Where Is Bitcoin? Cryptocurrency and California’s Income Sourcing Rules


a674d899-5f9f-449d-bc51-2374ab217032Where 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.

How It Works

First, to beat a dead horse, cryptocurrency isn’t currency. At least it isn’t as far as the IRS is concerned, and that’s all that matters for tax purposes (California generally follows IRS rules on definitions applicable to asset classes). If crypto were currency, how California taxed its use or transfer by nonresidents would be easy to determine. Generally it wouldn’t be taxable at all. But the IRS has spoken (barely), and despite calling cryptocurrency a “virtual currency,” for tax purposes, crypto is treated as an intangible asset, much like a marketable security.

As most crypto investors know, the IRS has only provided a single written instance of guidance to the public on the taxation of Bitcoin and other cryptocurrency. That was back in 2014, in Notice 2014–21. In that notice, the IRS excludes cryptocurrency from treatment as legal tender (even as foreign currency), and goes on to define it, generically, as “property.” Since crypto has no physical form, it is by default intangible property. This makes a big difference for how it is taxed by California.

Second, defining cryptocurrency as intangible property isn’t the end of the matter. How it is used determines how it is taxed. The notice goes on to discuss how crypto can be taxed as compensation, as ordinary income, as long- or short-term capital gain, depending on whether it is used to purchase goods or services, or bought and sold for investment, or mined.

Note that the tax treatment of crypto isn’t necessarily reflected in its treatment for other purposes. Thus, the Financial Crimes Enforcement Network issued guidance on virtual currency, stating that in the hands of individuals, crypto is not covered by money laundering rules, but as transacted by exchanges, it might be – just like a currency. (FIN-2013-G001, March 18, 2013).

To summarize: cryptocurrency is generally taxed as intangible property, though the particular tax aspects depend on its use. This means the California sourcing rules applicable to intangible property govern cryptocurrency. The implications of that may not have been fully realized by most nonresidents involved in cryptocurrency, or residents planning to leave California before cashing out their crypto investments.

Let’s apply the intangible property sourcing rules in situations that may make a difference in the state taxation of cryptocurrency transactions.

The Location of the Exchange

First, while cryptocurrency doesn’t have a physical location, the exchanges that trade and convert the virtual tokens do. The vast majority of cryptocurrency exchanges are offshore, with a particular concentration in Hong Kong, South Korea and various idyllic if dubious island tax havens. However, a number of major exchanges are based in San Francisco, including Coinbase, Kraken and GDAX. Why does this matter? On its face, it shouldn’t. Trading or converting cryptocurrency through a California exchange doesn’t make a nonresident owner subject to California income taxes any more than selling stock on the New York Stock Exchange triggers New York income taxes. However, it can matter in the same way in-state brokerage accounts do. California-based exchanges have to prepare and file tax information returns, specifically Form 1099s, to report distributions that exceed certain thresholds. The IRS requires the issuance of a 1099-K for account holders who receive more than $20,000 during the tax year, or who have more than 200 receipt transactions on an exchange.


Manes law pull quoteIf cryptocurrency is the Wild West of residency tax law, cryptolending is the Dodge City


Again, this isn’t the end of the world. However, exchanges that operate in California are required to file 1099s with the FTB, if the recipient is a California resident at any time during the tax year. Unfortunately, most California exchanges, like any other California business, follow the rule of “when in doubt, file something.” This happens when the account information includes a California address. The classic case involves a California vacation home, which the crypto investor uses for convenience sake to receive information from the exchange. But even more typical for crypto investors, who tend to be young and mobile, is the use of a relative’s address (often a parent’s or a girlfriend’s or boyfriend’s). As far as the exchange is concerned, if you give it a California address, you live there. The FTB follows suit. When the FTB receives a copy of the 1099 from the exchange with a California address but the recipient doesn’t file a California tax return (because nonresidents don’t typically have to), the result is automatic: the crypto investor will get audited (or to be more precise, a 4600 Notice will be sent, which is a pre-audit form to determine if a full audit is warranted).

This happened to more than a few crypto investors in 2018, when Coinbase started sending 1099-Ks to tax authorities for the 2017 tax year, to the chagrin of many of its account holders, who apparently didn’t expect to have California involved in their tax future. See, Coinbase Sends American Clients IRS Tax Form 1099-K.

Further, there are other ways the FTB can obtain a 1099 without an exchange ever sending one. California participates in the combined federal and state filing system. Companies that make use of the system only file 1099s with the IRS, but they are shared with California. A 1099 that makes its way to Sacramento with a crypto investor’s name on it, may cause an examiner to audit, especially if other facts suggest residency status.

More directly, nonresidents who are not casual investors in cryptocurrency, but who essentially make their living by buying and selling crypto, and who use a California-based exchange, risk running afoul of regulations involving the situs of intangible property. Specifically, 18 CCR § 17952(b) states:

“[I]f a nonresident buys or sells stock, bonds, and other such property in California, or places orders with brokers in California to buy or sell such property, so regularly, systematically and continuously as to constitute doing business in this State, the profit or gain derived from such activity is taxable as income from a business carried on here, irrespective of the situs of the property for taxation.”

Cryptocurrency is “other such property.” As a practical matter, most crypto traders are exempt from doing business in California if all they are doing is trading on their own account, regardless of the magnitude of the gain. However, the rules for doing business in California are notoriously complex. The simple action of managing the account of a friend or relative for a small commission can trigger an audit.

The fact is, crypto investors who use a California-based exchange are at greater risk of being audited due to common mistakes and oversights in the information on their 1099s, how the exchange processes their information, and the volume of their transactions.

Security Tokens

Initial coin offerings provide another flashpoint for the taxation of cryptocurrency by California. ICOs have come under increased scrutiny by the SEC and IRS, and the underlying theory of this oversight is that ICOs can constitute regulated securities. This occurs when the startup issues “security tokens” (as opposed to utility tokens); that is, a digital representation of a bundle of rights in an asset distributed to participants with the expectation of profit in exchange for funding a project. The project is typically the new cryptocurrency, though it may be a related blockchain application. Most ICOs involve security tokens. It’s the primary way developers/promoters fund new projects. Security tokens are regulated like other securities – stocks, derivatives, corporate bonds.

That’s good and bad.

The good part is California has traditionally followed the rule that sales of intangible property do not have a situs in California unless the owner is a California resident. The classic case is the sale of stock. If the owner is a nonresident, generally, gain from the sale of stock in a California-based business does not recognize gain subject to California income taxes. The legal principle is pompously stated as mobile sequuntur personam – “movables follow the person.” Securities are movables; therefore, so are security tokens. Nonresidents are safe under the traditional rule.


Manes law pull quoteDepending on what those investments are, and whether they have situs in California, this schema may create a situs of Libra in California under the new regulations


The bad part is, just within the last two years, the FTB has adopted regulations that purport to overturn this settle law. The FTB claims authority to tax the sale of intangible property owned by nonresidents in certain situations where the underlying assets or use are situated in California. Specifically, 18 CCR § 25136-2(d)(1)(A)1 asserts that if a business interest (such as stock) is owned by a nonresident, but the assets of the company are in California, then, after applying various rules, California may tax the gain on the sale of the interest. The regulation defenestrates mobile sequuntur personam. And it does so not only for stocks and other business interests, but any intangible property. Security tokens are not only intangible assets, but securities, just like stock. It is unclear, however, just when this regulation applies. Specifically, the regulation’s terminology (“assignment” of income to California as opposed to allocation of income) suggests that the sourcing would only apply when businesses are the owners and sellers of the interest, not when individuals are. See, Revisions to “Doing Business in California” Regulation Proposed, for a fuller discussion of this regulation and its potential impact on nonresidents.

Libra and Other Stablecoin

Note that these new regulations can be particularly problematic to Libra and other stablecoin (assuming Libra will even be a stablecoin – it’s impossible to tell at this point). In order to mitigate the volatility of crypto which makes it inefficient, if not perilous, for commercial transactions, stablecoins such as JPM Coin, Tether and USDC purport to tie their value to assets or currency outside the digital universe. The concept is, a less volatile crypto would be more useful as commercial tender and hence more likely to be adopted by the general public, since payees would be able to accept it without risking profit margins ruined when crypto value drops unpredictably.

But tying a virtual currency to a real-world asset raises the situs problem. In the case of Tether and most other stablecoins, it doesn’t matter since the purported anchor is US currency, which has no situs. But Libra apparently plans to peg its value not only onto “low-volatility assets, including bank deposits and government securities,” but investments in a reserve determined by Libra’s executive committee. Depending on what those investments are, and whether they have situs in California, this schema may create a situs of Libra in California under the new regulations.

Crypto Loans

If cryptocurrency is the Wild West of residency tax law, cryptolending is the Dodge City. Nobody is quite sure how the IRS will eventually end up taxing crypto loans. Cryptolending takes a number of forms. For sourcing purposes, I’ll focus on just one: the use of cryptocurrency as security for a cash loan.

Ironically, the use of Bitcoin and other cryptocurrency as security for cash loans falls squarely into a little-used exception to California’s situs rules governing intangible property. Specifically, while California has traditionally excluded securities from having a situs in California based on the mobile sequuntur personam principle, one exception always existed, is often mentioned, but rarely if ever applies. Namely, if a nonresident pledges an intangible asset, such as stock, as security for the payment of indebtedness, taxes, etc., incurred in connection with a business in California, then a California situs is established for the pledged stock or other intangible interest. 18 CCR § 17952(c).

In twenty-five years of practice, I’ve never seen the FTB assert this regulation against a nonresident taxpayer. There is no case law interpreting it. It isn’t even clear what the language means by “in California” or “in connection with a business in California”. The interpretation could be broad or narrow. But the rise of cryptolending may change that. As already discussed, cryptocurrency, as an intangible asset, has no situs in California on its own. Its situs is with the owner. And if the owner is a nonresident, gain from the sale or conversion of the intangible asset isn’t taxable by California (leaving aside the new problematic regulations).

But if the nonresident takes out a loan from a cryptolender located in California, pledging his Bitcoin or other cryptocurrency as security, and if the nonresident then uses the loan proceeds to pay debts or expenses associated with a California business, the cryptocurrency would appear to have acquired a California situs. Any tax incidents from the crypto would then be subject to California income taxes. Typically, the nonresident couldn’t sell the encumbered asset. But if the crypto rose precipitously in value, he would arrange with the lender to do exactly that – sell the crypto, pay off the loan, and keep the net. But under these conditions, the net would apparently be taxable by California.

Be Smart

The giddy days when early adopters of crypto wondered if they would ever have to pay income taxes again are long over. Crypto has been thoroughly incorporated into our income tax system as intangible property, similar to a security. That’s good and bad for California residency planning. Intangible property in the hands of nonresidents can often escape California income taxes. But California sourcing rules grow more complex every year, and there are traps for the unwary.



Manes Law is the premier law firm focusing exclusively on comprehensive, start-to-finish California residency tax planning. With over 25 years of experience, we assist a clientele of successful innovators and investors, including founders exiting startups through IPOs or M&As, professional athletes and actors, businesses moving out of state, crypto-asset traders and investors, and global citizens who are able to live, work, and retire wherever they want. Learn more about our services at our website: www.calresidencytaxattorney.com.


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