happens when Bitcoin is considered “property” rather than “currency.” It would be the same as you writing checks on your Fidelity or Vanguard mutual fund. Every time you do you are selling some of your mutual fund. And it all gets reported to the IRS at year-end.

Except that most of Bitcoin does not get reported to the IRS at year-end. Not yet, at least. In fact, in 2015 only 802 people reported Bitcoin on their tax return. You know that doesn’t make sense.

Which is why the IRS served a “John Doe” summons on Coinbase in November, 2016. Coinbase is an exchange for virtual currencies like Bitcoin and Ethereum. A “John Doe” summons substitutes a group or class or people for a specific person. It could be as easy as “anyone who sold more than $600 of Bitcoin between 2013 and 2015.”

Coinbase fought back, of course, but in the end the two wound up compromising. Coinbase will not provide 100% of its account data, but the IRS is getting information on over 14,000 account holders and almost 9 million transactions.

Bitcoin and other virtual currencies have become the new overseas bank accounts. It is time to come clean on this stuff, folks.

And yes, I believe there will be IRS reporting – akin to what the stock brokerages do – in the near-enough future. The government is flipping the sofa cushions for every nickel it can find. Until they get us to a 100% tax rate, they are going to keep looking for new sofas.

Someone – probably Fred - was telling me about a Bitcoin credit card.

That is a tax nightmare

Why?

Say that you bust to Starbucks in the morning. You put your coffee on the card. You stop for fuel – on the card. You go to lunch – on the card. You stop at the dry cleaners and Krogers on the way home – both on the card.

You have 5 “sales” that day. Each one has a cost, and who knows how we are going to come up with that number. Say that you do something comparable almost every work day. I will probably “fee discourage” you from using me as your tax advisor.

BTW, a similar thing can occur if you accept Bitcoin as payment for your services. Say that you are an independent contractor and two or three of your clients pay you in Bitcoin. You are going to have to price the Bitcoin every time you get paid with one, as your “proceeds” are its value on the day you receive it.

That is an accounting hassle.

Can you think of a nightmare scenario?

I  can.

What if you get paid with Bitcoin next year when it is worth $20,000. You hold onto it. Let’s say Bitcoin drops to $9,000 by December 31, 2018. You bring me the info for your taxes. How much do you have to report as income from that Bitcoin?

You have to report $20,000.

But it is only worth $9,000 now!

Yep. That is how it works since Bitcoin is not considered a currency.

What can I do to get my taxes down? Should I sell it?

Now you have a different problem. If that thing is a capital asset – and we said earlier that it was – you will have a capital loss upon sale. You will report a $11,000 capital loss on your return.

And unless you have capital gains to absorb those losses, you continue to have tax problems. Capital losses are allowed to offset only $3,000 of your “other” (read: Bitcoin) income on your tax return. You get no bang on the remaining $8,000 ($11,000 - $3,000), at least until the following year when you can use another $3,000. 

Don’t forget that you are also paying self-employment taxes on that $20,000 and not on $9,000.

This is ridiculous. If I were you, I would fire me as your tax advisor.

I do not accept Bitcoin for my fees, but I am waiting for someone to bring it up. I might do it for an isolated transaction or two. 

But no way am I using a Bitcoin credit card.

The Mary And Brad Story

"With respect to petitioner wife’s Federal income tax for 2008, the Internal Revenue Service … determined a deficiency of $106,733 and an accuracy-related penalty of $21,347 under section 6662(a). With respect to petitioners’ joint federal tax for 2010, the IRS determined a deficiency of $100,924 and a section 6662(a) penalty of $20,185.”

Someone went into Tax Court for a quarter of a million dollars. Let’s check it out.

Oh, oh. The issue was whether the taxpayers had a business or nonbusiness bad debt. If they did not, then other tax dominoes would tumble, such as whether a net operating loss existed.

We have Mary Bell. She was single in 2008. She married in 2010. They lived in Texas.

Mary had an MBA, and through 2010 she worked at Blockbuster Corp. You may recall how that turned out, and since 2011 Mary had been a partner with a private equity 

firm.

Her husband also brought some financial chops to the relationship. He was involved with real estate loans, but he lost his job with the 2009 crash. His health thereafter became an issue, but he hoped to get back into the business. His previous clients would eventually have their loans mature, and he wanted to be there when they refinanced.

Our story involves Mary.

Before marrying, Mary dated Brad. Brad was unemployed but full of hope and hype. He was working on a comic strip called “In the Rough,” involving golf.

Mary was making a couple of nickles, and she loaned Brad $75,000. Mary did not go through the due diligence a bank would do, though: investigate his credit rating, request tax returns, obtain other financial information.

She loaned him another $50,000. Brad, being a mature and responsible guy, bought a Hummer with it. He clearly was a keeper.

In all she loaned $430,500 to Brad.

She obtained a written note. It had interest at 5% and matured on December 31, 2007.

How did our tale turn out?

Yep. Our protagonist – the enigmatic, charismatic, problematic Brad – defaulted.

To be fair, he did repay $7,000, so it wasn’t a complete loss.

In 2010 Mary sent an e-mail demanding payment. Brad replied:

"I have no money.”

She continued trying.

In 2011 she filed suit for performance.

In 2012 she received a judgement against Brad.

In 2014 she reasoned that if Brad could get his comic strip syndicated, then he might have enough money to pay her back. She introduced Brad to people. She did not however get any interest, ride or other participation should Brad ever get the comic published.

In 2010 Mary set up an LLC to take-over the note. She then claimed it as a business bad debt on her/their 2010 joint tax return. The note, including interest, was over $600,000 at that time. Not surprisingly, this created a net operating loss, which she carried-back to 2008 for a refund.

We already know that they went to Tax Court.

While there were several issues in the case, we are concerned with only one today 

There are two pieces here:

You made a loan that went south, and

You are in the trade or business of making loans

The IRS quite agreed that Mary made a loan, but they argued that she did not meet the second requirement.

You do not need a building and employees to be in the trade or business of making loans, but you do need to make loans repetitively. That is what “trade or business” means: Jimmy John's does not make one sandwich and call it a day. One loan does not rise to the level of “repetitively.” It also helps to meet the routine requirements that banks and other lenders observe: perform credit checks, obtain financial information, obtain security for the loan, etc.

Mary in turn argued that she worked on content deals all the time at Blockbuster, and Brad’s comic strip was “content” by another name. She was in a “trade or business” because she had done something similar at work.

Not a bad argument, but it had two holes:

Mary did not loan money to Brad in the context of her job at Blockbuster. As a consequence, what she did at Blockbuster was not particularly relevant to the tax outcome of her loan.

Even allowing for that, she did not have an interest, royalty, or other equity participation in the comic strip. She could have demanded it from Brad, but she did not. The only thing she had was a creditor interest, the same as Fifth Third or SunTrust have when they lend money. We are still talking about a loan.

The Court decided that Mary had a nonbusiness bad debt.

The tax difference is huge.

If you have a business bad debt, you can deduct the loan the same way you would deduct your rent, payroll or any other expense. If the sum goes negative, you might have a net operating loss that you can carryback and/or carryforward, offsetting taxable income in other years. If you can carryback, you might even get a refund of taxes previously paid.

If you have a nonbusiness bad debt, the most you can do is offset your capital gains plus $3,000. That’s it. The biggest net subtraction you get can on your tax return is $3 grand. And there is no carryback. Mind you, you can carryforward indefinitely, but at $600 grand Mary would be carrying-forward until the cows came home.

Which is why Mary wanted the business bad debt so badly.

But she was not in the business of making loans. The best she could do was the $3,000. 

She owed the tax. She owed the penalty. It was a loser for her all around.

Pilgrim's Pride, A Senator And Tax Complexity

The Democratic staff of the Senate Finance Committee published a report last month titled “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions.”

I set it aside, because it was March, I am a tax CPA and I was, you know, working. I apparently did not have the time liberties of Congressional staffers. You know the type: those who do not have to go in when it snows. When I was younger I wanted one of those jobs. Heck, I still do.

There was a statement from Senator Wyden, the ranking Democrat senator from Oregon:

Those without access to fancy tax planning tools shouldn’t feel like the system is rigged against them. 

Sophisticated taxpayers are able to hire lawyers and accountants to take advantage of … dodges, but hearing about these loopholes make middle-class taxpayers want to pull their hair out.”

There is some interesting stuff in here, albeit it is quite out of my day-to-day practice. The inclusion of derivatives caught my eye, as that of course was the technique by which the presumptive Democratic presidential nominee transmuted $1,000 into $100,000 over the span of ten months once her husband became governor of Arkansas. It must have taken courage for the staffers to have included that one.

Problem is, of course, that tax advisors do not write the law.  

There are complex business transactions taking place all the time, with any number of moving parts. Sometimes those parts raise tax issues, and many times those issues are unresolved. A stable body of tax law allows both the IRS and the courts to fill in the blanks, allowing practitioners to know what the law intended, what certain words mean, whether those words retain their same meaning as one travels throughout the Code and whether the monster comes to life after one stitches together a tax transaction incorporating dozens if not hundreds of Code sections. And that is “IF” the tax Code remains stable, which is of course a joke.

Let’s take an example.

Pilgrim’s Pride is one of the largest chicken producers in the world. In the late 1990s it acquired almost $100 million in preferred stock from Southern States Cooperative. The deal went bad.  Southern gave Pilgrim an out: it would redeem the stock for approximately $20 million.

I would leap at a $20 million, but then again I am not a multinational corporation. There was a tax consideration … and it was gigantic.

You see, if Pilgrim sold then stock, it would have an $80 million capital loss. Realistically, current tax law would never allow it to use up that much loss. What did it do instead? Pilgrim abandoned the stock, meaning that it put it outside on the curb for big trash pick-up day.

Sound insane?

Well, the tax Code considered a redemption to be a “sale or exchange,” meaning that any loss would be capital loss. Abandoning the stock meant that there was no sale or exchange and thus no mandatory capital loss.

Pilgrim took its ordinary loss and the IRS took Pilgrim to Court.

Tax law was on Pilgrim’s side, however. Presaging the present era of law being whatever Oz says for the day, the IRS conscripted an unusual Code section – Section 1234A – to argue its position.

Section 1234A came into existence to address options and futures, more specifically a combination of options and futures called a straddle. . What options and futures have in common is that one is not buying an underlying asset but rather is buying a right to said underlying asset. A straddle involves both a sale and a purchase of that underlying asset, and you can be certain that the tax planners wanted one side to be capital (probably the gain) and the other side to be ordinary (probably the loss). Congress wanted both sides to be capital transactions (hence capital gains and losses) even though the underlying capital asset was never bought or sold – only the right to it was bought or sold.

This is not one of the easiest Code sections to work with, truthfully, but you get an idea of what Congress was after.

Reflect for a moment. Did Pilgrim have (A) a capital asset or (B) a right to a capital asset?

Pilgrim owned stock – the textbook example of a capital asset.

Still, what is stock but the right to participate in the profits and management of a company? The IRS argued that – when Pilgrim gave up its stock – it also gave up its rights to participate in the profits and management of Southern. Its relinquishment of these rights pulled the transaction into the ambit of Section 1234A.

You have to admit, there are some creative minds at the IRS. Still, it feels … wrong, doesn’t it? It is like saying that a sandwich and a right to a sandwich are the same thing. One you can eat and the other you cannot, and we instead are being wound in a string ball of legal verbiage.

The Tax Court agreed with the IRS.  Pilgrim appealed, of course. It had to; this was a $80 million issue. The Appeals Court has now overturned the Tax Court.

The Appeal Court’s reasoning?

A “right” is a claim to something one does not presently have. Pilgrim already owned all the rights it was ever going to have, which means that it could not have had a right as envisioned under Section 1234A.

The tax law changed after Pilgrim went into this transaction, by the way.

Do I blame the attorneys and accountants for arguing the issue? No, of course not. The fact that an Appeals Court agreed with Pilgrim means the tax advisors were right. The fact that the law was later changed means the IRS also had a point.

And none of the parties involved  – Pilgrim and its attorneys and accountants, the IRS , the Tax Court and the Appeals Court wrote the law, did they?

Although the way Congress works nowadays, they may have been the first ones to actually read the bill-become-law. There perhaps is the real disgrace.

Distinguishing Capital Gains From Ordinary Income

The holy grail of tax planning is to get to a zero tax rate. That is a rare species. I have seen only one repeatable fact pattern in the last few years leading to a zero tax rate, and that pattern involved not making much money. You can guess that there isn’t much demand for a tax strategy that begins with “you cannot make a lot of money….”

The next best plan is capital gains. There is a difference in tax rates between ordinary income (up to 39.6%) and capital gains (up to 20%). A tax geek could muddy the water by including phase-outs (such as itemized deductions or personal exemptions), the 15% capital gains rate (for incomes below $457,600 if you are married) or the net investment income tax (3.8%), but let’s limit our discussion just to the 20% versus 39.6% tax rates. You can bet that a lot of tax alchemy goes into creating capital gains at the expense of ordinary income.

The tax literature is littered with cases involving the sale of land and capital gains. If you or I sell a piece of raw land, it is almost incontrovertibly a capital gain. Let’s say that you are a developer, however, and make your living selling land. The answer changes, as land is inventory for you, the same as that flat screen TV is inventory for Best Buy.

Let’s say that I see you doing well, and you motivate me to devote less energy to tax practice and more to real estate. At what point do I become a developer like you: after my second sale, after my first million dollars, or is it something else?

The tax Code comes in with Section 1221(a), which defines a capital asset by exclusion: every asset is a capital asset unless the Code says otherwise.

For purposes of this subtitle, the term “capital asset” means property held by the taxpayer (whether or not connected with his trade or business), but does not include—

(1)  stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business;

Let’s take Section 1221(a)(1) out for a spin, shall we? Let’s talk about Long, and you tell me whether we have a capital asset or not.

Philip Long lives in Florida, which immediately strikes me as a good idea as we go into winter here. From 1994 to 2006 he operated a sole proprietorship by the name of Las Olas Tower Company (LOTC). Long had a drive and desire to build a high-rise condominium, which he was going to call Las Olas Tower.

He is going to build a condo, make millions and sit on a beach.

Problem: he doesn’t own the land on which to put the condo. Solution: He has to buy the land.

He finds someone with land, and that someone is Las Olas Riverside Hotel (LORH). LORC and LORH are not the same people, by the way, although “Las Olas” seems a popular name down there. Long enters into an agreement to buy land owned by LORH.

Long steps up his involvement: he is reviewing designs with an architect, obtaining government permits and approval, distributing promotional materials, meeting with potential customers. The ground hasn’t even been cleared or graded and he has twenty percent of the condo units under contract. Long is working it.

LORH gets cold feet and decides not to sell the land.

Yipes! Considering that Long needs to land on which to erect the condo, this presents an issue. He does the only thing he can do: he sues for specific performance. He needs that land.

He is also running out of cash. A friend of his lends money to another company owned by Long to keep this thing afloat. Long is juggling. Who knows how much longer Long can keep the balls in the air?

In November, 2005 Long wins his case. The Court gives LORH 326 days to comply with the sales agreement.

But this has taken its toll on Long. He wants out. Let someone finish the lawsuit, buy the land, erect the condo, make the sales. Long has had enough. He meets someone who takes this thing off his hands for $5,750,000. He sells what he has, mess and all. 

    QUESTION: Is this ordinary or capital gain income?

The difference means approximately $1.4 million in tax, so give it some thought.

The closer Long gets to being a developer the closer he gets to a maximum tax rate. The Courts have looked at the Winthrop case, which provides factors for divining someone’s primary purpose for holding real property. The factors include:

1. The purpose for acquisition of property
2. The extent of developing the property            
3. The extent of the taxpayer’s efforts to sell

The Tax Court looked and saw that Long had a history of developing land, had hired an architect, obtained permits and government approvals and had even gotten sales contracts on approximately 20% of the to-be-built condo units. A developer has ordinary income. Long was a developer. Long had ordinary income.

Is this the answer you expected?

It wasn’t the answer Long expected. He appealed to the Eleventh Circuit.

What were the grounds for appeal?

Think about Long’s story. There is no denying that a developer subdivides, improves and sells real estate. Long was missing a crucial ingredient however: he did not have any real estate to sell. All he had was a contract to buy, which is not the same thing. In fact, when he cashed out he still did not have real estate. He had won a case ordering someone to sell real estate, but the sale had not yet occurred.

The IRS did not see it that way. As far as they were concerned, Long had found a pot of gold, and that gold was ordinary income under the assignment of income doctrine. That doctrine says that you cannot sell a right to money (think a lottery winning, for example) and convert ordinary income to capital gains. You cannot sell your winning lottery ticket and get capital gains, because if you had just collected the lottery winnings you would have had ordinary income. All you did was “assign” that ordinary income to someone else.

The problem with the IRS point of view is that someone still had to buy the land, finish the permit process, clear and grade, erect a building, form a condo association, market the condos, sell individual units and so on. Long wasn’t going to do it. There was the potential there to make money, but the money truck had not yet backed into Long’s loading dock. Long was not selling profit had had already earned, because nothing had yet been “earned.”

Long won his day in Appeals Court.

He had ordinary income in Tax Court and then he had capital gains in Appeals Court.

Even the pros can have a hard time telling the difference sometimes.