Sober Realities of Tax and Accounting
September 2023 Commentary
Investors, hoping for central banks to relieve them of higher rates, began to sober up in September. “Higher for longer” is a common refrain we use to describe today’s US economic environment and investors’ expectations for this market. In its September 20th minutes, the Fed Reserve reiterated its commitment to bring inflation back to the 2% level and to reduce its balance sheet. Investors have taken note that inflation risks have not abated and have steadily pushed the 10-year yield on the US Treasury towards 4.60%, after keeping it well below 4% for most of this year. This has dampened the mood for risk assets, and helped to explain why digital assets are 15% off their highs attained in late spring.
Similarly, the digital assets industry is sobering up to what it means to have broader retail and institutional adoption. At the end of August, the US IRS proposed new rules for the reporting of digital asset transactions. Shortly thereafter, in the beginning of September, the US FASB proposed new accounting standards that would allow for fair-value accounting to be applied to cryptoassets. Both are not perfect, but both are important markers in acknowledging the importance of digital assets to mainstream investors and users alike.
“The hardest thing in the world is to understand the income tax.”
— Albert Einstein
In the US according to the Internal Revenue Service’s (IRS) rules and guidance, digital assets are currently treated like property, and individuals and businesses are required to report transactions in these assets. Receipt in return for services are considered wages, donations are considered gifts, and capital gains or losses need to be calculated in the event of a sale or disposal. But relying on self-reporting is a bit unreliable given the complexity (many don’t even balance their checkbooks) and the propensity to evade while thinking that one won’t get caught. At the end of August, the IRS proposed new regulations to enlist the help of exchanges with this reporting. The proposal will require brokers and exchanges to issue a 1099-DA to their customers, placing the reporting of digital asset transactions in line with other asset classes and adding to a long list of various 1099s that traditional banks, brokers, and other organizations need to file for the benefit of their customers. The proposal is open for public comments through October 30 and is slated to take effect in early 2026 for the 2025 tax year reporting.
The implications of the proposed tax rules, however, extend from the trivial, making year-ends more burdensome, to the more fundamental questions of what this means for privacy and decentralization. Coin Center, a non-profit focused on cryptocurrency education and advocacy, provided a commentary on the deficiencies in the IRS proposal before it was fully released. The commentary called for a de minimis exemption such that transactions below a certain amount would not need to be reported, much like exchanging a foreign currency for personal use when visiting another country. Sensibly, it also proposed that miners’ or validators’ block rewards should not be taxed upon receipt of the digital asset, much like oil or other commodity production companies that are not taxed upon production or discovery, but rather on its profits from the sale of the asset less its production costs. These are, in a sense, just a couple among other technical details that we hope and expect the IRS to correct in its final regulatory update.
Quite substantially, Coin Center calls for two action items – to repeal Title 26 Internal Revenue Code (IRC) Section 6050I as it applies to digital assets, and to provide clarity on the definition of a “broker”. Section 6050I currently requires persons to report on transactions exceeding $10,000 in cash, except if dealing with financial institutions, to the IRS by providing the transaction details and private information of the counterparty. Since digital asset transactions can be decentralized and peer-to-peer in nature, Coin Center warns that this is infringes on the Fourth Amendment of the US Constitution, which protects persons and their property from unreasonable searches and seizures, and furthermore creates a “'chilling effect' on First Amendment rights” if individuals and/or political organizations are required to report private information to the government. These are not trivial claims!
In its attempt to improve tax compliance, the IRS explains the need to collect transactional and other private information, and that the definition of a broker “has been revised to provide that any person that provides facilitative services that effectuate sales of digital assets by customers.” Coin Center warned that the expanded definitions “could be interpreted to encompass miners, lightning nodes, and other similarly situated persons” and is seeking clarity on this definition so that it is not as expansive.
“A good accountant is a good poet. He appreciates the true value of things.”
- Robert Frost
The list of companies holding digital assets on their balance sheets for their own corporate use consists of mostly digital assets native companies such as centralized exchanges (Coinbase), asset managers (Galaxy Digital), and miners (Marathon Digital). The non-digital asset native companies are just a few, but they certainly are vocal about their holdings, most notably Tesla (TSLA) and Microstrategy (MSTR). As required by current accounting standards, these companies record their digital assets on their balance sheet as intangible assets (similar to goodwill or intellectual property), account for them at cost, regularly test them for impairment at which if it occurs will require a write-down, and never re-value the assets upwards if they appreciate unless the asset is sold. For Tesla and Microstrategy, if the digital assets appreciate after being written down, their accounting book values are downwardly biased by not recognizing the appreciated assets, even though digital assets trade 24/7.
The US Financial Accounting Standards Board (FASB) has been busy updating its standards, and on September 6, after reviewing the positive feedback it had received from the digital assets community to adopt fair-value accounting of digital assets on corporate balance sheets, it approved the implementation for reporting starting in 2025. Microstrategy’s Executive Chairman Michael Saylor heralded that the “upgrade to FASB accounting rules eliminates a major impediment to corporate adoption of $BTC as a treasury asset.”
It’s no wonder that Microstrategy is supportive and considers this updated standard to be sensible. In its feedback to FASB back in May 2023, the company noted that its holdings of Bitcoin were undervalued by $2 billion. Looking at its balance sheet from the June 2023 10-Q, the book equity position of $819 million would be substantially improved by this re-valuation, especially compared to a total liability of $2.54 billion.
Walking a Fine Line
The focus of two major institutions in the US, its tax collection agency and accounting standards board, over the past month on digital assets is a strongly positive milestone that this asset class is gaining appeal for its many purposes from investing and payments to digital art collection and trading.
The process by which both the IRS and FASB have worked to update their rules and standards is laudable. They sought and incorporated community feedback and provided what seems to be a reasonable delay to allow for implementation.
That said, we in the digital assets community also have a role to play in determining how we responsibly develop blockchain technology, the protocols, and the Dapps. Fair value accounting may make it easier for corporations to own bitcoin in their corporate treasuries, but the corporations still need to determine whether it is the right thing to do to hold such a volatile asset. Witness the failure of Silicon Valley Bank and Silvergate at the beginning of 2023 when they improperly managed liquidity by holding too much long-dated Treasuries on their balance sheets.
Comments such as those by Coin Center in response to the proposed updates to the IRS taxation rules also highlight the tight line that we all need to tread. At a minimum, onerous regulations can potentially create extra costs to stay in compliance, increasing the regulatory moat that favors the larger established incumbents. Taken too far, it starts to eat away at the original tenets of why cryptocurrency was born in the first place – to allow for permissionless, decentralized peer-to-peer transactions – and ultimately, at privacy and freedom.
However, we aren’t able to live in a fully decentralized world and coordination with the aid of centralized entities remains important. There are plenty of examples of public goods suffering the tragedy of the commons that lead to overutilization and benefits accruing in an uneven manner unless we have proper coordination on providing taxation, infrastructure building, and transparency. There are many bad actors out there for whom we don’t want to direct capital towards, although admittedly, “bad” is not categorical and is sometimes quite subjective.
We have a new technology that can be levered for good. Let’s make sure we develop it responsibly and establish the compliance rules around them carefully and thoughtfully to not kill off the creativity and innovation.