Toby Mathis, Esq. welcomes Preston Knight, Esq., Senior Attorney at Anderson Advisors to the show to discuss some of the tax implications around crypto mining. You’ll hear how and when transactions are taxed, how the IRS views crypto and mining as a business entity, and some tips and tricks for avoiding and minimizing short and long-term capital gain and other taxes.
- Taxable events
- How the IRS views your work
- Capital gains hit when paying with bitcoin
- Short vs. Long term gains
- ‘Staking’ and how it is taxed
- Working through an S-Corp
- How to use a Roth to avoid taxes
- Using depreciation
- Writing off business expenses
- Airdrops and forks – what are the tax implications?
- Tracking and bookkeeping
Full Episode Transcript:
Toby: Hey, guys. Toby Mathis here. Today, we’re going to be talking about Bitcoin, the tax treatment, the good, the bad, the ugly, whether you’re a miner, whether you’re staking, whether you’re doing a soft fork, hard fork, no fork. We’re going to get into all the nitty-gritty. I have attorney Preston Knight with me, who is a bitcoiner. You actually are a miner if I’m not mistaken.... Read Full Transcript
Preston: Yeah. Thanks for having me, Toby. That’s right, I do a little bit of everything. I’m a holder, trader, a miner, and I wear all three of those hats. Some days are good, some days aren’t as good.
Toby: Hey, at least you’re making money right now.
Preston: A little bit.
Toby: Depending on energies, right?
Toby: It can be a good day, or it could be a bad day. All right, let’s dive into this. We’re going to make a little category. Somebody who’s a true believer in crypto and has miners, and by miners, I mean, the rigs. They have rigs, they’re paying kilowatts an hour, and all that good stuff, to run their rigs. They’re generating coins. I’m just going to use Bitcoin as an example.
We’re generating bitcoin on a daily basis. What are they responsible for, from a tax standpoint? I’ll use an example of, let’s say it’s you, and you generated $50 worth of bitcoin, and it costs you $25 in electricity. A week later, that $50 bitcoin is worth $100, and you sell it. What are the tax implications of that little bit of a mess?
Preston: Really, there are two taxable events there. The first one is when you receive the bitcoin payout, part of your mining fees. When you receive it, it’s ordinary income. It’s whatever the current value is of that.
In your example, you said $50. I just had $50 of earned income. It’s not a passive business, it’s an active business. It’s $50 of active income. From that, you can take away your expenses, so your expense of $25 for the electricity. You can also depreciate against that at the end of the year, whatever the cost for your mining equipment was, but let’s just stick with $25.
You have $25 in ordinary income, and then we have a cost basis of $50 for that amount of bitcoin. We sold it a couple of weeks later for $100. Let’s be honest, I’ll take that all day every day. That $50 is your capital gains. If you sold short term, short term capital gains. If you held it for more than a year, long term.
Toby: You just said a bunch of terms. I want to make sure people follow it. If I work, and I go and I dig ditches, and somebody pays me to dig that ditch, that is ordinary income. If it’s me doing the work, it’s called material participation. It’s subject to employment taxes. Your old age, disability and survivors, your Medicare, Social Security, just call them employment taxes you get hit with.
If I’m doing this in my name, and I’m digging ditches, and I make $100, I’m going to be paying federal income tax. Assuming it’s $100 net after I take all my deductions, then I’m going to be getting hit with my ordinary tax bracket plus my employment taxes. Is that how bitcoin mining is taxed?
Preston: Yeah. The IRS looks at it just as if you were out there digging ditches or running your own construction company. If you’re doing it in your own name, that can run into some hobby issues and expenses.
As you’ve talked many times on your channel, expenses may or may not be able to be deductible. But if you’re doing it inside a business structure, like for me, I’m doing it inside of an entity that I intend to be taxed as an S-corporation to help reduce that and payroll tax burden. It’s the same as if you’re out digging ditches, building skyscrapers, or being an attorney.
Toby: So that’s one half of it, and then the next half is now I have bitcoin. These are the misnomers. A lot of people think that they can trade bitcoin for things like cars or services, and it’s not taxable. But when you do those, they treat that as a sale, right?
Preston: Absolutely. This is where a lot of people I think get into trouble. They’ll have bitcoin on a wallet, and they’ll go buy a latte, or they’ll go buy a Ferrari, whatever they’re buying. It’s as if they’re selling bitcoin at that moment in exchange for dollars. At that exact moment, that’s when you have that taxable event, the capital gains taxable event.
Toby: All of a sudden, you’re getting hit. It’s capital gains. For those of you guys that aren’t familiar, capital gains are taxed at two levels. If it’s short term capital gains, meaning that you held the asset for less than a year, it’s going to be taxed at your ordinary tax bracket. If you hold it for more than a year, it’s going to be taxed as long term capital gains, which is 0%, 15%, or 20% plus our friend, the net investment income tax of 3.8% plus your state tax.
It’s going to be at a different level. If you hold on to it for at least a year, you get some savings. Let’s say that you’re pretty sophisticated. You have coins in your virtual wallet, and you stake. You say, I will stake transactions. What is staking and how is it taxed?
Preston: Staking is a new way of verification for the blockchain. Ethereum just recently changed to that proof of stake model, where it’s almost like buying a CD in a bank. You’re putting your Ethereum into a holding pattern. You can’t touch it, you can’t move it, but you are earning interest on that.
That interest is still taxed as income. It’s not tax free, you’re not getting extra Ethereum tokens for nothing. The IRS is going to look at it just like you’re making interest income off of that, because you’ve invested and it’s being held. It’s very, very similar to a CD. I think that’s a great analogy for it.
Toby: If it’s income, it’s ordinary income. It’s taxed at your tax bracket. Again, if you’re running this through an entity, in your case, an S-corp, S-corps flow down to the shareholders tax bracket. But as long as you pay yourself a reasonable salary, those profits won’t be subject to employment taxes, self-employment taxes. Old age, disability, and survivors, Medicare, whatever you want to call it, it’s not going to get hit.
For most people, it’s 15.3%. It’s not a small amount. Your S-corp is helping eliminate a big chunk of that. Do you ever see people doing these transactions inside of a C-corporation, where the corporation pays its flat tax of 21% instead?
Preston: When you get into that area, it’s for the extra wealthy. I’m not in that bracket, but that’s okay. That’s the goal someday, right? A corporation could have that tax. There’s actually a bunch of public corporations who are involved in mining that you can buy shares off, and they’re doing it through a C-corporation. It depends on the size of your operation and maybe your individual taxes.
Toby: The C-corporation, at least keep it off of your tax bracket. If you don’t want the ordinary income, like you said, probably for the rich, somebody who’s in the highest bracket, they’re making a million bucks a year, and the last thing they want is more taxable income, they may set it in a C-corp and let the mining go. The problem with that is then you have a coin that’s a capital asset stuck into a C-corp.
A lot of times, you’ll pay the coin out in the form of wages, or you’ll pay the coin out in the form of a dividend. Whatever the case, you’re paying a tax. You’re going to get hit reasonably hard on either one of those, or you’re just going to stockpile it. But if you’re paying it out to yourself, then at least you’re getting it into your taxable realm.
If I want to be really messed up, and you want to not pay tax, there’s a way to do this. You can actually have a Roth IRA or Roth 401(k), own a C-corp that then you pay the corporate level, and it pays it out to the coin as a dividend that same day, or periodically, because it’s owned by an exempt entity. You never pay tax. Because it’s held inside of that Roth IRA or that Roth 401(k), you’ll never pay tax on that money ever again on any of the growth.
There are some folks that like doing those types of strategies. Are there any other types of taxable transactions that occur with crypto that we need to be aware of? Even better yet, do you have any other tax tricks that these folks can use that legitimately can lower their taxes?
Preston: If you do jump into the mining space, I’m using the depreciation on my miners. That’s a huge tax write off against the income. Huge amount of depreciation. Hundreds of thousands of dollars in mining equipment that are depreciating over five years, and I’m taking it purposely over five years to spread it out a bit.
Toby: You could bonus that. We could do 179 or 168(k). We can accelerate that depreciation.
Preston: Yeah, I just don’t have enough income. Without getting too much into the technicals, if you look at the hash rate on the Bitcoin Blockchain, it skyrocketed. For every miner, it’s producing a little bit less. For me, there’s no advantage to taking it all now, except I’d just be carrying it forward. My CPA is taking care of that. That’s the big one.
Other than that, there’s not really a whole lot of escape. The IRS has really come down and basically treats it like gold. It’s a commodity as of right now. There’s a ton of lawsuits out there. The SEC has probably 15 different lawsuits against all kinds of different companies claiming that the tokens are actually securities.
The nice thing is bitcoin is the only one that the SEC has come out and said is not a security, which is fantastic. Ethereum is riding the line, and we’ll see how that shakes out here in the future. But as far as tax treatment goes, just minimizing your income, finding other ways to maybe offset any of that gains.
Toby: Could you do the home office deduction? Can you do things like writing off one of these things like your cell phone or whatnot? If you’re using that as part of your mining business, can you write those things off?
Preston: Yeah, the same way as Anderson talks about in the real estate side, any legitimate business expense. You can do reimbursements through a corporation. That’s why I like the S-corp, because you can do the write off. The C-corp, you get that one extra, the medical expenses. Maybe if you’re looking at retiring soon and want to reimburse some medical expenses with some bitcoin investment, maybe that’s a great way as well. Really, it falls into the same area as any other kind of commodity that’s making you money.
Toby: Let’s shift gears a little bit away from the entities, and let’s talk about other things. Let’s say that I own some coins, and then they airdrop me some other coins. I think that’s how it works, or it does a fork and you end up with more coins. How is that taxed?
Preston: An airdrop is like a gift. You’re receiving it. It’s like an income. Forks are a little bit different. When we’re jumping into forks, and we can talk about Bitcoin specifically, because that’s what I’m the most versed in, there are two different types. There’s a soft fork and a hard fork. A soft fork is just a minor change to the code, and it doesn’t result in a…
Toby: You don’t have any tax implications on a soft fork, right?
Preston: No, because you’re not changing the nature of the token. You’re not getting more tokens, nothing like that. That’s a soft fork, it’s just a minor change in the code. The hard fork is where you might take the Bitcoin network and say, I want to start Preston Bitcoin instead of just bitcoin Bitcoin.
I fork it off. I basically copy all the code, make one little change, and now I have my own. Depending on the value of it, it’s worth nothing when I start, but it could grow in value significantly. We’ve seen stuff like that in the network such as Bitcoin Cash, Bitcoin Satoshi Vision. There are literally hundreds of bitcoins out there now.
Toby: If they’re not worth anything, it’s not an issue. But if they give you something that’s worth something, if you airdrop some tokens that are actually a fair market value, that’s where you just have to be worried. It doesn’t matter what they call it. If you have value transferred to you, there’s a good chance there’s a tax implication from it. You want to talk to somebody and make sure you don’t get a nasty surprise come tax time.
Let’s talk about tax time. How the heck are you going to track all this? You’re sitting here doing your mining. How many miners do you have?
Preston: I have 20.
Toby: All right. You’re making a good chunk of change. How are you tracking all this? Do you have software that tracks it all? Does your bookkeeper do it? How are you doing it?
Preston: For me, the company that I’m working with to host my miners does it all for me, which is fantastic. But before I was doing that, I did have graphics cards in my basement, mining Ethereum every day. There are actually software companies out there that specialize in tracking your cost basis. You put in a spreadsheet, they crunch all the numbers, and spit out what you owe.
Toby: There’s a way to figure it out. You had machines in your home?
Preston: It was in my basement. It was actually nice, because it kept my basement nice and toasty. It was about 85 degrees in the wintertime, and I lived in northern Utah. My son loved it, because he lived in the basement. He’s like, it’s so warm down here in t-shirt and shorts all day every day.
Toby: Yeah, dissipating that heat. Anyway, hey, this is really helpful. I know there’s a lot of folks out there, there’s a lot of misinformation going around with Bitcoin. We’re still waiting for the government to give us some definitive rulings, but this is what we know right now.
I think you hit all the salient points really well. When you’re mining, it’s ordinary income. When you’re doing it, you’re making the money. It’s going to be subject even to self-employment tax. When you go to spend that coin, you may be looking at another taxable event, even if you’re trading that coin for something else of value, even other coins. The IRS is going to say, you sold it, took the money, and bought something else.
I think you hit the big ones and then staking, obviously. A lot of people have some misconceptions about that. I just want to say thank you for sharing that, because there’s a lot of folks out there that are getting misled. In the world of crypto, there’s some rather dubious advice, and there’s some really good advice. I think you definitely fall into the category of good advice.
Preston: Yeah, thanks for having me, Toby.