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Don't Get Caught in a Crypto Storm This Tax Season

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Despite the reports on the news that crypto might soon be on its way out, that's actually not the case. If you're not working with clients who have crypto transactions on their balance sheets already, you soon will be. Patrick White, CEO and Co-Founder of Bitwave, offers 5 best practices so you can head off crypto-related tax problems before they even start.

Jul 15th 2022
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We’ve been here before. 

Since the emergence of bitcoin over a decade ago, the cryptocurrency market has undergone four crashes where the price of BTC has fallen at least 80 percent, if not more. Yet, each time the industry is written off like a burning tulip field, it rises from the ashes with genuinely disruptive technologies and innovative use cases. 

Don’t believe the pundits that flip-flop on the importance almost as frequently as price fluctuations. Ethereum burst onto the scene in 2014, following the crash of Bitcoin that same year.. Decentralized Finance (DeFi) emerged after the 2017-2018 crash. 

Sorry Cramer, no take-backs. 

Ethereum and the Decentralized Finance (DeFi) ecosystem have real value—$62B Total Value Locked (TVL), for what it’s worth –– and that’s in a bear market! The TVL for DeFi peaked at about $180B in November 2021. 

That’s why JPM wants to bring $1T of tokenized assets into the DeFi ecosystem. And despite market turbulence, venture capitalists are still buying to the tune of $15B in 2022.

Where will we go next? I can’t say. But the takeaway for accountants is clear. Crypto has grown up and will soon be on your organization's balance sheets if it isn’t already. 

The revolution is here, but it won’t be televised. It’ll be recorded on the blockchain. As exciting as that is, there’s a common fallacy that the data accountants need to do their jobs as readily available. Yes, the ledgers are immutable, but it isn’t like a bank statement: extracting accounting data is not as easy as it seems. 

Suppose your organization or your clients keep digital assets on their balance sheets. In that case, they likely engage in many activities like moving digital assets between blockchains, staking, and yield farming. Making matters worse, they are performing these actions at the scale of 100s, if not 1000s, of daily transactions. 

Accurately capturing all the information is a tall order, but it’s not impossible if you follow a few guidelines. Here are five best practices to ensure your clients follow to make your life easier next tax season. 
 

1. Instill a culture that records everything –– and is strict about it

We touched upon this earlier, but diligent recordkeeping is a must. While many think of the blockchain as this all-seeing, self-documenting technology, that doesn’t mean it’s easy to interpret for tax purposes. 

Bank records, for example, are highly organized and detail information like vendors and payees. In some cases, they may have a short description of the sold item. 

While the blockchain is data-rich, it is essentially a permanent record of letters and numbers that can be examined through a block explorer like EtherScan. But this information isn’t accountant-friendly. Copying and pasting this into a spreadsheet isn’t going to help you. 

2. Some essential questions to ask are as follows: 

  • Who is the validator’s customer? 
  • What is the contract? 
  • Who is the principal, and who is the agent? 
  • What is our performance obligation? Is it at the block level? 
  • What is our pricing source? 
  • How many performance obligations are there? 

3. Advise your clients to use only one exchange.  

Using multiple exchanges introduces many unnecessary complications for your accountant come tax season.

The more sources you pull from on Tax Day, the larger the headache for your accountant. This is problematic for two reasons. The first is that every exchange outputs its data in a different format, which increases the likelihood of errors when your accountant is combining CSVs. The second is that this is an incredibly time-consuming, manual task that increases your billable hours. In other words, it’s a lose-lose for everyone involved.  
 

4. Ensuring your clients maintain excellent wallet hygiene is a must. 

It’s easy to think that maintaining all your digital assets in one location is best, but that’s not necessarily true. 

Good wallet hygiene is essential as organizations scale because it helps accountants understand transactions from a workflow perspective as they process them. Always keep transaction-specific wallets (e.g., investments, DeFi transactions, revenue, etc.), and use a consistent naming system. For example, if you are a miner, you would keep a separate wallet to hold mining rewards. 

5. Talk to your clients early and often.

Between tracking activity between and across disparate exchanges, blockchains, and wallets, and then accurately reporting those activities to your accountant, accounting becomes complicated very quickly. Talking to your accountant early and often can help mitigate this and ensure you are always aligned. 

Accountants, do you relate? My advice is that communication is a two-lane road, and you must work with your clients to ensure they follow best practices like what was described above. Another option is to use a software solution to automate and streamline many of these processes.
 

6. Test their holdings for impairment regularly: asset-to-asset or, even more granularly, lot-by-lot. 

I know, holding inherently volatile assets like crypto to the same standards as other intangible assets like goodwill seems like fitting a square peg in a round hole. Still, until we get better guidance, it is what it is. 

And let’s be honest. Suppose your business or your clients are holding digital assets on their balance sheet and must follow U.S. GAAP (Generally Accepted Accounting Principles) or International Financial Reporting Standards (IFRS). In that case, you’re going to have to test for impairment this year.

Between the volatility, transaction volume, and the sheer number of digital assets to track, accurately calculating carrying values across an organization's portfolio is easier said than done. At best, it is an incredibly time-intensive manual process, which is why many organizations struggle with impairment testing for digital assets –– or worse, don’t do it at all. 

Don’t be them. 

While manually testing for impairment is challenging, it is not impossible. 

Generally, there are four steps: 

1. Impairment testing is to be performed at the individual lot level; thus, it is very important to track each individual digital asset separately

2. Compare the purchase price—the cost basis—of the digital asset with the current market value of the digital asset 

3. Suppose at any point in the reporting period, the price of the underlying asset drops below its purchase price. In that case, the asset is impaired. The company would have to write down the digital asset's value to the lowest point within the reporting period, along with recognizing a corresponding loss.

4. As long as the company holds the digital asset, the asset must undergo continual impairment testing until it is sold, disposed of, or traded. 

Impairment can be a daunting task and full-time job in and of itself. You could give it to an intern or use software that makes it as easy as a click — your choice.