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Bitcoin Tax Checklist

  • Written by Jason M. Tyra, CPA

By: Jason M. Tyra, CPA | Last year was very kind to Bitcoin. So kind, in fact, that for the first time, many previously casual Bitcoiners are finding themselves with substantial and unexpected gains to declare to the IRS. The good news is that taxpayers with Bitcoin activity to report are generally subject to the same rules and should enjoy the same deductions and credits as for other types of income. Here is a short list of special considerations that you can use as a checklist or as a starting point for a conversation between you and your client.

Decide how to file. Bitcoins received in connection with a trade or business or received as wages are subject to ordinary income treatment at the time received. Bitcoins held for less than a year prior to disposal may either be declared as short-term capital gains or foreign exchange gains, which also subjects them to ordinary income treatment. Bitcoins held longer than a year prior to disposal may either be declared as long term capital gains (with proper records) or foreign exchange gains. Since the IRS has issued no definitive guidance yet, taxpayers remain free to take the treatment of their choice for federal income tax reporting.  

Consider whether your client might benefit from a request for a private letter ruling from the IRS. The IRS releases a list each year of tax issues for which it will not issue private letter rulings because they are currently in litigation, pending legislative action or under study. The latest list issued January 2 (see Internal Revenue Bulletin 2013-1) doesn’t mention Bitcoin, virtual currency, crypto currency or anything similar. This means that, for taxpayers with substantial gains to report, the time and expense associated with obtaining a letter ruling may be justified by the peace of mind gained by having one.

Consider theft and casualty losses that might have occurred during the year. In addition to being a year of tremendous gains, 2013 was also a banner year for Bitcoin thefts. In one particularly noteworthy incident, an unknown person or persons allegedly stole at least 96,000 Bitcoins from now-defunct Sheep Marketplace. A large number of Bitcoiners also lost money to frozen accounts (for various reasons, but mostly due to regulatory action) and failed exchanges.  Finally, Bitcoins held in cold storage paper wallets or on crashed hard drives might have also been lost. Total, permanent, irreversible losses can be claimed to the extent of gains, as long as taxpayers can prove that the losses actually occurred. Theft and casualty losses can also be claimed as deductions independent of gains under certain circumstances.

Consider whether your client’s Bitcoin activity qualifies as a trade, business or as a hobby. In order to be considered a trade or business, an activity must have a profit motive. The IRS bases its profit motive determination during audits on a number of tests and other objective characteristics. For example, the IRS considers expectation of profit in at least three of five tax years to be a key factor in making this determination. If Bitcoin activity can properly be called a trade or business, then Bitcoin related expenses will most likely be fully deductible. However, business income may also be subject to self-employment taxes. If a hobby, then Bitcoin hobby expenses are deductible only to the extent of hobby gains. Net operating losses can be carried back up to five years and forward up to twenty years. Hobby losses cannot be carried back or forward.

Claim the applicable deduction for capital expenditures made during the year. Capital assets, such as Bitcoin mining peripherals and computers, must be depreciated over time, but may qualify for Bonus Depreciation or Section 179 treatment for 2013. These special provisions and others, collectively known as “tax extenders” expired at the end of 2013 and have not been renewed. For 2014 and later, lower limits on Section 179 expense and Bonus Depreciation remain in effect. Expenditures that exceed the lower limits must be capitalized and depreciated. 

Don’t forget to include Bitcoin activity when calculating the net investment income tax. If your client is (un)fortunate enough to have modified adjusted gross income over the threshold amounts ($200,000 for single taxpayers, or $250,000 for those who are married filing jointly), Bitcoin gains may be subject to the net investment income tax. The statutory definition for net investment income includes interest, dividends, capital gains, rental and royalty income, income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to a taxpayer. Bitcoin may fall into several of these categories, depending on your personal circumstances. Non-passive business income is not subject to the tax.

Declare foreign banking activity by filing a Foreign Bank Account Report (FBAR), if necessary.  United States persons (citizens, residents and entities created in the United States) must file the FBAR if, at any time during the year, they had a financial interest or signature authority over a foreign financial account with a value of more than $10,000. A wallet with an exchange located in a foreign country, such as Mt. Gox, would cause the taxpayer to be subject to the FBAR rules. Note that the reporting threshold applies to your account balance on every day of the year, not the average balance or balance on just the last day. The FBAR threshold is also crossed when multiple foreign financial accounts have an aggregate value of greater than $10,000.

This list should serve as a starting point for addressing some of the most common Bitcoin-related tax issues and/or discussing them with your client. It is not all inclusive.

Feel free to contact me with questions or with feedback at This email address is being protected from spambots. You need JavaScript enabled to view it..

 

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The Dos and Don'ts of Engagement Letters

  • Written by T. Steel Rose, CPA

Engagement letters should be used for all engagements including tax returns and non-attest financial statement engagements. The primary objective of a well-crafted engagement letter is to make the engagement easy for your client to understand. By documenting the understanding with each client in the engagement letter you minimize a common reason for litigation. If litigation is initiated the engagement letter will serve as documented evidence of the duties your firm agreed to perform.

If you want to reduce your firm’s risk, utilize engagement letters that clearly define roles and responsibilities. An effective engagement letter limits the scope of work to be performed. By stating what is not being performed the agreement will provide an opportunity to explore other potential business with your client. If your client needs these additional services that are outside the engagement letter parameters, amend the original engagement letter to include additional services and additional fees.  

Remington Scott“Apart from a legal perspective, the firm should keep the business perspective in mind and ask the question ‘does this make it easier to contract and do business with my client?’” advised Scott Remington, the tax practice leader of Grant Thornton's Denver office. “We suggest a ‘Statement of Work’ format for engagement letters as an alternative to issuing new letters/terms annually that have to be renegotiated, etc. Using the ‘Statement of Work’ format can also be more efficient than amending prior engagement letters when there is a change in scope.”

While the following list is not all-inclusive and does not represent legal advice, it does represent ideas from professional liability insurance companies who are in the business of limiting your risk from litigation.

Do

Compose the engagement letter as a contract of mutual understanding of the services being provided.

State that the firm will be relying on the information provided by the client.

Clearly define specifically what your firm will and will not do.

Use limiting language that reduces your firm’s responsibility.

Detail what is not included in the services.

Define the client’s responsibilities.

Define deliverables, and due dates.

Inform the client if your firm will be outsourcing any part of the work.

Include limitation of liability language.

Include a mediation clause.

Insert the firms record retention policy.

Include a stop-work clause.

Clearly state the firm’s fee structure.

State your retainer and progressive billing policy.

Detail the consequences of late payment or failure to pay.

Include arbitration language for fee disputes.

Update and sign every year. 

Require new engagement letters for ongoing engagements that extend into new fiscal or calendar years. 

Include engagement letters in your annual organizer for individual tax clients.

Require the client to return the signed engagement letter before work begins.

Amend the document with a new engagement letter and have the client re-sign if the engagement expands or contracts from the original agreement.

Include a due date the client is to return the letter.

Do Not

Include any marketing information.

Use marketing language or superfluous information about the firm and its services. 

Use all-encompassing language;

Use absolutes.

Use superlatives.

Use words that expand rather than limit your firm’s responsibilities.

Use legal jargon or ambiguity.

Use abbreviations or words only an accountant would understand.

Use “evergreen” engagement letters, which may no longer reflect the actual scope of the services being provided.

 

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Improving the President's Tax Return

  • Written by T. Steel Rose, CPA

Rose Steel thumb

 No matter who you are, at tax time it boils down to numbers on a 1040 form. Here are the tax returns of President Barack Obama and Vice President Joe Biden, two of the most powerful people in the free world. In preparation for a tax tips article that we are working on, CPA Magazine challenges you to offer suggestions on how to improve the treatment of the tax positions on these 1040 tax returns. These suggestion topics can range from alternative state residency decisions for President Obama or how to handle book royalties. We will then publish the best suggestions for the benefit of our nation’s tax professionals. You can provide these suggestions with your name attached or anonymously. Professionals with the best suggestions will receive a certificate suitable for framing indicating that they offered the “Best Presidential Tax Return Advice”.

Neither tax return is very complicated but is weighty when printed. There are clear suggestions that may be obvious at first glance, but will still benefit from your explained comment. Submissions can be sent to This email address is being protected from spambots. You need JavaScript enabled to view it..

The President’s 2012 federal income tax return reflects that he and the First Lady filed their income tax returns jointly and reported adjusted gross income of $608,611. The Obamas paid $112,214 in total tax and reported donating $150,034 to 33 different charities. Their effective tax rate is 18.4 percent. The President and First Lady also reveal an Illinois income tax return paying $29,450 in state income tax.

Vice President and Dr. Jill Biden provided their 2012 federal income tax return and state tax returns for Delaware and Virginia. The Biden s filed joint federal and combined Delaware income tax returns. Dr. Biden filed a separate non-resident tax return for the state of Virginia. They reported adjusted gross income of $385,072 and paid $87,851 in total federal tax for 2012, an effective tax rate of 22.8%. They paid $13,531 in Delaware income tax and $3,593 in Virginia income tax. The Bidens contributed $7,190 to charity in 2012.

While political candidates are sensitive about limiting deductions, it is expected that a valuable tax advisor will provide the necessary suggestions to maximize deductions and defer income that is allowable by the Internal Revenue Code. To that end it may make sense to take a two-dollar deduction for donating underwear to charity. Kudos to the tax professional that first discovers and submits which presidential candidate took that deduction.

If you want to further flex your tax muscle, take a look at Mitt Romney’s 1040 from 2011. On the 379-page tax return, the presidential candidate didn’t deduct $1.8 million in donations.

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New Guidance for Preparing Financial Statement Engagement Letters

  • Written by T. Steel Rose, CPA

Rose Steel thumb

Early implementation is permitted for the proposed SSARS covering Preparation of Financial Statements. If accepted they would be effective for the preparation of financial statements for periods ending on or after December 15, 2015. This illus­trative engagement letter (Ref: par. A11) for an engagement to prepare financial statements in accordance with accounting principles generally accepted in the US is not authoritative. It is intended as an illustration that may be used in conjunction with the considerations outlined in Statements on Standards for Accounting and Review Services.

An example of such a letter:

 

To the appropriate representative of management of ABC Company:

You have requested that we prepare the financial statements of ABC Com­pany, which comprise the balance sheet as of December 31, 2014, and the re­lated statements of income, and changes in stockholders’ equity, and cash flows for the year then ended and the related notes to the financial statements. We are pleased to confirm our acceptance and our understanding of this engagement to prepare the financial statements of ABC Company by means of this letter.

Our Responsibilities:

The objective of our engagement is to prepare financial statements in accor­dance with accounting principles gener­ally accepted in the United States based on information provided by you.

We will conduct our engagement in accordance with Statements on Stan­dards for Accounting and Review Ser­vices (SSARSs) promulgated by the Accounting and Review Services Com­mittee of the AICPA and comply with the AICPA’s Code of Professional Con­duct, including the ethical principles of integrity, objectivity, professional com­petence, and due care.

We are not required to, and will not, verify the accuracy or completeness of the information you will provide to us for the engagement or otherwise gather evidence for the purpose of expressing an opinion or a conclusion. Accordingly, we will not express an opinion or a conclu­sion or provide any assurance on the fi­nancial statements.

Our engagement cannot be relied upon to identify or disclose any financial statement misstatements, including those caused by fraud or error, or to identify or disclose any wrongdoing within the entity or noncompliance with laws and regulations.

Your Responsibilities:

The engagement to be performed is con­ducted on the basis that you acknowl­edge and understand that our role is the preparation of the financial statements in accordance with accounting principles generally accepted in the United States.

You have the following overall re­sponsibilities that are fundamental to our undertaking, in accordance with SSARSs, the engagement to prepare your financial statements:

a. The prevention and detection of fraud

b. To ensure that the entity complies with the laws and regulations appli­cable to its activities

c. To make all financial records and re­lated information available to us

d. The accuracy and completeness of the records, documents, explanations, and other information, including significant judgments, you provide to us for the en­gagement to prepare financial statements

You agree that the financial state­ments will clearly indicate that no CPA provides any assurance on them.

Our fees for these services are…

You agree to hold us harmless and to release, indemnify, and defend us from any liability or costs, including attorney’s fees, resulting from management’s know­ing misrepresentations to us.

Please sign and return the attached copy of this letter to indicate your ac­knowledgement of, and agreement with, the arrangements for our engagement to prepare the financial statements de­scribed herein, and our respective re­sponsibilities.

Sincerely yours,

_______________________

[Signature of accountant or accountant’s firm]

Acknowledged and agreed on behalf of ABC Company by:

_______________________

Signed

[Name and title]

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3 Little Known Tax Tips

  • Written by Stanley R. Smiley, Esq.

1. You can use money from your non-qualified annuity for long-term care premium payments in a tax-free exchange.

This tax-free exchange enables a tax efficient mechanism and less expensive vehicle to use funds that would been taxed to pay for regular long term care payments. Had normal distributions been taken prior to annuitization those distributions would have investment gains coming out first and subject to ordinary income tax rates.

2. Retirees can leave a tax free legacy for a beneficiary through a Roth IRA.

A retiree earning wages below the tax threshold has an intriguing opportunity that many people don’t know about. They may choose to baby sit their own grandchildren and receive wages over time. Those wages allow them to make a Roth contribution. In many cases this additional income will have no negative tax consequence for them. They can choose perhaps a grandchild as a beneficiary and on their death provide a significant tax free earnings compounded account over the beneficiary’s lifetime.

Example

Grandma Brown, a widow age 66, wanted to leave a legacy to her grandson on her death. She desired to leave a Roth account but needed current income to make a Roth contribution. Initially, except for a modest social security pension award ($1,500 per month) and a small investment account she had no wage income. She decided to baby sit for her grandson and some neighbor children to obtain earned income. This earned income allowed her to make a Roth contribution. She earned $7,000 a year for babysitting. Even with this income she still was not subject to any income tax. Being over age 50 she was able to make a $5,500 Roth contribution each year plus a $1,000 catch up contribution. After five years contributing a total of $32,500 into her Roth account she died. At that time having earned 5% annually on her account it was valued at 37,713 at her death. {Future value calculation from Number Cruncher Software}.

Grandma Brown named her 10-year-old grandson Roth as the sole beneficiary of her Roth account. After her death, the $37,713 was transferred into an inherited Roth IRA for the benefit of grandson Brown. He began taking annual distributions over his life expectancy (year one his life expectancy is 71.8 years).  It is hoped that account will continue to grow at 5% per year.  If the grandson only takes his required minimum distribution (RMD) each year over his lifetime (assuming life expectancy of 82), he will have total tax free withdrawals of $338,530. {Lifetime stretch IRA distributions calculated with Cetera’s Netx360 stretch IRA calculator}

3. Take advantage of Net Unrealized Appreciation.

If you own your employer’s company stock in your 401k you have a great opportunity. When taking an eligible lump sum distribution from the account, you only pay ordinary tax on the original cost basis of the stock when it initially went into the plan. Any gain between that original cost and the market value when removed from the plan will receive capital gain treatment when ultimately sold. This would allow you to take personal possession of the company outside the plan while rolling over the remaining assets into an IRA. Without using this opportunity normal distributions from a 401k are taxed at ordinary tax rates.

Stanley R. Smiley, Esq. is senior vice president of the Advanced Planning Group department at Cetera Financial Group.

 

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