Accounting For Crypto Assets

Most income is taxed in three different ways, and taxpayers can make decisions that affect that classification. Understanding the tax classification of earned and asset-based income is essential to minimize taxes. Income is classified as:

Long-term capital gains (capital assets held more than a year)

Short-term capital gains (capital assets held one year or less)

Ordinary income (income earned by wages, salaries, tips, commissions, interest, income earned from a business or through self-employment, and non-qualified dividends)

Long-term capital gains (LTCGs) usually have the most favorable tax rates; tax brackets in 2022 for individual taxpayers and companies are 0%, 15%, or 20%. Short-term capital gains (STCGs) are subject to taxation as ordinary income at the marginal tax rate for individuals of as high as 37% and corporations of up to 21% in 2022. Gains and losses are also subject to netting by type. All short-term gains and losses are combined to determine the net short-term gain or loss, and all long-term gains and losses are combined to determine the taxpayer’s long-term gain or loss. The IRS allows individuals to deduct only $3,000 of any excess capital loss from your income each year (or up to $1,500 if you're married filing separately) with any remaining loss being carried forward to future years. Note that businesses may be able to carry Net Operating Losses (NOLs) forward to offset a portion of future business income. Also, if a significant portion of your income is from investment, you may be subject to an additional 3.8% Net Investment Income Tax as provided by IRC 1411. A great explanation of this may be found on the IRS’s website where they provide a Q&A related to NIIT: https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax

Cost basis and holding period are the two inputs that determine the tax impact of a capital asset transaction, including crypto assets.

Cost basis is an important concept as it determines your gain or loss when you arrive at a taxable crypto transaction. The automated tax software currently available for crypto accountants and investors is lacking in its ability to track basis across platforms. The software cannot know whether it has complete information or not, and sometimes comes to erroneous conclusions about basis in the face of DeFi transactions or users who interact with multiple exchanges or blockchains. Additionally, these programs will often pull in the data on pricing automatically, and it can be off by a significant margin. A prime example of this is when a user receives an airdrop of a coin that was traded on an exchange with low volume to artificially inflate the spot price. Since the software pulls in the best available data, it could think that a shitcoin airdrop you received was worth millions, when it was in fact effectively worthless. When the software can not automatically determine cost basis, it will default to a zero, a costly mistake. This is where much of the opportunity lies for practitioners serving the industry - accurately tracking basis.

What gives a cryptocurrency value?

Market capitalization is the price of a crypto asset multiplied by the circulating supply; the calculation offers a sense of the overall growth potential of a project. As an example, for the popular meme coin Shiba Inu (SHIB) to grow from a price of 0.00002447 to $1.00, it would require a 40,866x (4,086,600%) increase in price. This move would take the market cap from approximately 13,500,000,000 to 551,691,000,000,000 USD (yes, $551 trillion, which is more than the total value of all of the world’s real estate). Excluding discussions of burn mechanisms and prior performance (SHIB is still up 43,718,959.3% from its all-time low), the likelihood of SHIB reaching $1.00 is slim. 

A common misconception in the world of crypto assets is the desire to find “bargain coins” that are priced at sub $1 with the idea that they have greater growth potential. This flawed practice leads to many retail investors loading up on coins like SHIB with the idea that if it just grew to $1, they could 1,000x their investment.

Coins like ETH have value because they are the fuel used to transact on a secure and decentralized network. Since the network has a broad use and many dApps are built on Ethereum and require gas to operate, ETH benefits from high demand. While ETH grants the user the ability to process transactions on the Ethereum network, it also allows the user to put forward and/or vote on Ethereum Improvement Proposals (EIPs) that are intended to continually improve the Ethereum network. As a result, ETH has both an inherent utility and a governance component built into its economics.

Tokens do not have this same inherent value, so they must rely on either their utility or the right to direct the project they are associated with in the form of governance rights. Some tokens have a combination of these two attributes.

The utility of a cryptocurrency is a “use case,” which can come in the form of a discount for services provided by the project, act as an in-game currency, or help generate rewards in the case of crypto gaming. It can also unlock higher yields for staking or lending (more on this later). 

Governance tokens effectively grant voting rights and allow holders to guide the direction of a project either in the form of submitting improvement proposals or voting on a project’s milestones or roadmap. Uniswap and its native token UNI are one of the better-known governance tokens. UNI can be used to vote on existing proposals or generate new ones to help steer the direction of the project. These tokens have value because they allow users to influence the project. Since Uniswap is a DEX, users generate revenue by acting as liquidity providers (LPs). Users who generate revenue from this platform are incentivized to have a say in protocol evolution because it directly affects their profitability.

Whether a cryptocurrency is considered a utility token, governance token, or a combination of both, from an accounting perspective, we treat it similarly to a stock for tax purposes.

Coins and tokens form two major types of cryptocurrencies.

Coins are cryptocurrencies with their own native blockchain networks (Ether/ETH, Bitcoin/BTC, and Litecoin/LTC). These coins are the result of years of coding and building a robust and secure blockchain network that requires decentralized computing power to secure. As a result, coins are more difficult to create because they require entire networks to support their use and value proposition. Coins are rewarded to those who supply computing power for processing transactions and are generally used as the fuel for the transactions that are processed on that chain. For example, to execute a transaction on the Ethereum blockchain, you spend ETH as “gas” to fuel the transaction. The amount of gas required to execute the transaction depends on network congestion, the complexity of the action, and the speed necessary for confirmation. 

Tokens are cryptocurrencies that are created on top of existing blockchains. Since they do not require the infrastructure backing them, they are much easier to create; therefore, there are exponentially more cryptocurrency tokens than coins. One of the most common types of tokens are NFTS, which can be minted on a multitude of different blockchains including Ethereum, Solana, and Flow, just to name a few. NFTs can act as digital certificates of ownership that can be instantly verified and validated. Because tokens do not have the inherent utility of being gas on their native blockchains, they generally have a utility component that gives them value such as being a rare piece of art or music, gaining the holder access to discounts or events, or possessing a governance component.

While seemingly counterintuitive to the ethos of blockchain and cryptocurrencies, enterprise custody solutions can serve a purpose for high-net-worth (HNW) individuals who prefer a third party to hold and maintain custody of their crypto assets.

Companies like Ledger, Kraken, and Coinbase offer custody services for HNW and Ultra-HNW individuals, estates, and companies. These solutions are generally cost-prohibitive for the average investor.

For many public figures within the crypto space, their mere participation in the industry can put a target on their back, as a would-be thief may assume that the individual has access to the location of their private keys or seed phrase. 

The main advantage of these services is similar to that of a multisig wallet, as it removes a single point of failure in the event of a robbery or if the holder is taken hostage, with the ransomers demanding they turn over the keys to their crypto. The disadvantage is that you are again relying on the security protocols of a third party. Also, if you’re a crypto “whale,” hire bodyguards!

Multisig wallets require multiple signatures (multiple wallets approving the transaction) to sign or confirm transactions and can be secured with either a hot or cold storage wallet. This method provides for much greater security as there is no one single point of failure. A multisig wallet secured via cold storage is the gold standard for security with crypto assets, but this protection comes at the expense of convenience. This type of storage should be employed for large asset balances that are kept for longer time frames.

A cold storage wallet is used for storing crypto assets where the private keys and access to the wallet are offline thereby protecting the funds from unauthorized access, hacks, and other vulnerabilities. There are physical devices, like Ledger’s Nano S or Trezor’s One, or simply something analog like a sheet or paper containing the private keys to the wallet. With the physical devices, the unit is connected to a computer to authorize transactions and generally has a passcode to gain access to the device itself. 

The security advantage of storing funds on a cold wallet is that they cannot be hacked unless someone either:

• Has access to your 12- or 24-word seed phrase (or written private key in the case of a paper wallet)
• Has access to your physical device and the device’s passcode

Exchange wallets are funds held on centralized exchanges (CEXs). If a taxpayer purchases crypto assets on a CEX like Coinbase or Kraken, then the assets are in the exchange’s wallet. When investors leave funds on exchanges, they are relying on a third party to secure their assets. Exchanges have been hacked and bad actors inside an exchange have stolen and mismanaged funds; in the strange case of the Quadriga Ex exchange founder who suddenly died under suspicious circumstances, the private keys to $190 million of users’ funds vanished.

Relying on exchanges to secure funds is only for active traders and those comfortable with the security vs. convenience tradeoff that this provides.

Hot wallets are the next step up in security after exchange wallets because they allow the user better control over the protective measures they implement. The user can create complex passwords and cybersecurity features to reduce the chances of their funds being compromised.

These wallets are “hot” because they live on your computer, generally as an app or as a plugin to a web browser. As they require an internet connection to use, malware, keyloggers, and other common hacking tools can be used to gain access to this type of wallet.

Hot wallets are only as good as the security measures put in place to protect them. As a result, they should only be used with small balances of cryptocurrencies to reduce risk exposure.

Now that we have a better grasp of how wallets function for crypto assets, we need to understand the inextricable link between decentralization, self-custody, and security. In the world of blockchain and cryptocurrency, no bank holds and secures your funds. You are the bank. As a result, you rely on varied levels of security based on the context of the usage of funds.

A real-world example of this concept is the difference between a wallet you carry in your pocket and a bank vault. Obviously, the money kept in a wallet is less secure than money stored in a bank vault, but the sacrificed security of funds is offset by increased convenience. To reduce the risk, a nominal amount of a person’s total wealth is carried in their pocket. The same principle applies to crypto assets.