CGNA: Chapter 10 - Virtual Currency, Advanced

Below is an in-depth examination on gifts of virtual currency.1 Virtual currency topics are based on our “Charitable Gifts of Bitcoins: Tax, Appraisal, Legal, and Processing Considerations.” For quick take-aways on gifts of virtual currency, see Virtual Currency Quick Take-Aways. For a review based on that article, see Virtual Currency Intermediate. For an in-depth examination adapted and excerpted from the article, see Virtual Currency Advanced. For further details, see Virtual Currency Additional Resources.

Popular virtual currency Bitcoin has been a news fixture since its introduction in 2009.2 Bitcoin is the world’s leading virtual currency, with a market capitalization over $100 billion.3 Donors and their advisors are now exploring various charitable giving opportunities using virtual currencies. The Internal Revenue Service (IRS) describes virtual currency as “a digital representation of value that functions as a medium of exchange, a unit of account, and / or a store of value.”4 Its creators designed it to operate like legal tender, and as a medium of exchange, although no governmental body currently recognizes it as legal tender anywhere in the world.5

Currently, Bitcoin and other virtual currencies, such as Ethereum and Ripple, represent a total market capitalization of over $240 billion.6 Many large charities, including large donor-advised funds and community foundations, are eager to tap into this market or have already received virtual donations. For example, United Way Worldwide recently began accepting donations of Bit-coins.7 Smaller nonprofits have begun accepting the currency as well.8 This section discusses charitable donations of virtual currencies, including tax, appraisal, legal, and processing considerations.

Top ten virtual currencies by USD market capitalization (as of July 13, 2018)

1. Bitcoin                      $107,681,515,452

2. Ethereum                  $44,351,939,390

3. Ripple                       $17,289,649,418

4. Bitcoin Cash             $12,106,870,149

5. EOS                          $6,377,770,475

6. Litecoin                    $4,479,398,375

7. Stellar                       $3,529,849,005

8. Cardano                    $3,331,110,023

9. IOTA                        $2,729,548,769

10. Tether                       $2,711,634,199

Tax Considerations

In March of 2014, the IRS issued a Notice on the tax treatment of transactions involving virtual currency.9Most importantly, the IRS stated that, for tax purposes, virtual currencies are property and not currency.10 This means that traditional gain and loss principles will apply therefore treating these assets as securities or business property.11 A party selling, spending, or otherwise disposing of virtual currency may be subject to capital gains or ordinary income tax. Although the charity will be selling the currency, exempt organizations are not generally taxed on income, even from the sale of appreciated property.12

The major tax implications for donations of virtual currency, therefore, involve the donor. The main consideration for donors is the charitable income tax deduction received. The gain can be ordinary, or capital, depending on the source of the virtual currency to the donor. The determination on
the type of gain or loss the taxpayer recognizes depends on whether that person held the virtual currency as a capital asset for investment purposes.13 If the donor did not hold the property as an investment, it would be subject to ordinary gain or loss treatment. This is more likely to be the case if the donor is a so-called “miner” or where the virtual currency is otherwise income paid for services rendered.14

These possibilities lead to three potential tax results for donors of virtual currency. First, a donor giving virtual currency held short-term (i.e., less than one year) as a capital asset will be able to deduct the lesser of cost basis or fair market value up to 50 percent of adjusted gross income.15However, if the donor held the Bitcoin or other currency for more than a year as a capital asset, the deduction would be the fair market value of the gift up to 30 percent of adjusted gross income.16 Finally, if the currency is subject to ordinary gain or loss treatment in the hands of the donor, the donor may deduct the cost basis of the gift up to 50 percent of her adjusted gross income.17 If the donor received Bitcoin as ordinary income as payment for services rendered or property sold, the donor may only deduct the cost basis under the ordinary income reduction rules. The IRS defines the cost basis of the virtual currency as its fair market value when the owner receives it.18 So if a third-party pays the donor Bitcoin worth $500 for professional services, and that Bitcoin later appreciated to $1,000 USD, the donor’s charitable income tax deduction would be limited to $500, or cost basis.

These rules are very favorable to donors holding appreciated virtual currency as capital assets, allowing them to avoid incurring a tax for capital gains on the Bitcoins or other currency.19This is especially true following the Tax Cuts and Jobs Act of 2017, which limited Section 1031 exchanges to real estate only, meaning owners of virtual currency could not simply exchange them for other virtual currencies to avoid recognizing gain.20 Note that this donation would also allow the donor to avoid the potential 3.8 percent Medicare surcharge on investment income.

Appraisal Considerations

A major concern for potential donors of virtual currencies will be complying with IRS appraisal requirements. The Service requires that donors claiming total deductions of over $500 on noncash donations file Form 8283.21 Due to the IRS ruling that virtual currency is property, donors of such currencies must therefore file Form 8283 if their deductions exceed the statutory threshold.

More importantly, however, is that the IRS requires a qualified appraisal for donated property over $5,000 in value.22Although there is an exception for publicly traded securities, it seems improbable that the Service would deem virtual currency to be qualified appreciated stock. This is because it defines a “publicly traded security” as one that is “listed on a stock exchange in which quotations are published on a daily basis,” or “regularly traded in a national or regional over-the-counter market for which published quotations are available.”23 Although there are online virtual currency exchanges, these are not stock exchanges, and hence do not qualify under the first category. The second category is a closer case, because although traders can easily locate price information about virtual currencies online, it is difficult to say that virtual currencies fit within the sort of market described. For example, which one of the approximately 50 exchanges should be used? If exchanges have a higher value, but do not settle in USD (e.g., Asian exchanges) should that data be excluded? What 24 hour day should be used for pricing? Hence, virtual currencies are probably not within the IRS definition of “publicly traded security” for noncash donation purposes.

This means that persons planning to donate over $5,000 worth of virtual currencies should arrange for an appraisal of the currency’s value from a qualified appraiser. This may prove difficult, given the IRS requirements that the appraiser possess “verifiable education and experience in valuing the type of property being appraised.”24 This requirement poses a difficulty to donors thinking about making large gifts of virtual currency, due to the fact that virtual currencies are such a new asset. As a result, finding a qualified appraiser with the requisite education and experience may be difficult. For this reason, potential donors should always either identify a qualified appraiser prior to making their donation or limit their total contributions to all charities in virtual currency form to less than $5,000.25

Legal Considerations

When examining the legal considerations of virtual currency as a charitable gift, it is important to remember that Bitcoins and any other such currency are—for the moment, at least—simply property in the eyes of the IRS. Although virtual currencies share characteristics with both legal tender and more traditional securities, they lack the regulation that both those forms of property possess. In fact, it may be better to think of the virtual currencies as collectible property which uctuates— often wildly—in value. This is because the lack of regulatory oversight does not provide the sort of guarantees that exist with currency regulation (a guarantee of value) or securities regulation (a guarantee of compliance with reporting procedures and standards).

However, if charities are not careful, they may have to navigate SEC and state security licensing requirements. The SEC considers virtual currencies to be securities if their owners hold them for investment purposes.26Theoretically, this means a charity selling virtual currencies held for investment purposes may have to deal with the potential complications of federal and state securities regulations.27

With that basic framework of legal character in mind, the primary legal consideration for donors and charities considering the potential of Bitcoin and its counterparts is the unsettled regulatory environment. As of 2018, states agencies and legislatures have adopted a dizzying patchwork of regulations and guidance, providing little uniformity and inserting a great deal of uncertainty.28 In 2015, the state of New York, always influential in financial matters, recently enacted regulations for virtual currencies under its Department of Financial Services.29 Perhaps the biggest change is that the regulations state digital currency companies operating in the state must obtain a license which requires compliance with consumer protection, anti-money laundering, and cybersecurity standards.30

These regulations may imperil the anonymity of virtual currency transactions, which is the feature that many prize most about them.31 Should state agencies adopt regulations similar to those in New York (or more stringent requirements), it could drive people away from the currency.32 Further, it would likely hinder anonymous donations, as the virtual currency exchange operations enabling them would need to be state-licensed and report those transactions.33

Conversely, for charities receiving donations of virtual currency, the potential for increasing governmental regulation may assuage some fears about the less-than-legitimate uses the media so often associates the currencies with. Advocates of heavier regulation on virtual currency regulation cite a host of illegal activities publicly tied to Bitcoin and other cryptocurrencies, including the drug trade, money laundering, Ponzi schemes, and theft of the currency itself.34 Charities wary of accepting virtual currency because of its association with crime may be more willing to accept donations when there is a regulatory framework minimizing the presence of such elements. Fortunately or unfortunately, it appears that increasing regulatory oversight is only a matter of time.35

Process Considerations

Most charities have similar questions: What is the donation process? How does the charity convert the virtual currency to cash? What are the acknowledgment, compliance and substantiation requirements? Does the charity require the donor to provide personal information (name, address, Social Security Number, etc.) or other similar Know Your Customer protocols to guard against criminal or fraudulent activity? This section outlines a hypothetical donation of virtual currency from the donor's planning to the charity's liquidation.

Step 1: Donor has decided to donate $50,000 of Bitcoin to charity (recall substantiation thresholds of $5,000 in value). Charity may choose to collect donor personal information at this stage. Some virtual currency donors have shown a reluctance or simply refused to share this information.

Step 2: Donor consults with tax/legal advisor to determine the tax characterization of the holding—i.e., a short-term capital asset, a long-term capital asset, or an ordinary income asset. This classification will determine the charitable income tax deduction implications.

Step 3: Donor proceeds with donating Bitcoin to the charity through a processor, like BitPay to immediately convert the donation to cash, or to a “wallet” if they wish to hold the Bitcoin and sell it through an online exchange such as Bitstamp. A virtual currency wallet allows access to virtual currency either through an online platform, a software program (a “hot” wallet), or even offline hardware (a “cold” wallet).36 The potential problem is that anyone who has the private key to the wallet can access the wallet – and the Bitcoin it holds.37

A processor, on the other hand, handles virtual currency transactions for businesses and charities, and will also convert virtual currency to legal tender.38 This is likely the best and most cost-effective option for charities that wish to accept virtual currencies. Alternatively, the charity could refer its donor to a donor advised fund that accepts virtual currencies and have the donor recommend a grant to the charity.

Similar to receiving publicly traded securities, most Bitcoin gift acceptance policies should encourage automatic conversion because of price volatility. At its highest in early December 2017, the market valued Bitcoin approached $20,000.39 By comparison, January 2015, the market priced it at only $220, and in April 2016 was around $420.40 Many payment processors can provide immediate liquidation automatically, including BitPay, and will directly deposit the value of the Bitcoin in the charity’s bank account.41 Otherwise, the charity would have to go through a virtual currency exchange (essentially an online trading platform that works similar to an online stock brokerage platform) to sell the donated Bitcoin in exchange for legal tender, which can be a complicated process.42

Given the appreciation in value of Bitcoin and other cryptocurrencies in 2017, a nonprofit may receive proposals for donations more frequently, or donations of larger amounts, or even proposed gifts of virtual currencies other than Bitcoin. Many charities are seriously considering whether and how to accept virtual currency donations. These conversations should weigh the importance of exchanges, wallets, and security measures, given the high-profile and increased value of virtual currency.

The primary considerations with virtual currency exchanges are:

1. What is the process, information requirements and timeline to open an account?

2. Does the exchange allow charities to trade on their platforms?

3. Does the exchange trade the virtual currencies the charity will receive as donations?

4. Does the exchange allow US-based customers and withdrawals of USD (many large China-based exchanges do not)?

5. Can the charity quickly sell through the donated cryptocurrency and withdraw the USD received in exchange or are there limits?

6. If the virtual currency will take more than a short period of time to sell, is the charity comfortable keeping it in the charity’s account on the exchange?

The last question is important for security purposes. The charity may not want to keep the donated virtual currency on the exchange, given that exchanges are frequently the target of hackers. In that case, the charity will need to keep the virtual currency in a wallet. A wallet is a way of storing virtual currency, and can be simply software on a laptop, or even can be stored offline. Prior to accepting gifts of virtual currency, nonprofits should carefully research which solution, if any, will meet their needs. Unfortunately, there have been reports of virtual currency fraud, both phishing and hacking, where the charity was a victim.

Securing unsold virtual currency is extremely important, since theft or other loss cannot be undone, due to the nature of blockchain transactions. Two factor authentication, complex passwords, and separation of duties all merit consideration. Due diligence and research are essential advance tasks if a nonprofit is considering accepting gifts of Bitcoin or other virtual currency.

Each charity, of course, must weigh the convenience (nonprofits can accept Bitcoin from any source worldwide), set-up process, and the legal and tax considerations to determine whether it wishes to receive virtual currency directly or whether they wish to use a third-party charity like a donor advised fund.

Process Considerations in Donation of Virtual Currency

Is the charity able to receive virtual cur- rency gifts?

Conclusion

Virtual currencies like Bitcoin represent an exciting possibility for both charities and donors. Although the unsettled legal, tax, and regulatory framework may give some organizations pause, the charitable potential of the currencies is clear. Charities should be open to the speed and ease of donation that virtual currencies allow for once the charity is properly set up to receive these assets, as well as the ability to receive such donations from any source worldwide. Donors, meanwhile, should be aware of the tax advantages that can come with donating appreciated virtual currencies, while remaining mindful of potential ling and appraisal requirements. Even with the situation in a state of flux, the donation process itself is increasingly streamlined, which indicates a promising future for donations of virtual currency.