The Boring Tax Guy Blog

Blog post by R. Joseph Ritter, Jr. CFP® EA

A client recently made me aware of a federal court case involving cryptocurrency taxation. This post will review how the case may impact the future of cryptocurrency taxation.

In Jarrett v. USA, the taxpayers correctly reported their cryptocurrency transactions on their tax return but then requested a refund. Their rationale for the refund was that they disagreed with how the IRS viewed the reporting of cryptocurrency transactions. Once the relevant time period passed for the IRS to respond and no refund was forthcoming, the taxpayers sued. In response, the IRS issued a refund check.

Ultimately, the case was dismissed because the taxpayers had received the requested relief. Then, the Jarretts appealed, and their appeal was dismissed as well. Jarrett v. United States, No. 22-6023 (6th Cir. Aug. 18, 2023)

Both cases were dismissed because the judges ruled that the Jarretts had obtained the requested relief – a refund. The reason the Jarretts continued to push the case on appeal is that they wanted the court to rule on tax regulation. Unfortunately, because the IRS issued a refund and the judges ruled that they obtained the relief requested in court, no ruling on the regulation itself will be forthcoming.

So, where does this leave us? Essentially nothing has changed for cryptocurrency taxation after the Jarrett ruling.

What did the Jarretts want? The Jarretts were staking cryptocurrency, and they believed coins produced from staked cryptocurrency should not be taxed until converted into cash. While the government may tax transactions in currency issued by the U.S. Treasury, the United States Internal Revenue Code extends to accessions of realized wealth. And the tax code revolves around the timing of that income, or when income is realized. This was the whole argument of the Jarretts, beyond requesting a refund.

Tacitly, the fact that the IRS issued the refund might give the appearance that the IRS was admitting the tax regulation would not survive in litigation. However, the IRS has since issued a clarifying Revenue Ruling further outlining their position. We would not encourage reporting cryptocurrency transactions differently from an IRS Revenue Ruling.

What does the IRS say? The position of the Internal Revenue Service is that cryptocurrency is an asset similar to publicly traded securities. Notably, the IRS is not alone. The Securities and Exchange Commission, for example, is now suing cryptocurrency exchanges, such as CoinBase, for failing to register as a securities exchange. In other words, multiple branches of the government deem cryptocurrency as a security or an asset rather than a medium of exchange (currency).

Just yesterday, the Securities and Exchange Commission’s Hester Pierce gave a video interview in which she signaled that additional regulations are coming which “are not looking good” for cryptocurrency.

An alternative currency would compete with the U.S. Treasury and Federal Reserve. Thus, an alternative currency brings the potential of undermining the role of the dollar in the economy. Added to that, because it is not a fiat currency, the government’s currency regulators are not providing any oversight and may not be able to. This, then, seems to give rise to why the Department of Justice and SEC are intervening with litigation and regulation.

This is where an analogy would be helpful. Let’s say you purchase 100 shares of stock in Widget Company. This is an asset which you own, similar to staked cryptocurrency. Widget Co. declares a dividend. We understand that dividends paid in cash represent realized ordinary income. But what happens if Widget Co. pays the dividend with fractional shares of stock in Widget Co.? In the eyes of tax regulation, there is no difference between paying a dividend in cash or fractional shares. Income is realized at the time the dividend is issued.

To avoid double taxation, the amount of income realized becomes your basis in the fractional shares received by way of the dividend. When the fractional shares are sold, the difference between the sale proceeds and your basis represents capital gain or loss.

This is how the IRS also views cryptocurrency. Coins produced in staking are realized income, and the amount of income becomes the basis in those coins. Upon a future sale or conversion of the coins, basis is subtracted from the proceeds to determine capital gain or loss. This approach avoids double taxation on the original realized income.

While capital gains tax will likely be changing after 2025, we should note that the lowest capital gains tax bracket is zero, so it’s possible to be taxed on the ordinary income but avoid capital gains tax. It is also possible for high net worth individuals to be taxed on capital gain at a lower rate than their ordinary tax bracket. If the Jarretts had their way, these two forms of potential tax savings would be eliminated. This makes their argument a bit confusing, unless their end goal was to have cryptocurrency be deemed a cash equivalent or an alternative to the dollar. We here at Somerset Tax Partners, LLC don’t see that happening.

The federal government seems to be presenting a unified front against cryptocurrency competing with the dollar. Until further tax regulation comes to light, cryptocurrency should be reported on your tax return as property, not as a cash equivalent.

Real estate by default is treated as a passive activity for income tax purposes. This means that passive income is included in Adjusted Gross Income, however, passive losses can only be offset by other passive income. In many cases, real estate investing can produce tax losses, and while taxed as a passive activity, the use of these losses is limited.

There may be creative methods to enjoy passive losses. The two which immediately come to mind are if you already have another passive stream against which to deduct passive losses or creating your own passive income stream. Such creativity will be quite involved, so this is not the focus of today’s topic.

Tax losses from real estate can only be fully enjoyed on your tax return if the activity is non-passive. For purposes of our discussion, tax losses may not reflect your actual profit in the activity. We hope that your real estate ventures are profitable, and at the same time, we recognize that there are significant tax benefits to investing in real estate.

How can real estate income and losses be treated as a non-passive activity? For this discussion, non-passive is another term for active activity or material participation. For the most part, changing the nature of real estate from passive to non-passive is objectively measured.

The primary benchmark for material participation is 500 hours annually. There are some exceptions to the 500 hour test. The most notable exception is that you only have to log 100 hours annually if you also have documented time logs for everyone else (non-owners) who rendered services to your investment properties, and – this is important – their time cannot exceed yours. In other words, the activity cannot consume more than 200 hours per year, which is extremely challenging for certain types of real estate, especially short-term rentals.

Unfortunately, real estate activity is still treated as passive income even with material participation. Thus, material participation alone is insufficient.

The status needed to flip real estate activities from passive to non-passive is Real Estate Professional Status. This is claimed on your individual income tax return for property investments taxed on your individual income tax return (Schedule C or E) or through a pass-through entity (i.e., Partnership or S Corporation). Real Estate Professional Status requires logging a minimum of 750 hours annually and at least one-half of all time invested in all income-producing activities.

This means that, by default, a Real Estate Professional cannot be employed full-time and achieve Real Estate Professional status. This is because 750 hours per year are less than your full-time employment. Thus, even if you were able to work 1,500 to 2,000 in full-time employment and log an additional 750 hours in your real estate investments, you would still not qualify because less than half of your time invested in income-producing activities was in your real estate investments.

An example of this is with a married professional, such as physician, attorney or accountant. If the spouse is not employed, the spouse is able to invest 750 hours in the real estate activity. Because this is the spouse’s only income-producing activity, the spouse will qualify as a Real Estate Professional upon logging 750 hours. The spouse could also hold part-time employment, so long as that employment is less than 750 hours.

There are several notable points we should include here as well.

1. Material participation qualifies the taxpayer for the Qualified Business Income Deduction (QBI). This is a favorable deduction against taxable income.
2. Hours invested must be recorded in writing on time logs. This is very important and has been addressed very clearly and affirmatively in the U.S. Tax Court. Similar to mileage logs, time logs must show the date, amount of time, purpose or use of the time, and where the time was spent. The log is not required to be in any specific format, however, the log must not give opportunities for questions. An insufficient time log will undermine a claim to material participation and can give the IRS reason to assess underreporting or accuracy penalties. If your tax return is audited, you should expect that the revenue agent will request your time logs!
3. The property owner’s time must be the largest amount of total time invested if others are also servicing the properties. This includes contractors (or subcontractors) and those engaged for general repair or cleaning. Their time can easily be logged and tracked through invoices showing the amount of time billed.
4. Short-term rentals do not count toward Real Estate Professional Status. This is because short-term rentals are not considered to be a real estate activity. Short-term rental activity may be a business, and this by nature will already be treated as non-passive. If your objective is to flip passive income/losses to non-passive, focus on long-term rentals and real estate investing other than short-term rentals. Short-term rentals include Air BNBs.
5. Even if filing a joint income tax return, the time invested by one spouse permits both spouses to enjoy Real Estate Professional Status.
6. Be cautious of videos and articles on the internet and advice from non-tax professional friends. There are posts, for example, claiming that simply owning a short-term rental qualifies for Real Estate Professional Status. This is incorrect and misleading. You must also prove material participation in conjunction with the activity.

To summarize, real estate income is flipped from passive to non-passive primarily by logging 750 hours annually. Upon successfully achieving Real Estate Professional Status, you will be able to utilize tax losses from real estate investments against other, non-real estate and non-passive income.

If you have questions about time logs, the amount of time required and the time invested by people you may hire, it is best to obtain the advice of a knowledgeable tax professional.

This is a question I am receiving more frequently, and it seems fitting to address it in a blog post. There are also quite a few articles on this topic, but nearly all of them leave out important points and background information.

The question is usually posed by a business taxpayer treated as an S Corporation, and the client is typically the sole shareholder or owns the company entirely with the spouse. For purposes of this post, shareholder such as for a corporation has the same meaning as the member of an LLC. IRS regulation also applies to shareholders owning more than 2% of the S Corporation.

S Corporation shareholders are required to be paid a “reasonable salary” when providing services to the S Corporation. If you are the sole shareholder and have no employees, then you most likely fit under the requirement of taking a “reasonable salary.” We’re not going to address salary requirements here, but it is an element of the question.

Only employees are eligible for Health Reimbursement Arrangements (HRA). Thus, an S Corporation shareholder who is not receiving wages as an employee will not qualify. In most small businesses, the shareholder is also an employee.

At this point, we should acknowledge that tax regulation on health-related topics for S Corporations is not well defined. The tax professional community has been left hanging since 2015, so the science and technicalities of health care arrangements for an S Corporation are quite complex.

An HRA, more specifically, the Qualified Small Employer HRA (QSEHRA), must be coordinated with an Affordable Care Act compliant health insurance policy. A small employer is one with fewer than 50 full-time equivalent employees. The policy need not be provided by the same employer. For example, the employee may obtain coverage through the Marketplace and participate in a QSEHRA through an employer which does not offer health insurance. (Note: The presence of an HRA will render the employee ineligible for Premium Tax Credits through the Marketplace, and the HRA must be reported on Form 1095-C.)

To this point, it would seem that an S Corporation shareholder who is also an employee would qualify for the QSEHRA. Unfortunately, current IRS regulations do not permit the shareholder/employee and family members from participating in a QSEHRA. However, a QSEHRA can be offered to non-shareholder employees, so long as they are not family members of the shareholder. This rule is unique to S Corporations. Sole proprietors and C Corporations can implement a QSEHRA for anyone who is an employee, even if the employee is the sole proprietor’s spouse or the majority shareholder in the C Corporation.

Here, then, we must differentiate the two types of HRAs. We just discussed the QSEHRA. A different type of HRA is the self-insured plan. First, some brief background.

When the Affordable Care Act was first enacted, the law deemed any type of health reimbursement arrangement, even if it was just to reimburse out of pocket expenses or premiums, as an offer of coverage. Any offer of coverage must comply with ACA requirements, which include minimum essential coverage and coverage for preexisting conditions, among others. Initially, the HRA was all but eliminated under the guise of it being an offer of coverage, or rather, a substitute for health insurance coverage. Because the offer of coverage did not meet ACA requirements, the HRA was essentially deleted.

Although the HRA was brought back in the form of the QSEHRA, an alternative to traditional health insurance is to self insure. Applicable large employers (50+ employees) can adopt a self-insured plan so long as it otherwise meets ACA requirements.

Things get more sticky with small employers. Self-insured plans and HRAs are deemed to be offers of coverage. (The QSEHRA is exempt because it requires the employee be covered under an ACA-compliant insurance policy.) The ACA imposed daily penalties for offers of coverage which did not comply with ACA requirements. Not only does this mean small employers have a number of pitfalls to avoid, the penalties made it cost-prohibitive to offer anything unless the small employer offered a traditional group health insurance plan, which is also cost-prohibitive. Coincidentally, S Corporations were hit the hardest by the ACA.

In 2015, the IRS issued a notice relaxing these penalties for small employers, and particularly for S Corporations, until further guidance was provided, which has not happened yet.

Thus, premium reimbursement arrangements and self-insured plans for shareholder/employees is once again permissible without penalty even if they are not ACA compliant. However, anything offered for the shareholder/employee cannot discriminate against non-shareholder employees. Thus, before you construct an arrangement, you must be sure it is not discriminatory and that your business has the financial capability to include all qualifying employees in the plan.

Still, these arrangements only offer payroll tax benefits for an S Corporation. There is no income tax benefit to the shareholder. The reason for this is that any type of health care coverage or expense reimbursement arrangement is considered a fringe benefit. S Corporation shareholders are treated as partners under partnership taxation rules, and those rules require fringe benefits to be included in wages.

Thus, while the S Corporation can deduct amounts paid under a reimbursement arrangement, the shareholder must include the amount on box 1 of the W-2. There is only an offsetting self-employed health insurance premium deduction available when the S Corporation reimburses premiums for a “qualified health plan.” This terms limits premiums to insurance policies which are state regulated, and the IRS includes Medicare premiums for retirees.

Expense reimbursement arrangements and self-insured plans for shareholder/employees are not premiums because they are not state regulated plans. As medical-related expenses, however, they are excluded from wages for payroll tax (FICA/FUTA) purposes.

Thus, the primary benefit of a self-insured plan for the shareholder/employee will be a reduction in payroll taxes.

It’s been a long post, so we’ll end it here. Contact us if you have questions or would like to discuss these topics for your business.

Cryptocurrency is gaining more widespread acceptance as an alternative form of payment and transfer of assets. The question that invariably arises is how will cryptocurrency be taxed?

The tax landscape is most likely subject to change, however, currently, there are two basic tax impacts of cryptocurrency. First, we should know how the IRS views cryptocurrency. Rather than as liquid cash, the IRS views cryptocurrency as property (illiquid). This view is similar to bonds, stocks, and other types of property held for investment.

Income. Are you receiving cryptocurrency payments in lieu of cash? This mostly applies to businesses but can also apply to individuals receiving cryptocurrency as income. The cash value of the cryptocurrency received is taxed as income. If you hold onto the cryptocurrency received as income, the amount you recognized as taxable income becomes your basis.

Capital Gain. The other tax impact is when holding cryptocurrency as an investment. This will affect most individuals buying cryptocurrency as well as any individuals or businesses which receive cryptocurrency as income and then hold onto it. When you purchase or hold cryptocurrency and then sell it, the gain is taxed as short-term or long-term capital gain, depending on the length of time it is held. This is very similar to other types of property held for investment.

Do know that the IRS is starting to make mandatory answering questions on the tax return as to whether or not you have a cryptocurrency account. Failing to answer this question truthfully can cause problems down the road. Like all other parts of your tax return, you sign it under penalties of perjury.

If you have a cryptocurrency account, be sure to disclose it when contacting our office.

A client came recently with a TIAA 403(b) and traditional IRA seeking help correcting a TIAA RMD rollover mistake. For a number of years, the client had been able to roll taxable distributions from TIAA into the IRA. Each distribution contained both an RMD which the client took and a regular amount which was eligible for rollover. In 2021, TIAA continued the same practice, of rolling funds into the IRA, except this time TIAA rolled the entire amount into the IRA without separating the RMD.

The IRA custodian later alerted the client that the TIAA funds had been marked as a required minimum distribution (RMD). Then, my phone rang with the question on the other end, “How do we fix this?”

The IRA custodian told the client it was an impermissible rollover, and TIAA told the client that nothing needed to be done to correct the situation. The client tried several times to get a different resolution from TIAA, to no avail. TIAA even sent the client new paperwork indicating that to resolve the situation a new account would need to be opened. All this was very confusing to the client.

There are three issues at play here which needed to be resolved. First, an RMD from a 403(b) cannot be satisfied by an RMD from an IRA. Although RMDs from multiple IRAs can be aggregated from one account and likewise with 403(b) accounts, the two different types of retirement accounts cannot be aggregated.

Second, there may have been a failure to take an RMD from the 403(b) account, which triggers a 50% excise penalty. Third, given that an RMD was rolled into an IRA, there would be a smaller excess contribution penalty.

In trying to find the best course of action to deal with TIAA, I did some generic web searching. It amazed me that so many people were having the same problem, but no one was offering a solution. The client, IRA custodian and myself had a few phone conferences and did not seem to be any closer to a resolution. Then, the client had a lengthy conversation with TIAA and received a promise of a letter that would explain the situation and could be used to mitigate penalties.

Once the letter arrived, it was not as TIAA described it would be. We were all frustrated, and I set the letter aside. The next day, I picked up the letter again and decided to do more sleuthing. TIAA has a FAQ page which provides much the same information as in the letter, but the FAQ related to the account holder turning 72. Laying the FAQ and letter side by side and confirming the client’s age, a resolution was finally found.

We had all assumed that TIAA initiated RMDs when the client turned 70 ½ and that the practice would continue without interruption. However, TIAA’s FAQ and letter to the client stated that a new contract is created when the account holder turns 72, and the entire distribution becomes an RMD.

Armed with this information, we determined that the 2021 rollover from TIAA into the IRA was entirely impermissible because it all represented an RMD. The IRA custodian distributed the funds to the client to correct the excess contribution. Going forward, TIAA has been instructed to distribute funds to a taxable account (non-retirement), and this will prevent future problems.

Once issues such as this are resolved – excess contributions and failure to take RMD – you must still file the appropriate forms with your tax return to report the excess contribution or failure to take an RMD along with the resolving transaction. It is tempting to think that nothing needs to be done since you would qualify for relief from the penalties anyway. However, the IRS has successfully pursued failure to file arguments against taxpayers in the U.S. Tax Court related just to excess contributions and failures to take RMDs. Do not omit the required tax forms even if you do not owe any additional tax! It is to your benefit to timely report because you start the statute of limitations running, and after three years, the IRS is barred from examining the transaction, unless they can prove fraud or substantial underreporting.

I hope this explanation is helpful. Again, I found many similar posts on community boards across the web about correcting a TIAA RMD rollover, but almost all of them went unanswered.

R. Joseph Ritter Jr. CFP® EA discusses the ongoing saga of a premium tax credit case which involved mistakes by the Marketplace.

#premiumtaxcredits #AffordableCareAct #marketplace #taxtips

R. Joseph Ritter Jr. CFP® EA reviews the 2020 tax season after working with micro and small business startups. In this short coaching video, he discusses some basic tips for making your business venture profitable.

#smallbusiness #microbusiness #businessstartup #startupexpenses #businesscoachingv #incometaxes #businesstaxes #soleproprietor