Overview of the U.S. Cryptocurrency Tax System

This article aims to provide readers with a basic understanding of the U.S. cryptocurrency tax system, including the following three sections: General Tax System, Cryptocurrency Taxation, and Future Trends.

1. General Tax System in the United States

1.1 Overview of the General Tax System

The U.S. general tax system is multiple tax system which is primarily based on an income tax, where federal, state, and local governments each legislate and levy their own income taxes, supplemented by other types of taxes. In the United States, different levels of government have independent taxing and regulatory authority, resulting in a three-tiered tax system consisting of federal, state, and local taxation.

The "primarily based on an income tax" refers to the predominant role of income taxes in the overall U.S. government revenue. According to the 2022 fiscal year report published by the Internal Revenue Service (IRS), the total federal government tax revenue in the U.S. for the year 2022 was $4.9 trillion. Individual income taxes accounted for $2.8 trillion (57.1%), corporate income taxes accounted for $0.4 trillion (8.2%), payroll taxes for Social Security and healthcare accounted for $1.4 trillion (28.6%), and other direct taxes accounted for $0.3 trillion (6.1%).

The "multiple tax system" refers to a taxation system in which both direct and indirect taxes are levied by a country or region. In the U.S., federal, state, and local governments all impose direct and indirect taxes. The key difference is that the primary source of revenue for the federal and state governments is income tax, while local governments rely primarily on property tax (over 70%).

1.2 Main Direct Taxes

1.2.1 Income Tax

The individual income tax in the U.S. is a direct tax levied on the worldwide or domestic income of its citizens, residents, and non-residents, collected at federal, state, and local levels. The federal individual income tax adopts progressive tax system, varying based on the filing status (single, married, head of household). For example, income below $11,000 for single filers is taxed at 10%, while for heads of households, this threshold is $15,700.

In addition to federal individual income tax, taxpayers may also be subject to state and local individual income taxes, depending on the tax regulations in their state of residence. Different states have varying tax rules, deductions, and incentives. Some states have progressive income tax rates, while others impose a flat tax rate on all taxable income.

Similarly, U.S. corporate income tax is collected at three levels. Since January 1, 2018, the federal corporate income tax rate has been a flat 21%, replacing the previous progressive rates ranging from 15% to 35%. Apart from federal corporate income tax, U.S. corporations are also subject to state corporate income tax. Currently, 44 states and Washington, D.C., levy state corporate income taxes, with top marginal rates ranging from 2.5% (North Carolina) to 11.5% (New Jersey). Fifteen states tax corporate income at progressive rates, while the remaining 29 states and the District of Columbia have constant-rate tax systems.

1.2.2 Social Security Tax and Medicare Tax

In the U.S., Social Security tax is a tax used to fund benefits for U.S. citizens and residents upon retirement, disability, unemployment, or death. It includes the Federal Insurance Contributions Act (FICA) tax, the Railroad Retirement Tax Act (RRTA) tax, the Federal Unemployment Tax Act (FUTA) tax, and the Self-Employment Contributions Act (SECA) tax.

For example, FICA is a tax shared by both employers and employees, funding social security and Medicare programs. Social security provides basic living support for the elderly, survivors, and disabled individuals, while Medicare offers medical services for those aged 65 and above and certain disabled individuals. In 2023, the FICA tax rate is 15.3%, with 12.4% allocated to social security and 2.9% to Medicare. Both employers and employees contribute equally, at 6.2% and 1.45%, respectively. Social security tax has a maximum income limit ($160,200), beyond which no further tax is imposed. While there is no upper income limit for the Medicare portion, an additional 0.9% Medicare tax is levied on individuals with income above a certain threshold.

1.2.3 Inheritance Tax and Gift Tax

Inheritance tax is a tax levied on an individual's property transferred to beneficiaries at their death, collected at both federal and state levels. Federal estate tax applies to global property, while state estate tax is applicable only to property within the state. Gift tax, on the other hand, is levied on property transfers during the donor's lifetime, exclusively at the federal level.

In terms of exemption limits, inheritance and gift taxes are unified, meaning gifts made during the donor's lifetime affect the exemption limit for their estate after death. Tax is only imposed on amounts exceeding the exemption limit. Both federal estate and gift taxes are progressive, meaning higher-value estates or gifts incur higher tax rates. In 2023, the federal estate tax exemption is $12.92 million, with a maximum progressive tax rate of 40%.

In addition to the above tax exemptions, there is an annual gift tax exclusion. In 2023, U.S. citizens can gift up to $17,000 to non-spouse recipients (regardless of residency status) without incurring tax.

1.3 Main Indirect Taxes

1.3.1 Sales and Use Tax

Sales and use tax is a tax imposed by U.S. state and local governments on the sale of goods and services at a certain percentage of the sale price. While there is no federal sales and use tax, this tax is levied by individual states and local governments. Currently, 45 states and the District of Columbia have implemented sales and use tax systems, with Alaska, Delaware, Montana, New Hampshire, and Oregon being the exceptions.

The sales and use tax rate varies by state, ranging from 2% to 10% and typically consists of state and local rates. Local rates include taxes at the country, city, or special district level.

1.3.2 Excise Tax

Excise tax is an indirect tax imposed on specific goods or services (such as fuel, tobacco, and alcohol) upon their sale, collected by both federal and state governments. Federal excise tax applies to items like gasoline, aviation fuel, tobacco, alcohol, and telephone services, while state excise taxes are determined by each state's regulations.

Unlike sales and use tax, excise tax is levied on specific goods or services and is often designed by governments to regulate and discourage the consumption of certain products. It is sometimes referred to as a "sin tax" due to its focus on harmful or unhealthy products like tobacco, alcohol, and fuels. Excise tax comes in two main forms: specific tax (based on quantity or fixed value) and ad valorem tax (based on value proportion). For example, the federal government imposes a specific tax of 18.4 cents per gallon on gasoline, $1.01 per pack of 20 cigarettes, and a 10% ad valorem tax on tanning services.

1.3.3 Capital Gains Tax

Capital Gains Tax refers to the tax levied on individuals who are not primarily engaged in the buying and selling of real estate and securities, for the realized capital gains. Capital gains refer to the profits obtained from the sale or exchange of capital assets, such as stocks, bonds, real estate, etc., usually calculated as the selling price minus the purchase price and other expenses.

In the United States, capital gains tax is divided into two categories: short-term capital gains tax and long-term capital gains tax. Short-term capital gains tax applies to gains from assets held for one year or less, while long-term capital gains tax applies to gains from assets held for more than one year. The short-term capital gains tax rate is the same as the taxpayer's ordinary income tax rate, whereas the long-term capital gains tax rate is typically lower. It is divided into three brackets based on the taxpayer's annual total income and tax filing status: 0%, 15%, and 20%.

In addition to the two basic capital gains tax rates mentioned above, the United States also imposes additional surtaxes or provides preferential policies for certain types of capital gains. For instance, high-income earners (individual taxpayers with annual income exceeding $200,000 or married couples filing jointly with annual income exceeding $250,000) are required to pay an additional 3.8% Net Investment Income Tax on their investment income.

2 U.S. Cryptocurrency Taxation

2.1 IRS Definition of Cryptocurrency

As early as 2014, the IRS issued a notice (Notice 2014-21) outlining the treatment of virtual currency transactions for federal income tax purposes. In this notice, all cryptocurrencies are classified as property rather than currency, subject to general tax principles for property transactions. This implies that most cryptocurrency transactions are subject to capital gains tax.

The IRS defines cryptocurrency broadly as "a digital representation of value recorded on a cryptographic secure distributed ledger or any similar technology." Under this definition, cryptocurrency encompasses (but is not limited to) convertible virtual currencies, cryptocurrencies, stablecoins, and non-fungible tokens (NFTs).

2.2 Cryptocurrency Transactions Involving Income Tax

According to current IRS regulations, the following cryptocurrency transactions are considered income tax events and are subject to income tax rules:

• Receiving cryptocurrency from airdrops

• Cryptocurrency income from DeFi lending

• Cryptocurrency mining income from block rewards and transaction fees

• Receiving cryptocurrency from liquidity pools and interest-bearing accounts

• Receiving cryptocurrency as wages, compensation, etc.

If investors acquire new cryptocurrencies through methods such as airdrops or hard forks, they generally need to include the fair market value at the time of acquisition in their cost basis and pay the corresponding income tax.

2.3 Cryptocurrency Transactions Involving Capital Gains Tax

Cryptocurrency transactions subject to capital gains tax include:

• Converting cryptocurrency to fiat currency

• Gifting cryptocurrency

• Using cryptocurrency to purchase goods and services

• Exchanging one cryptocurrency for another

When engaging in cryptocurrency transactions subject to capital gains tax, investors need to calculate capital gains or losses by subtracting the cost basis from the selling price and pay the appropriate capital gains tax. As mentioned earlier, the holding period of cryptocurrency (categorized by a one-year division) determines the capital gains tax rate. If the cryptocurrency is held for over one year, investors are subject to long-term capital gains tax, which is generally lower than the rate for short-term capital gains tax, which applies to holdings of one year or less.

The IRS suggests that cryptocurrency investors should specifically identify the assets they dispose of whenever possible. This means that if investors can specifically identify the assets they are disposing of, they can use a cost basis method within the Specific Identification (Spec ID) method, such as HIFO, LIFO, and FIFO. Once a cost basis method is chosen, it must be consistently applied when calculating gains and losses.

2.4 Other Tax Considerations

For minting tokens, the IRS has not yet explicitly clarified whether minting tokens (including public minting of NFTs or minting interest-bearing assets) triggers taxable events. This remains a gray area that may require future regulations or rulings to clarify. One possible view is that minting tokens is similar to cryptocurrency mining, as both involve using computational resources to create new digital assets, which may subject minting tokens to income tax rules.

Regarding DeFi, while there is currently no specific IRS guidance on DeFi transactions, cryptocurrency staking is considered income subject to income tax in the U.S. As such, earnings generated through DeFi platforms are likely to be treated as income for tax purposes.

3 Future Outlook of U.S. Cryptocurrency Taxation

In March of this year, Biden Administration proposed several cryptocurrency tax reform suggestions in the 2024 federal budget. Firstly, investors with annual income exceeding $1 million would see their capital gains tax rate increase from 20% to 39.6%. Secondly, companies engaged in mining using computational resources (whether owned by the company or leased from others) would be subject to an excise tax equivalent to 30% of the electricity cost used for mining. Lastly, cryptocurrencies would ultimately be included in the wash-sale rule similar to stocks, preventing investors from tax avoidance through active loss trading. This proposal is expected to take effect for tax years starting after December 31, 2023, pending approval.

Prior to this, the IRS has also issued tax guidance and regulations for cryptocurrency assets. For instance, in October 2022, the IRS issued new guidance (Revenue Ruling 2022-25) clarifying the tax treatment of non-fungible tokens (NFTs). In January of this year, the IRS explicitly instructed taxpayers to continue reporting all digital asset income from the previous tax year. Furthermore, the IRS has been increasing its oversight and audits of cryptocurrency traders, requiring them to accurately report their digital asset transactions and provide corresponding evidence and documentation when filing taxes.

In summary, the U.S. cryptocurrency tax landscape is an evolving field. With the rapid growth and innovation in the cryptocurrency market, both tax authorities and taxpayers need to adapt to new challenges and opportunities. Investors should remain informed about and stay updated on U.S. cryptocurrency tax regulations and undertake reasonable and legal tax planning based on their specific circumstances.