While accepting cryptocurrency and digital assets as payment can be a great way to bring in new customers, cryptocurrency transactions come with a unique set of tax challenges for small businesses.
In this guide, we’ll explore 5 common cryptocurrency tax related challenges for businesses — and break down solutions to help you stay compliant with IRS guidelines.
Challenge 1: Understanding the tax implications of cryptocurrency
In the United States, Bitcoin and other cryptocurrencies are typically considered capital assets subject to income tax and capital gains tax for both individuals and businesses.
Income tax: When you receive cryptocurrency, you’ll recognize income based on the fair market value based on your crypto at the time of receipt. Receiving cryptocurrency as payment for goods and service is considered income.
Capital gains tax: When you dispose of cryptocurrency, you’ll incur a capital gain based on how the price of your crypto has changed since you originally received it. Examples of disposals include converting your cryptocurrency for fiat currency.
It’s important to note that how cryptocurrency is taxed may vary depending on the nature of your business. Some tax professionals argue that for crypto mining businesses, cryptocurrency may be considered inventory rather than a capital asset. As a result, it’s likely that profits from disposals of cryptocurrency will be considered income instead of capital gains.
The solution: Understanding tax implications for your businesses
Before your business gets started handling crypto transactions, it’s important to understand how cryptocurrency will be taxed for your business. It’s likely that for most businesses, cryptocurrency will be treated as a capital asset and subject to income tax and capital gains tax.
If you have questions about how your cryptocurrency profits will be taxed, reach out to your tax professional.
Challenge 2: Tracking your crypto transactions for tax purposes
If your business is planning to get started with crypto-assets, you’ll need to keep complete records of transactions for tax purposes. This will help you easily track your capital gains and income and give you receipts in the case of an audit.
These records should include the following:
- The type of crypto involved in the transaction
- The amount of crypto involved in the transaction
- The date you received the cryptocurrency
- The date you disposed of the cryptocurrency
- The fair market value of your crypto at the time of receipt
- The fair market value of your crypto at the time of disposal
- The cost of relevant fees
If you paid your employees in cryptocurrency, you will need to keep records of the value of the cryptocurrency at the time of payment so you can accurately report this information on your W2 Form.
The solution: Accurate recordkeeping
To track your cryptocurrency transactions, you’ll need a system to keep track of the value of your cryptocurrency at receipt and at disposal. Cryptocurrency payment processors like Coinbase Commerce allow you to generate your transaction report — which contains the information you need to report your taxes.
However, if your business is using multiple cryptocurrency platforms, you’ll need to keep track of all of your transactions to accurately report your taxes.
Many businesses choose to automate tax reporting through a crypto tax calculator — a software solution that can plug into your cryptocurrency platforms of choice and automatically generate a comprehensive tax report.
Challenge 3: Dealing with capital gains from appreciated crypto-assets
As noted earlier, cryptocurrency profits are subject to income tax and capital gains tax. If the value of your cryptocurrency increased since you originally received it, you will need to pay capital gains tax based on how much the price of your crypto appreciated.
Here’s an example to better understand how this works.
Your business receives $1,000 of BTC as a payment.
When the value of your BTC reaches $1,500, your business disposes of BTC.
Your business recognizes $1,000 of BTC and $500 of capital gain.
Cryptocurrency being taxed as income upon receipt and capital gains upon disposal can cause issues for businesses. For example, in a period of a rapid market downturn, the value of your crypto-assets may decline so rapidly that selling them off won’t cover your income tax liability.
The solution: Disposing of your cryptocurrency immediately
Many businesses choose to dispose of their crypto assets immediately after receipt to avoid potential issues with capital gains and losses. While this means you can’t benefit from the potential appreciation of your crypto, it can help simplify tax reporting and protect you from the risks of a downturn in the crypto market.
Of course, it’s important to note that there are benefits to holding your crypto-assets for long periods of time. If your business is set up as a flow-through entity, your profits from cryptocurrency disposed of after more than a year will be subject to long-term capital gains tax rates (0-20%). This is significantly lower than the short-term capital gains tax rate (10-37%).
Challenge 4: Commingling business and personal cryptocurrency holdings
Some businesses commingle cryptocurrency from business and personal accounts. It’s important to note that this can lead to tax issues down the line.
In the case of an audit, you’ll be required to show proof of profits and expenses. If you’ve kept cryptocurrency from business and personal use in a single place, you may have trouble proving which transactions should be taxed as business income.
The solution: Creating separate cryptocurrency accounts for your business
To prevent this issue, you should hold cryptocurrency owned by you and cryptocurrency owned by your business on separate wallets. It’s recommended that you set up an independent cryptocurrency account that is registered in the name of your business entity.
Challenge 5: Filling out your crypto tax forms
Once you’ve collected the records you need to report your taxes, you’ll need to fill out your crypto tax forms. The right tax form for you depends on the structure of your business.
In addition, if your business is set up as a sole proprietorship or flow-through entity, you’ll need to report your share of income and capital gains on your personal tax return.
The solution: Finding the right tax forms for your business
If you’re running a sole proprietorship, your income and capital gains should be reported on your individual tax return. Your cryptocurrency business income should be reported on Schedule C of Form 1040 and capital gains should be reported on Schedule D of Form 1040.
How do I report taxes as a corporation or flow-through entity?
If your business is set up as a flow-through entity, your business capital gains should be reported on Form 4797, Sales of Business Property, and should flow through to your Form 1040, Schedule D.
Your business income should be reported as well. Here’s the form you can report your income for a few common types of business entities:
C-Corp: Form 1120
S-Corp: Form 1120S
Partnership: Form 1065
If your business is a flow-through entity, your flow-through income should also be reported on Form 1040, Schedule E.
In conclusion
While cryptocurrency can lead to tax issues for your small business, understanding how cryptocurrency is taxed and setting up the right solutions to track tax liability and accurately report your capital gains and income can help save you time and effort during the tax season.
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