How does a small business deal with receipt of virtual currency?
A sole prop is paid virtual currency for work. How do they report it on their tax return? What about the checkbox on Form 1040 and what if they sell it?
Q: Does a Schedule C small business have to pay tax on virtual currency received for services?
A small business client started his own web design business a few years ago. George is a sole proprietor and files Schedule C. In 2020 he agreed to a design project that paid him in the virtual currency Litecoin. The customer sent him a 1099-NEC that shows $927.50 in box 1. The 1099 has a notation that he was paid in Litecoins and the number of Litecoins they paid him.
He also received a printout from his new Litecoin account soon after the work was completed. The printout shows the receipt of Litecoin on September 30, 2020.
Since he did not receive actual dollars, does he report the $927.50 on his 2020 tax return? If so, where is the receipt of virtual currency reported?
How does he answer the virtual currency checkbox question since he didn’t purchase the virtual currency? What happens if George sells the Litecoin?
A: Yes, the fair market value (FMV) of the virtual currency at the time services were provided is reported on Schedule C and is subject to income and SE tax. The taxpayer should check “yes” to the virtual currency question on Form 1040.
Litecoin is a type of virtual currency and virtual currency is treated as property for tax purposes. Taxpayers are required to report transactions involving virtual currency on their tax returns.
Where and how virtual currency is reported depends on the nature of the transaction.
Completing the virtual currency checkbox on Form 1040
First, George should check “yes” to the question on page 1 of Form 1040: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”
Receipt of virtual currency in exchange for providing services is one type of acquisition of virtual currency that must be disclosed on Form 1040.
Self-employed taxpayers report virtual currency received for services on Schedule C and Schedule SE
Since George is self-employed and received the Litecoin as payment for his services, the fair market value of the payment ($927.50) should be reported on Schedule C along with all other gross receipts for his business. This tax treatment would apply even if George wasn’t issued a Form 1099-NEC.
In other words, treat the payment in Litecoin the same way as a payment received in U.S. dollars for services provided.
Assuming the business was profitable in 2020, the Litecoin payment should be included with net profit or loss from Schedule C on line 2 of Schedule SE for purposes of calculating self-employment tax. Similarly, the virtual currency is included in business income for the qualified business income calculation.
Reporting a sale of virtual currency treated as a personal capital asset
Keeping in mind that virtual currency is property for tax purposes, it’s likely that in this situation the Litecoin is held as a personal capital asset. Although Litecoin is not a stock or security, a sale of virtual currency held as a capital asset for real currency is reported in a similar manner.
Selling the virtual currency
George’s basis in the Litecoin is $927.50 and his acquisition date is September 30, 2020. For example, if he sells the Litecoin for $1,200 on July 30 of this year he would report the sale on Form 8949 and Schedule D. He would have short-term capital gain of $272.50. As with any sale of property, whether gain is short- or long-term depends on the holding period of the property.
Should George decide not to sell all of the Litecoins, dividing the $927.50 FMV by the number of Litecoins received will provide his per-unit basis. The 1099-NEC and exchange printout show the number of Litecoins he received for this transaction.
Exchanging the virtual currency
If instead of selling the Litecoin George exchanges it for other property, gain or loss would be figured based on the fair market value of the property received. For instance, if George exchanges the Litecoin for shares of publicly traded stock valued at $1,200, he would also report the transaction on Form 8949 and Schedule D. If he exchanges it for another type of virtual currency, he would need to know the FMV of the other virtual currency on the date of the exchange.
Going forward, George should keep records of all transactions involving Litecoin and other virtual currencies including services he provides for virtual currency in the future, sales and exchanges (including exchanges for other virtual currency), and receipt of virtual currency through an “airdrop.”
Holding onto the virtual currency
If George does not sell or exchange the Litecoin or have any other transactions involving virtual currency in 2021 he can check “no” for the virtual currency question on his 2021 return. Otherwise, he should check “yes” in any year there is a reportable transaction.
Because George is a sole proprietor, we’re assuming he is holding the Litecoin as a personal capital asset, but other situations are possible. For instance, if the business had been organized as an S corporation, the Litecoin received for services would be treated as a business asset.
Selling or exchanging the Litecoin might then be treated as a sale or exchange of business property.