The Bitcoin ecosystem is continuing to gain traction and it is beginning to garner mainstream popularity and corporate support. Currently, bitcoin’s market cap is more than $400 billion despite the industry suffering through another bear market. Still Bitcoin’s net continues to spread as countries are slowly beginning to adopt or explore adopting bitcoin as legal tender and Fortune 100 corporations continue to put bitcoin on their balance sheet. With the rise of the Lightening Network more and more retailers are accepting bitcoin as a medium of payment for goods and services.
Moreover, some employers are beginning to explore the possibility of paying their employees with bitcoin. In 2021 the starting left tackle for the Carolina Panthers, Russell Okung, convinced the team to pay a portion of his $13 million salary in bitcoin. The idea of paying a portion of an employee’s salary in bitcoin is not limited to the wealthy. The Mayor of Miami is exploring the possibility of paying the city’s 3,500 employees partially in bitcoin in an effort to make Miami the center of the crypto universe.
New ways for everyday individuals to acquire and earn bitcoin are quickly rising beyond just employers paying employees. As discussed in our previous publication, startups like Lolli and Fold allow individuals to earn bitcoin when purchases are made with select retailers. Additionally, several companies are launching credit cards that will offer their clientele bitcoin back when purchases are made with the credit card. Companies like these are recording thousands of bitcoin transactions per day. These companies are allowing more and more individuals from all backgrounds to easily have access to bitcoin.
As the trend continues, there will soon be hundreds of millions of small transactions (purchases that result in bitcoin as a reward, payment of bitcoin to employees, retailers accepting bitcoin as payment, individuals buying bitcoin on exchanges, etc.) occurring weekly with bitcoin. It is easy to envision a world where millions of people have thousands of individual bitcoin transactions in a single wallet.
While these transactions will not be occurring on chain in many cases, each and every transaction will have unique tax consequences regardless of whether the transaction is occurring on chain. There is no way individuals will have the sophistication or time to sort through how to most efficiently utilize bitcoin when they would like to sell or exchange it. For the crypto ecosystem’s long-term success, meticulous, organized records of each transaction will be required for IRS reporting.
The number of bitcoin transactions an employer accepting bitcoin as payment would have to analyze is even more staggering. A company who accepts bitcoin as payment could soon have thousands of different bitcoin transactions it has to analyze each day. Each transaction would have slightly different tax information related to it which would be vital for the company to sort through and utilize properly.
Bitcoin is extremely volatile and the price fluctuates widely throughout the day and even more so over the course of a year. For example, the price of bitcoin on October 15, 2021 was 61,660, the price of bitcoin on January 15, 2022 was43,078, the price of bitcoin on April 15, 2022 was 40,554, and the price of bitcoin on July 15, 2022 was20,826. The volatility over this time period is normal for bitcoin and while the price is down significantly from October 15, 2021, the price has continued to grow exponentially with each of Bitcoin’s three halving cycles to date. The next halving is scheduled to occur around April 2024.
An individual receiving bitcoin in hundreds of transactions throughout the year will have a slightly different tax basis in each bitcoin transaction. Similarly, an employer accepting bitcoin would face even more complicated decisions regarding bitcoin it is receiving because of the sheer amount of data that would need to be analyzed for tax purposes. Projects like the Lightening Network and other similar projects have the ambitious goal of creating a robust off chain transaction environment. However, for tax purposes that does not matter. Every single transaction will have its own unique tax basis that needs to be recorded.
It is clear that the payment of bitcoin to an employee would be taxed at the employee’s ordinary income rate and a company accepting bitcoin as payment would be taxed just as if it were receiving USD. It is equally clear that any gain or loss once the individual or employer holds the bitcoin will be taxed at a capital gains rate. There are four different tax buckets for capital gains. Short-term capital gain is taxed at an ordinary income rate, short-term capital loss is taxed at an ordinary income rate, long-term capital gain is taxed at the capital gains rate, and long-term capital loss is taxed at the capital gains rate.
Therefore, when an individual or employer elects to sell or exchange their bitcoin position, thousands of bitcoin transactions will need to be reviewed to determine which bitcoin should be sold first for the most tax efficient outcome. In a world where bitcoin payments become more and more prevalent, the tax efficient decision will have to be made almost instantaneously. In theory, every single bitcoin transaction that has occurred in the space since Satoshi’s white paper needs to be examined using the concepts discussed in this article. Yes, every single one!
As we discussed thoroughly in our previous publication, the IRS allows an individual to identify specific units of virtual currency and dispose the individual’s virtual currency in whatever order the individual wishes so long as certain criteria are satisfied. In order to identify a specific unit of virtual currency an individual must show: (1) the date and time each unit was acquired; (2) the basis and fair market value (FMV) of each unit at the time of acquisition; (3) the date and time each unit was disposed; and (4) the FMV of each unit when disposed and the amount of money or the value of property received for each unit. However, if an individual is unable to meet the IRS’ criteria, the default method for determining the ordering of how units of an individual’s bitcoin position are disposed is the FIFO (first in, first out) method of accounting. This means that bitcoin positions are disposed in chronological order beginning with the earliest unit of an individual’s bitcoin position. The FIFO method, particularly in light of bitcoin’s exponential growth with each halving cycle, is almost always the least efficient way to dispose of an individual’s bitcoin position.
As the price of bitcoin continues to mature, more transactions will take place using bitcoin. Inevitably, employers accepting bitcoin as payment will need to sell the bitcoin or exchange the bitcoin in the course of their day-to-day business. Any transaction involving bitcoin will trigger a tax realization event involving capital gains. The excess of the value of the bitcoin over the taxpayer’s adjusted basis would need to be recognized as capital gains for tax purposes. It would also be possible the tax realization event would result in a loss. If the taxpayer’s adjusted basis in certain bitcoin transactions exceeded the value of the bitcoin, the taxpayer would be able to recognize a capital loss. Figuring out the most tax efficient solution will be vital along with keeping meticulous records and updating an individual’s transaction history to reflect which prior transactions have been sold and are therefore no longer relevant to the taxpayer.
Even in a world where the United States government passes a de minimis exemption for bitcoin transactions, determining which prior bitcoin transaction to use for the de minimis transaction would be just as important. For example, if purchases under 50 using bitcoin are exempt from taxes, an efficient taxpayer would want to use their bitcoin transactions with the highest possible tax costs associated with the transaction for de minimis purchases. In this hypothetical world, once a transaction exceeds50, the most tax efficient utilization of bitcoin would flip back to the other side of the bitcoin transaction tax basis tail.
There are a few key items that are important for each bitcoin transaction. First, the time the bitcoin transaction was made will be imperative for determining if the transaction falls under the short-term or long-term umbrella. Additionally, the number of satoshis received in the transaction will be important to determine how deep each “transaction bucket” is for future bitcoin transactions. Finally, the value of the bitcoin (or satoshis) at the time of acquisition will also be imperative. Technically, other items could be key to certain transactions that would adjust an individual’s basis, but for most transactions the three items discussed above should be all that is needed.
Let’s look at a simple example to help flesh out some of the concepts discussed in the article. Suppose McGee has made three transactions during his bitcoin life. McGee purchased 100 worth of bitcoin November 8, 2020. The price of bitcoin at the time of the purchase was15,000. The transaction netted McGee 666,667 satoshis. McGee makes a second bitcoin transaction on February 24, 2021 purchasing another 75 worth of bitcoin. The price of bitcoin at the time of McGee’s second transaction was50,000. The second transaction netted McGee 150,000 satoshis. Finally, McGee used Lolli’s services to purchase concert tickets on April 18, 2022. Lolli rewards McGee 25 worth of bitcoin. The price of bitcoin at the time of the Lolli transaction was40,000. The third transaction netted McGee 62,500 satoshis.
| McGee’s Bitcoin Wallet | ||||
Transaction Number | Date of Transaction | Number of Satoshis | Value of BTC in Transaction | Price of BTC at Transaction |
| 1 | November 8, 2020 | 666,667 | $100 | $15,000 |
| 2 | February 24, 2021 | 150,000 | $75 | $50,000 |
| 3 | April 18, 2022 | 62,500 | $25 | $40,000 |
If McGee decides to spend his bitcoin, the most tax efficient way for the transaction to occur will depend upon several factors. The first factor will be when the bitcoin is being spent as that will determine if McGee’s previous transactions are considered short-term capital gain (loss) or long-term capital gain (loss). The second item that will matter is the price of bitcoin at the time of the transaction. McGee’s income and relevant tax bracket will also impact the most tax efficient solution. The final item that will matter is any relevant tax law that either exempts bitcoin from taxation below a certain threshold or any other feature of future crypto taxation legislation.
Suppose McGee decides to purchase a widget with his bitcoin on March 1, 2023. The price of bitcoin at the time of the purchase is 75,000. The widget costs100 or priced in satoshis, 133,333. If there is no applicable law that exempts the bitcoin transaction from taxes, the most efficient way to dispose of McGee’s bitcoin would be to utilize all of the second transaction for the purchase of the widget. McGee would owe long-term capital gains on his transaction for the widget.
To determine the basis of each satoshi in the second transaction, take the USD value of the transaction and divide by the number of satoshis. In this case, each of the 150,000 satoshis in the second transaction would have a cost basis of 0.0005. To determine the value of each satoshi in the widget transaction take the price (100) and divide by the number of satoshis needed to achieve that price, 133,333 satoshis ((100/75,000) * 100,000,000). This number comes out to be 0.00075 (100/133,333). Each satoshi used in the transaction would cause there to be a long-term capital gain of 0.00025. Therefore, there would be a long-term capital gain McGee would need to report of33.33 (133,333 * $0.00025).
After the transaction McGee’s wallet would need to be updated to reflect the 133,333 satoshis he used to purchase the widget. McGee’s updated wallet would look as follows:
| McGee’s Bitcoin Wallet | ||||
| Transaction Number | Date of Transaction | Number of Satoshis | Value of BTC in Transaction | Price of BTC at Transaction |
| 1 | November 8, 2020 | 666,667 | $100 | $15,000 |
| 2 | February 24, 2021 | 16,667 | $75 | $50,000 |
| 3 | April 18, 2022 | 62,500 | $25 | $40,000 |
If there was a law in place that allowed bitcoin transactions under $200 to be exempt of taxation, the tax efficient way for McGee to use his bitcoin would be much different. In that case, McGee would want to use his satoshis with the highest tax cost associated with them first. The satoshis with the highest tax cost will depend on McGee’s other income, but let’s assume that the satoshis in McGee’s third transaction have the highest tax cost. In that case, using all of the satoshis in the third transaction, then using satoshis from the first transaction for the remaining portion of the transaction. The first transaction will be preferable to the second transaction because the price of bitcoin during the first transaction was lower than the price of bitcoin at the time of the second. As a result of both transactions falling under the long-term capital gain umbrella the first transaction would have higher tax consequences associated with it so using the first transaction before the second transaction would create the most tax efficient solution in this hypothetical.
After the transaction, McGee’s wallet would need to be updated to reflect the 133,333 satoshis he used to purchase the widget. Therefore, McGee’s entire third transaction of 62,500 satoshis would need to be deployed for the transaction. Additionally, McGee’s first transaction would need to be reduced by 70,833 satoshis (133,333 – 62,500) to reflect the remaining satoshis needed to complete the transaction. McGee’s updated wallet would look as follows:
| McGee’s Bitcoin Wallet | ||||
| Transaction Number | Date of Transaction | Number of Satoshis | Value of Satoshis in Transaction | Price of BTC at Transaction |
| 1 | November 8, 2020 | 595,834 | $100 | $15,000 |
| 2 | February 24, 2021 | 16,667 | $75 | $50,000 |
As the examples above illustrate, how an individual disposes of his/her bitcoin in a tax efficient manner will depend on several factors. The crypto ecosystem needs a better way for its users to have the relevant tax information saved and transferred as an individual or employer transfers their bitcoin to different wallets. As we continue the path towards hyperbitcoinization this is one of the many issues that will need to be solved.
