A paycheck in crypto? There might be some headaches

Cryptocurrencies have been on an upswing after months of declines, giving some credence to those who say digital currencies are resilient and on the cusp of becoming more widely accepted.

While it's too difficult to predict anything when it comes to Bitcoin and other coins, more people are getting paid, or wanting to be paid, in cryptocurrencies, from professional athletes to tech employees and beyond. They cite the ease and transparency of payments in digital currencies, especially when employers and employees aren't based in the same country.

But there are some important considerations to keep in mind. Aside from the volatility, a misstep could result in not getting compensated correctly, or creating potential trouble with the Internal Revenue Service.

U.S. employers may be resistant to compensation in cryptocurrencies at the outset. It's a lot more work for them when withholding some of the income that's required to pay Social Security and Medicare taxes. If an employee is paid in digital coins, employers have to deal with additional accounting and the conversion of some of that income into U.S. dollars to pay those federal taxes.

Some may find that employers would prefer to classify them as contractors rather than employees so they can push the withholding burden onto workers, who would then be considered self-employed.

For contractors, it's imperative they request a 1099 form, which is what's used to report income from the companies they work for. They should ask for details listing when individual units of Bitcoin, or the likes, were received and the price for each. Doing so will help those receiving this form of compensation to calculate their tax liabilities accurately.

Sketch of Alexis Leondis

Note that non-employees are responsible for paying the self-employment tax (a 15.3% tax that goes toward Social Security and Medicare). Software such as cryptotrader.tax and bitcoin.tax can help with record-keeping.

Recipients owe ordinary income tax on whatever the fair market value of the coins is when they receive them. They'll also face capital gains taxes when they sell or swap the coins for other digital currencies. 

If it's within a year, they'll be subject to short-term capital gains tax rates (which are generally the same as ordinary income tax rates), or, if it's longer, then they'll face long-term capital gains tax rates (0%, 15% or 20%, depending on their tax bracket).

Since tax isn't automatically withheld by employers for contractors, those workers are usually advised to make estimated tax payments each quarter rather than face a big bill when they file their returns. With cryptocurrencies, it can be difficult to estimate what's owed, so self-employed workers should consider paying 100% (or 110%, if they earn more than $150,000) of what they paid the prior year. Doing so will help to avoid any underpayment penalties when they square up at the end of the tax year.

Some cryptocurrency devotees may be reluctant to sell any holdings to make those estimated payments and would rather face the underpayment penalty. That could be a red flag to the IRS to open up an audit.

It's wise to hash out with an employer ahead of time when the value of cryptocurrency compensation is being calculated. Is it when a work period ends? Or when payment is due?

Given the volatility of Bitcoin and others, a few days can make a big difference in what's paid out. It's also helpful to agree on how to compensate for things like paid vacation days, says Nicole Green, a principal at NGG Tax Group. Whatever it is, workers need to make sure it's clearly stated and not just at the discretion of the employer.

Those working for crypto-focused companies may be given compensation in the form of private tokens that aren't traded as easily as Bitcoin, Ethereum or Litecoin. Figuring out the fair market value of those tokens can be tricky when calculating tax owed, but token holders shouldn't use that as a free pass to ignore reporting requirements.

In addition, those coins may be granted as bonus compensation that vests, similar to stock options. But there's an important distinction. With stock options, the recipient has the ability to recognise some of the income sooner to pay less tax in the future. It's likely that the IRS wouldn't allow a private token-holder to make the same election, according to Matt Metras, an enrolled agent who works with about a dozen clients who are compensated in cryptocurrencies. 

The smartest approach for those interested in getting paid in digital currencies is usually a hybrid, with some compensation in cryptocurrencies and some in dollars. For those more bullish on the future of digital currencies, it's better to just invest in them outright than gamble with your paycheck.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement.