Reality check: Virtual Currency And Its Tax Ramifications

Virtual currencies are created by “mining,” in which    the miner, using powerful computers, authenticates a transaction in the blockchain, a digital ledger of transactions. Besides bitcoin, the most familiar virtual currency, hundreds of others have been created, with more appearing all the time. Digital currency can be traded on third-party digital trading platforms such as Coinbase, used as payment for goods and services, held for investment, and loaned to others. 

Although IRS guidance on virtual currency is sparse, Notice 2014-21 lays out some ground rules. Chief among them is that virtual currency is treated as property for tax purposes, and transactions involving virtual currency are governed by the general tax principles for property transactions. When paid as employee compensation, the fair market value (FMV) of the virtual currency (at the time it is paid) must be included in the employee’s W-2 wages, and the employer must withhold income and employment taxes. Similar rules apply when virtual currency is received as payment for services provided as an independent contractor.

Trade Or Business Treatment And Its Impact On Investment Partnerships         

 In Lender Management LLC, T.C. Memo. 2017-246, the Tax Court concluded that a taxpayer was engaged in the trade or business of providing investment management services and, therefore, could benefit from having its expenses treated as fully deductible business expenses under Sec. 162 rather than being treated as expenses for the production of income under Sec. 212 subject to the Sec. 67(a) 2%-of-adjusted-gross-income floor for miscellaneous itemized deductions. The court ruled that the operations of the company consisted of activities that were beyond those of an investor even though the clients it provided investment management services to were primarily family entities, and its primary source of income was an allocation of profits (i.e., an incentive allocation, or carried interest) from various partnerships to which it provided these services.

During the years covered in the case (2010-2012), Lender Management provided direct management services to three limited liability companies (LLCs) taxed as partnerships for federal income tax purposes. The only members in these three LLCs were the families.

Each LLC had a distinct investment strategy, with one investing in private equities, one investing in public equities, and the third investing in hedge funds. The end-level owners of the three LLCs were, in all cases, children, grandchildren, or great-grandchildren.

To consider an activity as a trade or business, “the taxpayer must be involved in the activity with continuity and regularity and . . . the taxpayer’s primary purpose for engaging in the activity must be for income or profit.”

Given the familial relationship of the owners of Lender Management and the investors of the investment LLCs, the court reviewed the economic arrangement between the entities with a heightened scrutiny. Specifically, the court examined whether the arrangement was a bona fide business relationship or an arrangement due to the familial relationship. Applying this heightened scrutiny, the court noted: (1) There was no requirement or understanding that Lender Management would remain the manager of the assets held by the LLCs indefinitely; (2) investors could withdraw their individual money at any time (subject to the LLC’s liquidity restrictions); (3) Keith, as one of the investors in the LLCs, would still have benefited from the investment returns of ownership of the LLCs if he did not work for Lender Management, and any additional income to him was due to the services he provided to Lender Management; and (4) while each investor was a member of the Lender family, the members did not act collectively and, in some cases, did not know each other or were in conflict with each other. The Tax Court found that even though the investors were all members of the Lender family, Lender Management provided investment advisory services and managed investments for each of its clients individually.

Ultimately, the Tax Court held that the activities of Lender Management rose to the level of a trade or business, and it was entitled to deduct its expenses under Sec. 162.

Lender Management affirms the position that an investment adviser can be in a trade or business even if the primary source of its income is from the allocation of profits from underlying managed partnerships. In considering these structures, it is critical that taxpayers and their advisers consider the specific facts and circumstances of each particular situation for the structure to be respected.

Understanding the new Sec. 199A business income deduction

• Sec. 199A allows taxpayers other than corporations a deduction of 20% of qualified business income earned in a qualified trade or business, subject to certain limitations.
• The deduction is limited to the greater of (1) 50% of the W-2 wages with respect to the trade or business, or (2) the sum of 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (generally, tangible property subject to depreciation under Sec. 167). The deduction also may not exceed (1) taxable income for the year over (2) net capital gain plus aggregate qualified cooperative dividends.
• Qualified trades and businesses include all trades and businesses except the trade or business of performing services as an employee and “specified service” trades or businesses: those involving the performance of services in law, accounting, financial services, and several other enumerated fields, or where the business’s principal asset is the reputation or skill of one or more owners or employees.
• Qualified business income is the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business that are effectively connected with the conduct of a business in the United States. However, some types of income, including certain investment-related income, reasonable compensation paid to the taxpayer for services to the trade or business, and guaranteed payments, are excluded from qualified business income.
• The W-2 wage limitation does not apply to taxpayers with taxable income of less than $157,500 for the year ($315,000 for married filing jointly) and is phased in for taxpayers with taxable income above those thresholds. Income from specified service businesses is not excluded from qualified business income for taxpayers with taxable income under the same threshold amounts.
• The new law also reduces the threshold at which an understatement of tax is substantial for purposes of the accuracy-related penalty under Sec. 6662 for any return claiming the deduction, from the generally applicable lesser of 10% of tax required to be shown on the return or $5,000 before the new law, to 5% of tax required to be shown on the return or $5,000.

The law’s many yet-unclear points include its application to rental property, the netting of qualified business income and loss for taxpayers with multiple qualified trades or businesses, determining the deduction for tiered entities, allocating W-2 wages among businesses, and whether compensation paid to an S corporation shareholder is included in W-2 wages for purposes of that limitation.

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Income taxation of trusts and estates after tax reform

 Rate reduction and thresholds: The law provides, for tax years 2018 through 2025, a new table under Sec. 1(j)(2)(E) of ordinary income tax rates and thresholds for trusts and estates (subject to adjustment for inflation for years after 2018) as shown in the chart below.

Ordinary income tax rates

The law retains the preferential rates for qualified dividend and long-term capital gain income under Sec. 1(j)(5) but adjusts the thresholds as illustrated in the chart below.

Capital gains and qualified dividend rates

Application of Sec. 641(b): Generally, under Sec. 641(b), the taxable income of an estate or trust is computed in the same manner as for an individual. This means that many of the amendments to the Code applicable to individuals are also relevant to calculating the adjusted total income of trusts and estates:

Sec. 164, state and local taxes: The law amends Sec. 164(b) to limit the aggregate deduction for state and local real property taxes, state and local personal property taxes, and state and local income taxes to a maximum of $10,000 per year. This limitation does not apply to any real property taxes or personal property taxes incurred by a trust or estate in carrying on a trade or business, or an activity under Sec. 212.

Sec. 67, miscellaneous itemized deductions: The law amends Sec. 67 by suspending all miscellaneous itemized deductions. Trusts and estates will not be permitted to deduct investment fees and expenses and unreimbursed business expenses, among others. On its face, the law does not appear to impact Sec. 67(e), which does not apply the 2% limitation to administration expenses incurred solely because the property is held in a trust or estate (i.e., trustee fees); however, this is an area where clarification will be required.

Sec. 642(b), personal exemptions: The law amends Sec. 151 to suspend the personal exemptions for individuals; however, trusts and estates remain entitled to their personal exemptions under Sec. 642(b). The amounts of the personal exemptions for trusts and estates remain unchanged.

Alternative minimum tax (AMT) — Sec. 55: The law did not amend the AMT for trusts and estates. The exemption of $24,600 and phaseout threshold of $82,050 for trusts and estates (for 2018) were not changed. These amounts will continue to be adjusted for inflation under Sec. 55(d)(3).

Income distribution deduction (IDD) under Sec. 651: Under Sec. 651(b), simple trusts are entitled to an IDD, which is limited to the lesser of fiduciary accounting income (FAI) or distributable net income (DNI). In the past, FAI has generally been greater than DNI for simple trusts, so the IDD for simple trusts usually equals DNI. This is because all expenses were allowed in calculating DNI, while some expenses were allocated to principal when calculating FAI.

As trusts and estates lose the deductions discussed above, the adjusted total income (ATI) will increase. As ATI increases, DNI increases. FAI will remain the same, as the allocation of expenses for FAI is controlled by a trust’s governing document or the applicable state’s Principal and Income Act. As such, this may result in FAI becoming the more common IDD limitation, which may result in trusts and estates paying more income tax at the trust level than before the Tax Cuts and Jobs Act was enacted.

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