Articles Posted in Bitcoin

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graphic for NFT article

The non-fungible token market has become as hot as a recalled MacBook lithium battery (if that’s possible). You’ve probably seen the figures: digital artist Beeple sold an NFT for $69 million; a LeBron James non-fungible dunk clip lasting ten seconds went for $200,000; Jack Dorsey’s first tweet was auctioned at $2.9 million.

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Various funds and exchanges now tally NFT transactions in the hundreds of millions of dollars.

The lucky beneficiaries of the market have surely taken into consideration federal taxes. But if they are nonresidents of California, they may not be thinking of how California might treat NFTs for tax purposes. Specifically, depending on the location of the buyer and the status of the seller, the income from NFT sales might be sourced to California, making it subject to California income tax. Oddly, in that case, due to favorable federal capital gains treatment of NFTs, it’s even possible that the California income tax might be higher than the federal tax.

What is an NFT?

People are used to non-fungible assets in the analog world: Action Comics #1 (the first Superman comic book), a stretch of beachfront real estate, the Mona Lisa. You might be able to copy these assets one way or another, but only the original has value. A snapshot of the Mona Lisa or a video of a beach house isn’t worth much. Hence, the non-fungible designation.

In contrast, media on the internet has always been susceptible to unlimited reproduction (whether in violation of copyright or not) without much loss a value. A copy of a YouTube video of Milli Vanilli has pretty much the same value, or lack thereof, as the original. Then came blockchain. The same public-ledger technology that authenticates bitcoin transactions can be used to validate the original digital file of a work of online art, or the NBA’s official slam-dunk competition clips, or Jack’s first, fateful tweet. Blockchain transformed digital media that could be infinitely reproduced with no significant diminishment of value, into a class of assets, like comic books or baseball cards, that could never be copied without a total loss of value. You can still copy an online version of an NFT as a screenshot or other facsimile. But the result is equivalent to a photo of the Mona Lisa.

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Bitcoin image for manes law articleWhere is Bitcoin?

This may sound like a question on a Philosophy 101 midterm exam. But in fact, it’s a real-world tax issue, with potential huge tax consequences for nonresident traders, investors, and users of cryptocurrency, at least to the extent they have financial connections with California, through an exchange or via cryptolending. This is all the more true with the recent IRS announcement that it is scrutinizing thousands of cryptocurrency investors to determine if they have properly reported taxable income relating to crypto. Where the IRS finds taxes due from cryptocurrency transactions, the Franchise Tax Board, California’s main tax enforcement agency, is sure to follow.

Why It Matters

California taxes residents on all their taxable income, from whatever source. In contrast, California taxes nonresident only on income sourced to California. Some income is easy to source. Rents from California real estate? It’s California source: California taxes that income even if the owner lives on the moon. Wages from working in California or selling a product in state? Same result, regardless of the taxpayer’s nonresident status.

Those examples are clear. But what happens if the source involves the trade or investment of an intangible asset? Then things get complicated, if not murky. What are the tax consequences of selling founders stock you own in a California startup for a $10 million gain and you now live full-time in Texas? If the proceeds aren’t sourced to California, you owe zero state taxes. If the proceeds are California-source, you might owe over $1.3 million. The same considerations arise with vesting stock options, sales of software, goodwill, trademarks, royalties. And the answer under California sourcing rules when it comes to intangibles is always: “it depends.”

Cryptocurrency falls into the intangible category. And because crypto is a relatively new class of assets, the rules that apply to California taxation remain out of focus.

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ill-never-make-that-mistake-again-ill-never-make-that-mistake-again-lyric-1-233x300With Tax Day having come and gone, the Franchise Tax Board, California’s tax authority, is now busy sending out its annual 4600 Notices, also known as “Request for Tax Return” letters.  Almost all 4600 Notices are sent to nonresidents, mostly those who own a vacation home or have a business interest in California, and have made one of several common mistakes.  For a full discussion of what a 4600 Notice is, see “They’re Back: FTB 4600 Notices Coming Soon to You.”

If you receive a 4600 Notice, the first order of business is to timely and effectively respond.  Whether that means filing a nonresident tax return (a Form 540NR) or providing a proper legal explanation for why you don’t have to, depends on the circumstances.  Second, assuming the notice gets resolved favorably, the next task is preventing the same problem from recurring in future years.

Automatic vs “Reviewed” Triggers

4600 Notices don’t just happen.  They are triggered.  The trigger is usually one of several common, avoidable mistakes by nonresidents.

In my practice, the typical 4600 Notice involves a nonresident who owns a vacation home in California with a mortgage.  Out of convenience or just as an oversight, the nonresident tells the mortgage lender to send the Form 1098 Mortgage Interest Statement to the vacation home.  Form 1098 is the “information return” mortgage lenders generate to report loan interest.  They send one copy to the FTB and another to the borrower.  If the “Payer/Borrower” address on the 1098 is in California, and the borrower doesn’t file a state tax return, the FTB will automatically send a 4600 Notice.  Continue reading →

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Bitcoin-California-Residency-300x300The fortunes currently being made in Bitcoin and other cryptocurrency investments and trading offer unique opportunities for tax planning that other appreciated assets often do not. This article discusses one of those aspects: the importance of residency planning in reducing cryptocurrency tax liability at the state level.

What Makes Cryptocurrency Conducive To Residency Tax Planning?

Bitcoin and other cryptocurrencies are unique assets in many ways. But for residency tax planning purposes, these three factors make all the difference.

First, much of the taxable gain in appreciated cryptocurrency investment remains unrealized – that is to say, the investors have yet to sell or exchange their initial investment. This is due to the volatile nature of cryptocurrency values, but it’s also a result of the second factor.

Second, unlike traditional investments, the Bitcoin phenomenon has been driven by young disruptive investors, not the usual Wall Street sages with briefcases stuffed with earnings-to-value reports. Many of my clients made relatively small investments, either directly or through mining, in their early twenties, and now, as they enter their thirties, they find themselves sitting on millions or even tens of millions of untaxed appreciated cryptocurrency. Because younger people tend to be mobile, they can move anywhere before cashing out. Which brings us to the third factor. Continue reading →

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