State income taxation of virtual currency, or cryptocurrency, transactions is complicated. The recognition of income from virtual currency transactions takes many taxpayers by surprise. Also, while state taxation rules follow federal in many respects, most states have not yet addressed issues like nexus and the proper apportionment of income.
Federal Tax Treatment of Virtual Currency
Virtual currency is treated as property for federal tax purposes. Taxpayers must report all sales, exchanges, and other dispositions. A virtual currency exchange includes the use of the virtual currency to pay for goods, services, or other property, including another virtual currency such as exchanging Bitcoin for Ether.
If a taxpayer sells or exchanges their cryptocurrency, then the amount of the gain or loss is the difference between the adjusted basis in the virtual currency and the amount received in exchange. In determining whether a gain will be considered a long-term capital gain or short-term capital gain, the holding period generally starts the day after the taxpayer receives the virtual currency.
A taxpayer providing a service and receiving virtual currency as payment must include the fair market value in income. If a taxpayer pays for a service using virtual currency being held as a capital asset, then a capital asset has been exchanged for that service resulting in a capital gain or loss.
Any wages paid in virtual currency are subject to federal income tax withholding, FICA and FUTA tax, and are reported on Form W-2, Wage and Tax Statement. The computations are based on the fair market value in U.S. dollars on the date of receipt.
State Income Taxation
States follow many federal tax provisions as the starting point for computing state taxable income. However, there are some state variations depending on whether that state conforms to the applicable Internal Revenue Code sections.
For example, most states follow federal provisions regarding the determination of a capital gain or loss from sales or exchanges of property. But states may decouple from provisions taxing specific types of income or enact their own laws allowing additional deductions or exemptions.
State Income Tax Laws
States have been slow to address taxation of virtual currency separate from federal laws and guidance. However, there have been some recent enactments.
- Nevada enacted legislation clarifying that certain virtual currencies are intangible personal property and are exempt from property taxation.
- Tennessee allows a candidate or political campaign committee to accept digital currency as a contribution and requires any increase in the value to be reported as interest. The candidate has to sell the digital currency and deposit the proceeds before spending the funds.
- Wyoming exempts virtual currency from property taxation.
Also, the New Jersey Division of Taxation has issued guidance on the state tax treatment of transactions involving convertible virtual currency. Specifically, for New Jersey Corporation Business Tax and Gross Income Tax purposes:
- the fair market value of convertible virtual currency paid as wages is subject to withholding;
- an independent contractor receiving convertible virtual currency for services performed determines the fair market value of the currency in U.S. dollars as of the date received; and
- payments made using convertible virtual currency are subject to information reporting requirements to the same extent as any other payment made in property.
Proposed State Income Tax Legislation
In addition to enacted law, some interesting state legislation has been proposed.
- Colorado proposed a bill allowing individual and corporate taxpayers to subtract from federal taxable income up to $600 in gains from each sale or exchange of virtual currency for other than cash or cash equivalents.
- A bill introduced in Iowa would have exempted virtual currencies from individual, corporate, franchise, sales and use, and inheritance taxes.
- Kentucky proposed legislation to extend its tax incentives under an energy independence program to include facilities engaged in the commercial mining of cryptocurrency.
- Legislation proposed in New Jersey would exclude from gross income up to $1,000 of gains or income from the sale or exchange of virtual currencies for other than legal tender and up to $250 of dividend distributions in the form of virtual currencies arising from the ownership of virtual currencies, with annual increases in the exclusion amounts.
- South Carolina proposed legislation allowing a candidate or committee to accept digital currency as a contribution. Any increase in value would be reported as interest on the appropriate certified campaign report.
Corporate Income Taxpayer Virtual Currency Issues
Businesses with multistate activities face added corporate income tax issues. Businesses must pay close attention to any states where they might have taxable income so they don’t incur penalties and interest on unpaid taxes.
For a state to impose income tax on a company, they must establish nexus. Most states now use an economic or factor presence nexus standard. In such states, income tax nexus may be created by the company making material sales of virtual currency into the state. Other factors could create nexus as well, such as agency or affiliate relationships and employee activities.
Apportionment of the company’s income is complicated by the fact that virtual currencies are operated on a relatively new technology. Some states treat virtual currency as tangible personal property for purposes of sourcing receipts. However, other states view virtual currencies like intangible property, applying a different set of sourcing rules.
Most states have not issued definitive guidance on the applicable apportionment rules for virtual currencies. This can be problematic for companies conducting virtual currency transactions in multiple states, or with customers or employees located in multiple states.
Where Do States Go From Here?
Taxpayers face many unanswered questions on state taxation of investment in and use of virtual currencies. Given the rapid appreciation in some virtual currencies, such as Bitcoin, more taxpayers are becoming owners of virtual currency. At the same time, there is heightened scrutiny by tax authorities. Taxpayers may need to recognize gains they would not normally in other types of transactions due to how virtual currencies are taxed. It is necessary for states to respond either through guidance or legislation providing taxpayers with more certainty on how to comply.
By Tralawney Trueblood, J.D., M.B.A.