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Cryptocurrencies have an interesting lineage that makes taxing them a taboo subject for enthusiasts and regulators alike.

Many supporters view cryptocurrency as the culmination of decades of research for an alternative monetary system outside government control. A counterpoint to their idealism is the practicality of monetary regulators like the Internal Revenue Service (IRS), which must exercise mandates irrespective of trends, despite the technological disruption currently redefining what money is.

Indeed, cryptocurrency is a prime example that until there is a way to hard-fork civilization overnight, the technologies of tomorrow will have to be gradually phased into our society, regardless of their potential to positively disrupt it.

The implementation and acceptance of future technologies must be gradual because people’s behavior cannot change and adapt as quickly as technology. And the bureaucratic wheels of government turn even slower, requiring even more time. This is perhaps why, although cryptocurrency has existed since the birth of Bitcoin in 2009, governmental taxation guidance pertaining to cryptocurrency has only existed since the IRS published its “Virtual Currency Guide” in 2014.

Although there is still a lot to be decided about cryptocurrency, there has never been more information to help law-abiding citizens understand how, when, and why they are required to pay taxes on it.

As 2017 comes to a close, understanding where the US government draws the line on crypto taxes is essential for those wishing to toe the line as responsible US citizens; it’s also important for citizens of the growing crypto community and the future of the global economy.

Remarkably, it could be the act of paying taxes on cryptocurrency that catapults the monetary revolution into mass adoption.

IRS Classification And Guidance

Regardless of your position on taxes or taxing cryptocurrencies, the Internal Revenue Service (IRS) has made theirs clear:

“The sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.”

The US Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) had to classify and define cryptocurrency when they perceived it overlapping their individual mandates, like when Ether exchange-traded notes or bitcoin futures launched. The IRS found it needed to create classifications as well. As of April 14, 2014, the IRS has informed American taxpayers with the six following points, pursuant to the taxation of cryptocurrencies – or, as the IRS refers to them, “virtual currency.”

1) “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments, it operates like ‘real’ currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance—but it does not have legal tender status in any jurisdiction.”

2) “For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.”

3) Those who receive virtual currencies for goods or services must report the fair market value (FMV) of their newly acquired virtual currency on the date each payment is made. The FMV can be calculated by converting virtual currencies into US dollars on the day of payment. Those who receive wages in virtual currency are liable for withholding to the same extent as those who receive dollar wages. In addition to federal employment taxes like FICA and FUTA also applying, independent contractors are subject to the same self-employment taxation standards.

4) Those who hold (or hodl) virtual currencies as capital assets will have it taxed liked property. Individuals who hold virtual currencies will, like with traditional stocks or bonds, be taxed according to short or long-term capital gains. Short term capital gains tax applies to those who sell before holding for a year, while the better tax rate associated with long-term capital gains requires holders to retain their virtual currency for longer than a year’s time.

5) Those who mine virtual currencies are required to record the FMV of any virtual currency they mine on any given date. After a miner accrues earnings, they must include that figure in their gross income and calculate that virtual currency profit at FMV in US dollars. If a miner is self-employed, his or her gross earnings are subject to self-employment tax. However, miners can deduct business expenses, notably electricity.

Most importantly:

6) “Taxpayers may be subject to penalties for failure to comply with tax laws. For example, underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties under section 6662. In addition, failure to timely or correctly report virtual currency transactions when required to do so may be subject to information reporting penalties under section 6721 and 6722. However, penalty relief may be available to taxpayers and persons required to file an information return who are able to establish that the underpayment or failure to properly file information returns is due to reasonable cause.”

IRS Legal Action As A Case Study

Understood as a whole, the IRS’ published guidance and its legal undertakings represent the breadth of crypto taxation knowledge inside the US.

On Wednesday, November 30, 2016, a federal court from the Northern District of California granted in part the Internal Revenue Service’s (IRS) motion to enforce a John Doe summons it had served the crypto exchange Coinbase. The IRS wanted Coinbase’s data, specifically user transaction histories, most likely to see who wasn’t paying their taxes.

As stated by Principal Deputy Assistant Attorney General Caroline Ciraolo on the day the IRS issued the summons to Coinbase:

“Tools like the John Doe summons authorized today send the clear message to U.S. taxpayers that whatever form of currency they use – bitcoin or traditional dollars and cents – we will work to ensure that they are fully reporting their income and paying their fair share of taxes.”

This statement was echoed by IRS Commissioner John Koskinen who stated, “transactions in virtual currency are taxable just like those in any other property. The John Doe summons is a step designed to help the IRS ensure people doing business in the emerging economy are following the tax laws and meeting their responsibilities.”

Since the summons wasn’t a specific inquiry, but rather a blanket demand for user data, it was immediately challenged by crypto-centric law firm Berns Weiss, LLP, which took the IRS to court over the summons on behalf of Coinbase users.

A subsequent IRS affidavit in the same case was issued several months later. It states that, in each of the prior three years going back to 2013, the IRS found that less than 1,000 Americans included cryptocurrencies when filing taxes.

Whether the IRS’ action against Coinbase was the result of strategic planning or fortuitous timing is irrelevant. Their mandate required them to act in accordance with the growing cryptocurrency market. It had only been a matter of time. The IRS deemed “convertible virtual currency” territory for taxation and acted in accordance with their mandate.

On November 28, 2017, nearly a year to the day of the initial summons, a Judge in the Northern District of California ruled on the IRS John Doe Summons to Coinbase stating:

“That only 800 to 900 taxpayers reported gains related to bitcoin in each of the relevant years and that more than 14,000 Coinbase users have either bought, sold, sent or received at least $20,000 worth of bitcoin in a given year suggests that many Coinbase users may not be reporting their bitcoin gains. The IRS has a legitimate interest in investigating these taxpayers.”

Although the legal trial resulted in the scope of the summons narrowing considerably, the ruling reinforced the IRS’ legal claim to tax cryptocurrency. This is the primary case study at this moment for understanding how tax law is being applied to digital currencies. From it, we can infer several things about the future of crypto taxation and how to understand it historically.

The Revolution has Arrived

History predicted this exact moment nearly two decades ago. Some people inferred that the advent of the internet would lead to digital, programmable money, which would challenge the power of governments by specifically disrupting taxation. Whether or not we are prepared as a society to handle this revolutionary change is now a moot point. The moment has arrived and the world will never be the same again.

The specific conundrum of taxing cryptocurrency was predicted in 1999 by the Nobel Laureate economist Milton Friedman:

“The major effect of the internet will be to make it harder for the government to collect taxes … I think the internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing, but will soon be developed, is a reliable e-cash. A method whereby, on the internet, you can transfer funds from A to B without A knowing B or B knowing A. The way in which I can take a twenty dollar bill and hand it over to you and there’s no record of where it came from.”

Perhaps the best historical quip relevant to the taxation of cryptocurrency comes from Thomas Kuhn’s 1962 work “The Structure of Scientific Revolutions,” in which he states, “scientific revolutions are here taken to be those non-cumulative developmental episodes in which an older paradigm is replaced in whole or in part by an incompatible new one.”

If cryptocurrency is a revolution born out of decades or even centuries, it will take time for it to be widely understood enough for adoption to reach critical mass and society to change. Perhaps taxes are a small price to pay in order for crypto, blockchain, and the hope of decentralization, to be eventually realized.

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