Taxation with Representation

I was driving in the car and heard on the radio recently that 3LAU (an American DJ and electronic dance music producer) and Bdice (a Canadian music producer and visual creative director) had been collaborating on a project. During their work together, it came up that Bdice had significant debt from Audio Engineering and Music Production school – he had spent $100,000 over 10 years in interest payments alone. It is a story that we are all too familiar with these days. But what came next was what made me turn up the volume. 

3LAU asked Bdice how much he needed to pay off his loans. He said he needed 20.5 Ethereum, which was worth around $80,000 at the time. Next thing he knew, that exact amount showed up in his electronic wallet. Bdice immediately posted to Twitter,  thanking 3LAU for allowing him to pay off his student debt with the Ethereum transfer.

While others are focused on the generosity of 3LAU’s gesture, I was thinking through the various tax implications for both 3LAU and Bdice, who, for purposes of this article, I’ll treat as an American citizen. First, Ethereum is a cryptocurrency, which, in and of itself, is a misnomer, as cryptocurrency is more akin to property than currency. The IRS has issued guidance defining cryptocurrencies as virtual currency. 

What does the tax code say about this?

While the IRS’s guidance is subject to interpretation, the main issues to consider from a tax perspective are:

1. How long did you hold your cryptocurrencies from purchase to sale? If held for less than a year, any profit may be liable for short-term capital gains tax. If held for longer than a year, any profit may be liable for long-term capital gains tax.  What those specific tax rates are depend upon the questions below. 
2. What is your tax filing status and taxable income? That will determine your tax bracket and the tax rate on any cryptocurrency profits.
3. What is your state tax rate? That will determine how much you may owe in state taxes.

So, my questions to 3LAU and Bdice would be:

1. Did 3LAU pay Bdice for services rendered with the transfer of the 20.5 Ethereum, or
2. Was 3LAU’s transfer of the 20.5 Ethereum a gift to Bdice?

Tax implications if the 3LAU-Bdice transfer was for payment of services

3LAU – If a taxpayer uses cryptocurrency to purchase a good or a service, then they will be subject to a capital gain tax. Therefore, if 3LAU paid Bdice with the 20.5 Ethereum for services rendered, then 3LAU would owe capital gains calculated from the day after he purchased the 20.5 Ethereum to the date of the transfer to Bdice multiplied by either his short term or long term capital gain tax rate.

Bdice – If a taxpayer receives cryptocurrency as payment for goods or services, then they must, in computing gross income, include the fair market value of the cryptocurrency, measured in U.S. dollars, as of the date that the cryptocurrency was received. (See IRS Notice 2014-21, IRB 2014-16). Therefore, if Bdice received the 20.5 Ethereum from 3LAU as payment for services rendered, Bdice would have to report the transfer as income.

Tax implications if the 3LAU-Bdice transfer was a gift

3LAU – If a taxpayer gifts cryptocurrency to someone, no gift tax applies so long as they gift that individual at or below the annual gift tax exclusion, which is $16,000 per recipient in 2022. If a taxpayer gifts more than the annual gift tax exclusion, then a taxpayer has to file Form 709 – United States Gift (and Generation-Skipping Transfer) Tax Return – and may owe taxes on the gift depending on how much of the lifetime federal gift tax exemption the taxpayer has already utilized ($12.06 million in 2022). Therefore, if 3LAU gifted Bdice the 20.5 Ethereum, then 3LAU would have gifted more than the annual gift tax exclusion and should file an IRS Form 709. However, whether or not he owes tax now or has begun to use up a portion of his lifetime gift tax exemption will depend on his prior gifting.

Bdice – If a taxpayer receives cryptocurrency as a gift and decides to sell the cryptocurrency, the cost basis is the same as that of the donor and they will not recognize the income until they sell, exchange, or otherwise dispose of that cryptocurrency, at which point the taxpayer will have to pay capital gains. Therefore, if 3LAU’s transfer was a gift, Bdice would owe no tax upon his receipt of the gifted 20.5 Ethereum until he sold, exchanged, or otherwise disposed of the 20.5 Ethereum. Subsequently, if he turned around and immediately paid off his student loans with that 20.5 Ethereum gift, Bdice would now be subject to capital gains.

To determine whether you have a gain, your basis is equal to the lesser of the donor’s basis plus any gift tax the donor paid on the gift, or the fair market value of the cryptocurrency at the time you received the gift. If you do not have documentation to substantiate the donor’s basis, then your basis is zero. This is a perfect example of why it is important for taxpayers to maintain records that are sufficient to establish the positions taken on tax returns, as required by the Internal Revenue Code and regulations. Therefore, if 3LAU’s transfer was a gift, Bdice should get documentation to substantiate 3LAU’s basis and understand that he would be liable for short term capital gains as he likely held the 20.5 Ethereum less than 12 months before using the cryptocurrency to pay off his student debt.

If Bdice had experienced a capital loss on the 20.5 Ethereum in paying off his student loans, which exceed his capital gains, the amount of the excess loss could be claimed to lower his income as the lesser of $3,000 ($1,500 if married filing separately) or his total net loss on line 16 of Schedule D (Form 1040).

With all of this being said, the question ultimately remains whether 3LAU’s gift of 20.5 Ethereum was a magic pill in paying off Bdice’s student loans, or a double-edged sword resulting in short term capital gains tax consequences to Bdice, such as- having to come up with additional funds to pay off the taxes (which would not have happened with a cash transaction).

Either way, this is a prime example of why you should consult knowledgeable tax professionals before, during, and even after a complex transaction.  Contact us today to speak with a member of the Bowles Rice Tax Team regarding your cryptocurrency questions.