Over the last several years, virtual currency has become increasingly popular. Bitcoin is the most widely recognized form of virtual currency, also commonly referred to as digital, electronic or crypto currency.

While most smaller businesses are not yet accepting bitcoin or other virtual currency payments from their customers, more and more larger businesses are. Businesses also can pay employees or independent contractors with virtual currency. But what are the tax consequences of these transactions?

Virtual Currency 101

Virtual currency has an equivalent value in real currency and can be digitally traded between users. It also can be purchased with real currencies or exchanged for real currencies and is most commonly obtained through virtual currency ATMs or online exchanges.

Goods or services can be paid for using “virtual currency wallet” software. When a purchase is made, the software digitally posts the transaction to a public ledger. This prevents the same unit of virtual currency from being used multiple times.

Tax impact

Questions about the tax impact of virtual currency abound and the IRS has yet to offer much guidance.

In 2014, the IRS ruled that bitcoin and other convertible virtual currency should be treated as property, not currency, for federal income tax purposes. This means that businesses accepting virtual currency payments for goods and services must report gross income based on the fair market value of the virtual currency when it was received, measured in equivalent U.S. dollars.

When a business uses virtual currency to pay wages, the wages are taxable to the employees to the extent any other wage payment would be. You must, for example, report such wages on your employees’ W-2 forms. They are subject to federal income tax withholding and payroll taxes, based on the fair market value of the virtual currency on the date received by the employee.

When a business uses virtual currency to pay independent contractors or other service providers, those payments are also taxable to the recipient. The self-employment tax rules generally apply, based on the fair market value of the virtual currency on the date received. Payers generally must issue 1099-MISC forms to recipients.

Finally, payments made with virtual currency are subject to information reporting to the same extent as any other payment made in property.

Deciding whether to go virtual

Accepting virtual currency can be beneficial because it may avoid transaction fees charged by credit card companies and online payment providers (such as PayPal or Venmo, in some cases) and attract customers who want to use virtual currency. It can also pose tax risks as guidance on the tax treatment or reporting requirements is limited.

It is important to research and contact your business adviser on the tax considerations when deciding whether your business should accept bitcoin or other virtual currencies.

In a much-anticipated ruling that confounded the expectations of many court watchers, the U.S. Supreme Court has given state and local governments the green light to impose sales taxes on out-of-state online sales. The 5-4 decision in South Dakota v. Wayfair, Inc. was met by cheers from brick-and-mortar retailers, who have long believed that the high court’s previous rulings on the issue disadvantaged them, as well as state governments that are eager to replenish their coffers.

The previous rulings

The Supreme Court’s holding in Wayfair overruled two of its precedents. In its 1967 ruling in National Bellas Hess v. Dept. of Revenue, the Court tackled a challenge to an Illinois tax that required out-of-state retailers to collect and remit taxes on sales made to consumers who purchased goods for use within the state.

That case involved a mail-order company. The high court found that, since the company’s only connection with customers in Illinois was by “common carrier” or the U.S. mail, it lacked the requisite minimum contacts with the state required by the Due Process and Commerce Clauses of the U.S. Constitution to impose taxes. It held that the state could require a retailer to collect a local use tax only if the retailer maintained a physical presence, such as retail outlets, solicitors or property in the jurisdiction.

Twenty-five years later, in Quill Corp. v. North Dakota, the Supreme Court reconsidered the so-called physical presence rule in another case involving mail-order sales. Although it overruled its earlier due process holding, it upheld the Commerce Clause holding. The Court based its ruling on the Commerce Clause principle that prohibits state taxes unless they apply to an activity with a “substantial nexus” — or connection — with the state.

Criticism of the physical presence rule

The rule, established in Bellas Hess and affirmed in Quill, has been the subject of extensive criticism. This has been particularly true in recent years as traditional stores have lost significant ground to online sellers. In 1992, the Court noted that mail-order sales in the United States totaled $180 billion, while in 2017 online retail sales were estimated at $453.5 billion. Online sales represented almost 9% of total U.S. retail sales last year.

It is estimated that states lose $8 billion to $33 billion in annual sales tax revenues because of the physical presence rule. States with no income tax, such as South Dakota, have been especially hard hit. South Dakota’s losses are estimated at $48 million to $58 million annually.

The sales tax at issue

In response to the rise in online sales and the corresponding effect on sales tax collections, South Dakota enacted a law requiring out-of-state retailers that made at least 200 sales or sales totaling at least $100,000 in the state to collect and remit a 4.5% sales tax. The 2016 law also included a clause declaring an emergency in light of the need “for the support of state government and its existing public institutions …”

South Dakota subsequently sued several online retailers with no employees or real estate in the state. It sought a declaration that the sales tax was valid and applicable to the retailers, along with an injunction requiring the retailers to register for licenses to collect and remit the tax. A trial court dismissed the case before trial, and the State Supreme Court affirmed, citing its obligation to follow U.S. Supreme Court precedent, however persuasive the state’s arguments against the physical presence rule might prove.

The Supreme Court’s reasoning

The majority opinion — penned by Justice Kennedy but joined by the unusual mix of Justices Thomas, Ginsburg, Alito and Gorsuch. It described the physical presence rule as “unsound and incorrect.” According to the Court, the rule becomes further removed from economic reality every year.

Quill, the opinion said, creates market distortions. It puts local businesses and many interstate businesses with a physical presence at a competitive disadvantage compared with remote sellers that need not charge customers for taxes. Kennedy wrote that the earlier ruling “has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a State’s consumers — something that has become easier and more prevalent as technology has advanced.”

In addition, the Court found that Quill treats economically identical actors differently for arbitrary reasons. A business with a few items of inventory in a small warehouse in a state is subject to the tax on all of its sales in the state, while a seller with a pervasive online presence but no physical presence is not subject to the same tax for the sales of the same items.

Ultimately, the Supreme Court concluded that the South Dakota tax satisfies the substantial nexus requirement. Such a nexus is established when the taxpayer “avails itself of the substantial privilege of carrying on business” in the jurisdiction. The quantity of business the law required to trigger the tax could not occur unless a seller has availed itself of that substantial privilege.

Of course, as the Court acknowledged, the substantial nexus requirement is not the only principle in the Commerce Clause doctrine that can invalidate a state tax. The other principles were not argued in this case, but the high court observed that South Dakota’s tax system included several features that seem designed to prevent discrimination against or undue burdens on interstate commerce, such as a prohibition against retroactive application and a safe harbor for taxpayers who do only limited business in the state.

The impact

The significance of the Supreme Court’s ruling was felt almost immediately in the business world, with the share prices of major online retailers quickly dropping (even those that do collect and remit sales taxes). It is not just the behemoths that could be affected, though.

The Court recognized that the burdens of nationwide sales tax collection could pose “legitimate concerns in some instances, particularly for small businesses that make a small volume of sales to customers in many States.” But, it said, reasonably priced software eventually may make it easier for small businesses to cope. The ruling also pointed out that, in this case, the law “affords small merchants a reasonable degree of protection,” such as annual sales thresholds.

Further, the Court noted, South Dakota is one of more than 20 states that are members of the Streamlined Sales and Use Tax Agreement (SSUTA). These states have adopted conforming legislation that provides uniform tax administration and definitions of taxable goods and services, simplified tax rate structures and other uniform rules. Colorado does not participate.

Closer to Home

Colorado has an incredibly complex sales and use tax system, with over 300 jurisdictions that impose and administer tax, including home-rule cities, or cities who collect their own sales tax. Business owners can learn more by reviewing Colorado’s Sales and Use Tax General Information and Reference Guide; however, confirming your tax liability with your CPA is recommended.

What next?

In light of the Supreme Court’s decision, states may need to revise or enact legislation to meet the relevant constitutional tests — including, but not limited to, the substantial nexus requirement. If you have questions regarding sales tax collection requirements for your business, please contact your business adviser.

The sweeping changes of recent tax reform may impact the choice of how business taxpayers maintain their financials, specifically regarding the cash vs accrual methods of accounting. In tax years beginning after December 31, 2017, taxpayers may select their accounting method according to the new limits and conditions, as applicable:

Tax reform permits taxpayers in certain circumstances to recognize income for tax purposes no later than the year in which it is recognized for financial reporting purposes:

Tax law changes may impact on a businesses’ accounting method choice, and warrant a company to review and, possibly, revise those choices.

In a like-kind exchange, a taxpayer doesn’t recognize gain or loss on an exchange of like-kind properties if both the relinquished property and the replacement property are held for productive use in a trade or business or for investment purposes. For exchanges completed after Dec. 31, 2017, the TCJA limits tax-free exchanges to exchanges of real property that is not held primarily for sale (real property limitation). Thus, exchanges of personal property and intangible property can’t qualify as tax-free like-kind exchanges.

Although the real property limitation applies to exchanges completed after Dec. 31, 2017, transition rules provide relief for certain exchanges. Specifically, the real property limitation doesn’t apply to an exchange if the relinquished property is disposed before Jan. 1, 2018, or the replacement property is received by the taxpayer before Jan. 1, 2018. If the transition rules apply and all other requirements for a tax-free exchange are satisfied, an exchange of personal property or intangible property that is completed after Dec. 31, 2017 can qualify as a tax-free like-kind exchange.

Before the Tax Cuts and Jobs Act, a second tax system called the alternative minimum tax (AMT) applied to both corporate and noncorporate taxpayers. The AMT was designed to reduce a taxpayer’s ability to avoid taxes by using certain deductions and other tax benefit items. The taxpayer’s tax liability for the year was equal to the sum of (i) the regular tax liability, plus (ii) the AMT liability for the year.

A corporation’s tentative minimum tax equalled 20% of the corporation’s “alternative minimum taxable income” (AMTI) in excess of a $40,000 exemption amount, minus the corporation’s AMT foreign tax credit. AMTI was figured by subtracting various AMT adjustments and adding back AMT preferences. The $40,000 exemption amount gradually phased out at a rate of 25% of AMTI above $150,000. “Small” corporations-those whose average annual gross receipts for the prior three years didn’t exceed $7.5 million ($5 million for startups)-were exempt from the AMT. A taxpayer’s net operating loss (NOL) deduction, generally, couldn’t reduce a taxpayer’s AMTI by more than 90% of the AMTI (determined without regard to the NOL deduction). Very complex rules applied to the deductibility of minimum tax credits (MTCs). All-in-all, the AMT was a very complicated system that added greatly to corporate tax compliance chores.

Corporate AMT repeal

The Tax Cuts and Jobs Act repealed the AMT on corporations. Conforming changes also simplified dozens of other tax code sections that were related to the corporate AMT. The TCJA also allows corporations to offset regular tax liability by any minimum tax credit they may have for any tax year. And, a corporation’s MTC is refundable for any tax year beginning after 2017 and before 2022 in an amount equal to 50% (100% for tax years beginning in 2021) of the excess MTC for the tax year, over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the corporation’s MTC will be allowed in tax years beginning before 2022.

The Tax Cuts and Jobs Act (TCJA) should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC or sole proprietorship. This income is sometimes referred to as “pass-through” income. The deduction is 20% of your “qualified business income (QBI)” from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business.

The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.

The deduction is taken “below the line,” i.e., it reduces your taxable income but not your adjusted gross income. It is available regardless of whether you itemize deductions or take the standard deduction. The deduction cannot exceed 20% of the excess of your taxable income over net capital gain. Current QBI losses will be carried forward to offset future QBI income years.

For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. Here’s how the phase-in works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, or $415,000.)

Additionally, for taxpayers with taxable income more than the thresholds ($157,000/$315,000), the deduction is limited by either wages paid or wages paid plus a capital element. Here’s how it works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000.

Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.

The complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the threshold discussed above.

The Tax Cuts and Jobs Act makes changes to the general business credit by adding a new component credit for paid family and medical leave, and changing two current component credits, i.e., the rehabilitation credit and the orphan drug credit.

First, the Act introduces a new component credit for paid family and medical leave, i.e. the paid family and medical leave credit, which is available to eligible employers for wages paid to qualifying employees on family and medical leave. The credit is available as long as the amount paid to employees on leave is at least 50% of their normal wages and the leave payments are made in employer tax years beginning in 2018 and 2019. That is, under the Act, the new credit is temporary and won’t be available for employer tax years beginning in 2020 or later unless Congress extends it further.

For leave payments of 50% of normal wage payments, the credit amount is 12.5% of wages paid on leave. If the leave payment is more than 50% of normal wages, then the credit is raised by .25% for each 1% by which the rate is more than 50% of normal wages. So, if the leave payment rate is 100% of the normal rate, i.e. is equal to the normal rate, then the credit is raised to 25% of the on leave payment rate. The maximum leave allowed for any employee for any tax year is 12 weeks.

Eligible employers are those with a written policy in place allowing (1) qualifying full-time employees at least two weeks of paid family and medical leave a year, and (2) less than full-time employees a pro-rated amount of leave. On that note, qualifying employees are those who have (1) been employed by the employer for one year or more, and (2) who, in the preceding year, had compensation not above 60% of the compensation threshold for highly compensated employees. Paid leave provided as vacation leave, personal leave, or other medical or sick leave is not considered family and medical leave.

Second, the Act changes the rehabilitation credit for qualified rehabilitation expenditures paid or incurred starting in 2018, by eliminating the 10% credit for expenditures for qualified rehabilitation buildings placed in service before 1936, and retaining the 20% credit for expenditures for certified historic structures, but reducing its value by requiring taxpayers to take the credit ratably over five years starting with the date the structure is placed in service. Formerly, a taxpayer could take the entire credit in the year the structure was placed in service. The Act also provides for a transition rule for buildings owned or leased at all times on and after Jan. 1, 2018.

Third, the Act also makes significant changes to another component credit of the general business credit, i.e., the orphan drug credit for clinical testing expenses for certain drugs for rare diseases or conditions. For clinical testing expense amounts paid or incurred in tax years beginning in 2018, the former 50% credit is cut in half to 25%. Taxpayers that claim the full credit have to reduce the amount of any otherwise allowable deduction for the expenses regardless of limitations under the general business credit. Similarly, taxpayers that capitalize, rather than deduct, their expenses have to reduce the amount charged to a capital account. The credit has been reduced and now equals 25 percent of qualifying clinical testing expenses. However, the Act gives taxpayers the option of taking a reduced orphan drug credit that if elected allows taxpayers to avoid reducing otherwise allowable deductions or charges to their capital account. The election for the reduced credit for any tax year must be made on a tax return no later than the time for filing the return for that year (including extensions) and in a manner prescribed by IRS. Once the reduced credit election is made, it is irrevocable.

Net Operating Losses

Under pre-Tax Cuts and Jobs Act law, a net operating loss (NOL) for any tax year was generally carried back two years, and then carried forward 20 years. Taxpayers could elect to forego the carryback. The entire amount of the NOL for a tax year was carried to the earliest of the tax years to which it may be carried, then carried to the next earliest of those tax years, etc.

New Law: Tax Reform repeals the general two-year NOL carryback and the special carryback provisions, but provides a two-year carryback for certain losses incurred in a farming trade or business. The Act also provides that NOLs may be carried forward indefinitely. There is also a provision that limits the NOL deduction to 80% of taxable income.

Disallowance of Excess Business Losses

Under pre-Tax Cuts and Jobs Act law, if a non-corporate taxpayer received any applicable subsidy for any tax year, the taxpayer’s excess farm loss for the tax year wasn’t allowed. Thus, the amount of losses that could be claimed by an individual, estate, trust, or partnership were limited to a threshold amount if the taxpayer had received an applicable subsidy. For this purpose, an excess farm loss was the excess of the taxpayer’s aggregate deductions that were attributable to farming businesses over the sum of the taxpayer’s aggregate gross income or gain attributable to farming businesses plus a threshold amount. Any excess farm loss was carried over to the next tax year.

New Law: The Tax Cuts and Jobs Act provides that, for a tax year of a taxpayer other than a corporation beginning after Dec. 31, 2017 the limitation on excess farm loss for non-corporate taxpayers under Code Sec. 461(j) doesn’t apply. Thus, for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, excess business loss of a taxpayer other than a corporation are not allowed for the tax year. In other words, the Tax Cuts and Jobs Act expands the limitation on excess farming loss to other non-corporate taxpayers engaged in any business. This can apply to the excess business loss of sole proprietorships, partnerships, S corporations, limited liability companies (LLCs), estates, and trusts.

An “excess business loss” is the excess (if any) of  the taxpayer’s aggregate deductions for the tax year that are attributable to trades or businesses of the taxpayer, over the sum of:  (i)  the taxpayer’s aggregate gross income or gain for the tax year which is attributable to those trades or businesses, plus (ii)  $250,000 (200% of that amount for a joint return (i.e., $500,000)).

Any loss that is disallowed as an excess business loss is treated as a net operating loss (NOL) carryover to the following tax year. Under the Tax Cuts and Jobs Act, NOL carryovers are generally allowed for a tax year up to the lesser of the carryover amount or 90% (80% for tax years beginning after 2022) of taxable income determined without regard to the deduction for NOLs.

As you can see from this overview, the new law affects many areas of taxation. If you wish to discuss the impact of the law on your particular situation, please give us a call.