TrumpWatch 2017: Proposing a Proposal

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Posted by David Roer, CPA

On revisiting a TrumpWatch article I wrote back in January, I was struck by the opening tagline:

“There’s been an abundance of 2016 headlines you’ve no doubt heard on loop this year and are probably sick of listening to – Brexit! Zika! ISIS! The election! Star Wars! One headline that we at REM Cycle can’t get enough of, however, is the Trump Tax proposal.”

Almost a full year later, sadly the same holds true for 2017, except substitute the headlines with: Equifax! Hurricanes! North Korea! The White House! and (still) Star Wars! Sad.

On September 27, President Trump and “The Big Six” (a name given for a tax crew consisting of Gary Cohen, Steven Mnuchin, Mitch McConnell, Orrin Hatch, Paul Ryan, and Kevin Brady, and which sounds like it could be the title for a Quentin Tarantino film) detailed the skeleton of what a Trump Tax Reform could look like.

While the nine-page plan is just that—a plan—many believe that the window of opportunity for getting a bill passed in 2017 seems unlikely: with only 28 working days remaining on the legislative calendar, chances for a 2017 tax reform are increasingly slim.

With that being said, as the October 15 tax extension deadline has come and gone, we at the REM Cycle look to the future.

We’ll focus on individual tax changes within the proposed nine-page plan.

Let’s begin with tax rates. The proposal indicates a three-tax bracket system: 12%, 25%, and 35% (the current top rate is 39.6%). Trump did leave wiggle room, however, for a fourth bracket to be enacted if the tax-writing committees (maybe they’ll get a Hollywood-esque nickname like “The Big Six” too?) grant it to be so: to quote the plan: “an additional top rate may apply to the highest-income taxpayers to ensure that the reformed tax code is at least as progressive as the existing tax code and does not shift the tax burden from high-income to lower-and middle-income taxpayers.”

Another important detail left out of the plan regarding the three tiers is the income ranges for the three (or potentially four) brackets. This leaves a lot in the air as to determining whom these bracket changes may impact the most.

In the context of tax rates, the plan also indicates a full repeal of the Alternative Minimum Tax (AMT, a 28% minimum tax that, simply put, ‘traps’ those individuals with certain high deductions by the disallowance of them). The plan also eliminates most itemized deductions except for charitable donations and mortgage interest paid, rendering the AMT moot for many taxpayers who are subject.

On the topic of itemized deductions, the items that are getting most discussed are the state taxes paid and real estate tax deduction. These two items are heavily utilized (unless you’re in the AMT) by taxpayers, especially those living in high state-income tax states like New York and California. I envision this to be a heavily disputed topic as any tax reform bill begins to work its way through Congress, especially since President Trump was angered to learn that this would increase middle-income taxpayer burden.

With an elimination of significant itemized deductions, the plan attempted to counter that ‘hit’ by increasing the standard deduction by nearly doubling it: $12,000 for individuals (an increase from $6,350) and $24,000 for married couples (an increase from $12,700).

The plan also mentions the child tax credit, which would make the first $1,000 of the child tax credit refundable as well as increase the income levels at which the credit would begin to phase-out for individuals.

In a section titled “WORK, EDUCATION AND RETIREMENT,” the plan shuns specifics, merely explaining that “the framework retains tax benefits that encourage work, higher education and retirement security ... Tax reform will aim to maintain or raise retirement plan participation of workers and the resources available for retirement.”

Lastly, the plan proposed the full elimination of the generation skipping tax and the estate tax, a tax which applies to Estates in excess of $5.49 million or more as of 2017. This will only benefit the wealthiest Americans (in the top 0.1%).

While the release of the nine-page proposed plan wasn’t too much of a shock (most of the above had been discussed in the infancy of Trump’s presidency earlier this year), I envision the details, once emerged, will begin a more serious discussion of (a) how to begin working on 2018 tax planning and (b) coming up with a catchier nickname than The Big Six.

Stay tuned to the REM Cycle for more TrumpWatch updates.

Tax procrastination: the most dangerous game

 
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April 15. This is the deadline set by the IRS for filing your personal tax return.  (It’s usually April 15; this year, it happened to be pushed back to April 18, as a result of the 15th falling on a Saturday and then the observance of Emancipation Day in Washington, D.C. the following Monday, but that is a different story).  As most of us know, the IRS allows taxpayers to file an extension granting six additional months (usually to October 15… Because this date falls on a Sunday this year, the extension deadline is October 16).  But, and this is a big but, the extension grants only additional time to file, not additional time to pay. This point should be made abundantly clear to taxpayers, because no one wants to be hit with late payment penalties.  And most of us seem to completely disregard the first five months and push off getting our tax information to our preparers until we glance up at the calendar and realize we are almost out of time.

This is a dangerous game to play, for multiple reasons.

Most preparers have a full docket of work from the end of summer right through the extended due date.  This is due in part to procrastination of taxpayers and preparers, as well as a schedule in which multiple deadlines occur in rapid succession. The deadline for pass-through entities is September 15 (just one month prior to the deadline for personal returns), and trust returns are due September 30 (just two weeks prior).  When some of the information required isn’t available, this can create a butterfly effect.

Not all of the required information may be immediately available, but this is not a good reason to neglect sending over the readily-available information to your preparer.

Add the overwhelming amount of work to the complexity of tax law and expertise required to properly prepare a tax return, and one can see how there is an increased likelihood of errors, omissions, and/or missed opportunities.  This is a serious no-no for tax professionals.

The more time a preparer has to consider options and the presentation of facts, the more value can be added.  Additionally, there is greater opportunity to consider actions that can be taken in the subsequent year (which we are usually in the middle of when we are looking at last year’s information) or future years that can be favorable to the taxpayer.  Timing matters.

For estimated taxpayers, timing is of increased importance.  If your tax liability has changed and the prior year’s tax has been underpaid or overpaid, waiting until the deadline could leave you having paid three quarters of estimated taxes at the incorrect amounts.  This can result in penalties for underpayment of estimated tax or, even worse, giving excess interest-free loans to the government (oh, the humanity!).

None of the above addresses a more intangible issue, which is finality; crossing something off a list.  Getting your return filed offers just such a feeling, and I urge you to experience it.  Your preparer will thank you, too.

Bottom line? Don’t treat the filing of an extension as permission to procrastinate for six months, but rather just a short window to have everything lined up to comfortably make the extended due date in spite of any outstanding information. 

6 ways the IRS and NYS are collecting back taxes

Guest post by Karen J. Tenenbaum, Esq., LLM, CPA, Tax Attorney at Tenenbaum Law, P.C.

 
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Taxpayers who owe money to the IRS or New York State face an expanding arsenal of tools the government is using to collect back taxes. The federal and state governments are using similar tactics, but each with their own twist. Due to the success of some of these methods, taxpayers and tax professionals can expect to see them more often. Here are a few of the top collection tactics.

1) Private debt collectors                                                                   

Both the IRS and New York State have recently started using outside collection agencies to collect delinquent taxes. The IRS uses private debt collectors for tax liabilities of less than $50,000. Private debt collectors are only allowed to locate taxpayers, ask taxpayers if they can pay in full, or set up a five-year Installment Agreement if they cannot pay in full. Despite criticism of the program and collectors’ tactics, they are permitted to contact taxpayers by phone, unlike government agencies. The private agencies cannot collect any actual payments; those are made directly to the IRS. The agencies receive 25% of the funds collected. Currently, the IRS is using four agencies: CDE Group, Conserve, Performant, and Pioneer. Note that taxpayers who have accounts in Offer in Compromise, Installment Agreement, Collection Due Process, and Innocent Spouse Relief status are exempt.

New York State is currently contracted with one outside collection agency: Performant Recovery Inc. As with the IRS, taxpayers will continue to make payments directly to the state, not the collection agency.

2) IRS passport revocation

Since the end of 2015, a taxpayer can lose his/her passport if he/she owes the IRS $50,000 or more including penalties and interest. The Secretary of State is permitted to deny the issuance or renewal of a passport or revoke the passport of that individual. The IRS must give notice to the individual involved at the same time it gives notice to the Secretary of State that the taxpayer is “seriously delinquent.”

If the individual is outside the United States, the Secretary of State may also limit a previously issued passport only for return travel to the United States or issue a limited passport that only permits return travel to the United States.

3) NYS driver’s license suspensions

The State can suspend an NYS Driver’s license if the driver owes $10,000 or more in tax, penalty, and interest and there is no collection resolution in place (such as an Installment Payment Agreement, Income Execution, or Offer-in-Compromise). New York State has collected over $715 million in back taxes to date from this program.

An added twist to this tactic is the Multi-State Driver License Compact. Many taxpayers think that if their New York State driver license is suspended, they can simply get one from New Jersey or Florida. However, 45 states and the District of Columbia have entered into the Compact, which is an interstate information exchange. If the taxpayer’s license is suspended in any member state, that suspension will hold in all other member states. The only states not in the program are Georgia, Maine, Michigan, Tennessee, and Wisconsin.

4) Liens

A New York State Tax Warrant is a legal judgment and notice for priority. It is a perfected lien and enables New York State to take certain collection action against a taxpayer’s real and personal assets. A Tax Warrant also ensures that New York will get paid ahead of subsequent creditors. It is a public document, and can be found on the Department of State’s website. It should be noted that there is now a single 20-year statute of limitations on collections, which begins on the first day that a tax warrant could have been filed.

The IRS uses a federal tax lien to collect back taxes. If a tax isn’t paid after a formal request, the Internal Revenue Code grants the IRS an automatic lien, sometimes referred to as a “silent lien” against all of a taxpayer’s property and rights to property. It even attaches to property acquired after the assessment itself.

The IRS files a Notice of Federal Tax Lien in order to establish collection priority. The IRS must collect a tax liability within 10 years from the date of assessment.

5) Levies on wages

In New York, an income execution is a type of levy that is issued against a taxpayer’s gross wages. It is limited to 10% of gross earnings and it remains in effect until the underlying tax liability is satisfied. The state is not required to issue a tax warrant prior to entering into an income execution.

At the federal level, the IRS can also levy on a taxpayer’s wages. Federal wage garnishment is quite harsh, since the IRS takes almost everything. The employer is provided an exemption table to calculate the amount of wages exempt from the levy based on the number of exemptions claimed by the taxpayer.

6) Other levies

New York can collect on a taxpayer’s outstanding liabilities with various types of levies, including: bank levies that last for a 90-day period; levies on third parties, such as customers or tenants; refunds and offsets; and seizure and sale at tax auction. 

The IRS can also levy on property, including bank accounts, provided it meets notice requirements and gives the taxpayer an opportunity to file a request for a collection due process hearing.

In order to avoid or stop these collection actions, both the IRS and New York State offer ways for taxpayers to address their debts. An IRS Installment Agreement or NYS Installment Payment Agreement allows taxpayers who are financially unable to pay the full amount of the liability at once to pay in monthly installments over time. Taxpayers who cannot afford to pay their tax bill may qualify for an Offer in Compromise, wherein the government agrees to accept less than the full amount due of tax, interest, and penalties. Both options have stringent requirements.

If you are facing an audit or collection matter, consult a qualified tax professional.


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Karen Tenenbaum, Esq., LL.M. (Taxation), CPA is founder and partner of Tenenbaum Law, P.C., a tax law firm in Melville, New York, which has focused its practice on the resolution of IRS and New York State tax controversies for over 20 years.

Special report: 4 things you can do to protect your data

Posted by Amy Frushour Kelly, Communications Manager

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By now, you’re almost certainly aware of the data breach at Equifax, in which the sensitive personal information of approximately 143 million American consumers was compromised. This included names, social security numbers, home and work addresses, and in some cases, credit card information.

It’s essentially impossible to know whether your personal information was breached. The website Equifax provided as a tool for consumers to learn if their data was breached has been tested, and found to be unreliable. We tested this by inputting “Cookie Monster” with the last six digits of the social as 123456. Good news for “Sesame Street” fans – Cookie Monster’s data has not been breached. Elmo, however, wasn’t so lucky. Bottom line: the tool Equifax has provided is useless. Additionally, the tool prompts the user to provide their last name and the last six digits of their Social Security number, which is rather sensitive information, without advising the user to do so on a secure computer and an encrypted network connection to limit the possibility of further compromising their data.

Raich Ende Malter’s Director of IT, Louis Moran, offers this advice: “Even if you don’t know who Equifax is, it is likely that they have, or have access to, your information. The safest course of action is to act as though your data has been compromised. If you already have an identity theft protection service, start paying attention to it. If you don’t, consider getting one.” More on that below.

We strongly encourage you to take action as soon as possible. The steps below have been reported by multiple sources as a best course of action to take.

  1. Consider using an identity theft protection service. Here’s an article we found useful comparing some of the top identity and credit protection services. The best services will:
    1. Monitor changes to your credit reports at all three major credit-reporting agencies (Experian, Equifax, and TransUnion)
    2. Monitor the use of your personally identifying information online
    3. Use more than one method to alert you to suspicious activity (e.g., let you know by both email and text message) and have 24-hour service lines available
    4. Do everything they legally can to reclaim your stolen identity
  2. Not purchasing a service? Consider placing a credit freeze on your report. It won’t affect your credit score, but it will make it very difficult for anyone to open new accounts in your name. Fees to place a credit freeze are generally in the $5 to $10 range. The freeze will remain in place until you ask the credit-reporting agency to temporarily lift it or remove it completely. The fees to remove a freeze vary from state to state.
  3. Consider placing a fraud alert on your information. This is an option if you’ve decided against a credit freeze. Different types of fraud alert are available. A fraud alert is free, and can be effective in preventing people from opening accounts in your name. However, it does not prevent illegal use of existing accounts.
  4. File your taxes early. Tax-related identity theft is a very real and serious issue. Basically, it occurs when someone uses a stolen Social Security number to file a tax return claiming a refund that person is not entitled to. File your taxes as soon as you have all your necessary tax information, so someone else doesn’t file first.

Moran concludes, “If this is similar to the Target hack a few years ago the bad guys won’t be using your information for six to nine months. I suggest you use that time to batten down your hatches in regard to your identities.”

If you suspect your identity has been stolen, the Federal Trade Commission’s IdentityTheft.gov site provides a helpful guideline for your best course of action.

Further reading

W-8BEN: Keep more of the pie for yourself

 
 

When it comes to getting their piece of the pie, the U.S. Government has done everything within its power to make the world so small that there’s nowhere for a non-compliant taxpayer to hide. Because U.S. taxation is based on worldwide income, all amounts earned globally are subject to U.S. tax and reporting. Even if you’re not a U.S. citizen or a resident, you’re still subject to U.S. tax on any amount earned from U.S. sources. However, the U.S. identified two major issues within its worldwide system:

  • Foreigners weren’t reporting and paying taxes on U.S. source income
  • U.S. taxpayers weren’t reporting their worldwide income and income-producing assets

The IRS responded by adding two new chapters to the Internal Revenue Code for new special reporting related to foreign assets and income.

CHAPTER 3: WITHHOLDING OF TAX ON NON-RESIDENT ALIENS AND FOREIGN CORPORATIONS

Let’s put that title into layman’s terms: a U.S. person (“person” in the tax code sense) must withhold tax on income earned by foreigners. The types of income covered by Chapter 3 are commonly referred to as “FDAP” income (fixed, determinable, annual, and periodical). “FDAP” income usually consists of dividends, interest, rents, royalties, etc. Any U.S. person who’s paying out FDAP income to a non-U.S. person generally has the responsibility to withhold 30% of the income and remit it to the government.

This chapter was created to compel non-U.S. taxpayers to report income earned from U.S. sources. The tax due is withheld by an agent (the payer) and remitted to the government in lieu of the foreign person filing a tax return (sometimes). The withholding agent uses Forms 1042 and 1042-S to report the withholding.

CHAPTER 4: TAXES TO ENFORCE REPORTING ON CERTAIN FOREIGN ACCOUNTS

To folks “in the know", parts of this chapter are referred to as “FATCA” reporting (Foreign Account Tax Compliance Act) or sometimes erroneously as “FACTA”. This chapter is directly responsible for both the foreign financial asset reporting on Form 8938 and all of the associated headaches. However, there’s another key component to the chapter: the manner in which foreign institutions exchange information with the U.S. government about U.S. persons. More often institutions are entering agreements with the U.S. to disclose information about the financial holdings of their customers… bad news for the willfully non-compliant.

This chapter is designed to compel U.S. taxpayers to report their worldwide income through a system of compliance for non-U.S. institutions holding U.S. taxpayer assets. The chapter separates non-U.S. institutions into two distinct classes: “Foreign Financial Institutions (FFI)” and “Nonfinancial Foreign Entities (NFFE).” Each includes different types of subclasses, but the general idea is that the withholding responsibilities are determined on whether the institution is a bank or something else.

So what? What about my piece of the pie?

The new reporting requirements mandate that participating withholding agents do the following:

  • Disclose pertinent information to the IRS about assets held within their institutions
  • Withhold money and remit it to the U.S., if applicable

As a result, more taxpayers are entering into offshore voluntary disclosure programs, and the IRS is collecting more U.S. tax. Which brings us to the BEN forms.

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What are BEN/BEN-E forms? Do they involve pie?

No. The pie was a metaphor. Sorry to get your hopes up.

The W-8BEN series (Certificate of Foreign Status of Beneficial Owner for United States Withholding and Reporting) is a group of forms created to document the status of a person that would potentially be subject to U.S. withholding tax by a withholding agent and remember: 30% by default. When a foreign person is the ultimate beneficiary of U.S.-source income, they are generally subject to withholding. The BEN series is a way of tracking that withholding requirement for withholding agents. W-8BEN forms are filed for individuals, and W-8BEN-E forms are filed for entities. There are a number of other forms in the series, but we’ll focus on these two. Although complex, the BEN forms serve three distinct functions:

  • Establish that you are not a U.S. person (for Chapter 4 purposes)
  • Claim that you are the beneficial owner of the income subject to the withholding
  • Claim a reduced rate of withholding or exemption from withholding based on treaty benefits

The third function is key, because it can allow a non-U.S. person to reduce or even eliminate the amount of withholding required by the withholding agent. This keeps your client’s money in their pockets and out of the hands of the government; more pie on their plate.

I just received one of these forms. Now what do I do?

The forms (especially the W-8BEN-E) can be daunting, even to an experienced professional. But they’re worth the time and effort it takes to fill them out accurately. They’re a valuable means to reduce potential withholding on income. Ignoring these forms can cause the institution to withhold at the max 30% rate. Not good. When faced with one of these forms, take a deep breath and contact your trusted accounting professional for help. You’ll be glad you did.

Is it time for you to make the mark-to-market election?

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Investors and traders are treated differently by the IRS

If the markets reach a tipping point and crash, how will you be affected? The tax implications will depend on whether you're an investor or a trader who has made a mark-to-market election under Section 475 of the Internal Revenue Code. Traders who seek treatment under Section 475 can gain advantages in a down market, and here's why.

The Dow Industrial Average is on an unprecedented rally, exceeding 22,000 and continuing for more than eight years. But the simple truth is that bull market streaks always come to an end. The extended low-interest rate policy and quantitative easing program set by the Fed have assisted the climb of the market indices, but authorities are now debating how to end these programs and normalize economic policy. Looking forward, both investors and traders need to employ the best investment and tax strategies to maximize gains and minimize the damage from the impending bear market.

Whether you’re defined as an investor or a trader by the IRS, it’s critical to use advanced tax planning and good record-keeping.

Are you an investor or a trader?

Investors are defined as individuals who seek to profit from capital appreciation, dividends, and interest. When they hold assets longer than a year and a day are rewarded with preferential tax rates (generally 15%-23.6%). Otherwise, the gain is taxed at the ordinary rate (as high as 39.6%). Excess losses can be used against ordinary income from other business activities, limited to only $3,000 per year; the remainder is carried forward. Investment expenses incurred, such as trading programs, software, and conferences are limited to an amount that exceeds 2% of adjusted gross income and are not deductible at all for alternative minimum tax purposes. In a volatile or bear market, managing losses can be tricky for the investor. Under Sec. 1901, losses are further limited: the investor’s repurchase of a security that would otherwise be reported as a loss within 30 days of sale (a “wash sale”) is disallowed and added to the basis of the security, which will only be allowed upon ultimate disposition of said security.

Trader status is less clearly defined, but court decisions offer some guidance. Traders are individuals who seek to profit from daily market movements; their activity must be substantial; and it must occur with continuity and regularity. The trader treats the buying and selling of securities as if carrying on a business activity.

Here’s where traders can tip the scales in their favor: individuals who qualify as traders may make a Sec. 475 mark-to-market election. The timing is important to understand: the election must be filed by April 15 with the preceding year’s tax return or extension (e.g., to be effective for 2017, a statement must have been filed with your 2016 tax return or extension by April 15, 2017). Relief is technically available for late elections, but taxpayers are not frequently successful in receiving that relief. Form 3115 should be filed with the 2017 tax return to change accounting methods.

Advantages of the mark-to-market election

Taxpayers who have made the mark-to-market election benefit in several ways:

  • Losses are unlimited (as opposed to the $3,000 limit)
  • Investment expenses are 100% deductible
  • No self-employment tax
  • Wash sale rules don’t apply

Keep in mind, though, that traders report all gains and losses as ordinary income or loss, so there is the potential for an increase in rate on those gains from the preferential tax rates previously mentioned.

No self-employment tax              

There is no IRC section or regulation dealing specifically with self-employment tax on traders, but case law findings now support the position that traders are not subject. This is a tax issue that has shifted over time. As an example, the $8.1 million first prize for the Main Event World Series of Poker that was captured by a New Jersey accountant was subject to both income and self-employment (Social Security and Medicare) taxes, which added up to a staggering 47.11% tax bite. The IRS reasoned that there was no distinction between a gambler or active trader who devotes his full-time on the exchanges for his livelihood. Trading should be regarded as a trade or business and subject to self-employment taxes. However, the IRS more recently advised that individuals who qualified for trader status “occupy an unusual position under tax law because they engage in a trade or business [that] produces capital gains and losses.” In 1999, an IRS letter stated that “self-employment tax does not apply since the sale of a capital asset is involved and is only ordinary because of the mark-to-market election.”

Bottom line

If you engage in short-term trading and qualify for trader status, you can take advantage of some significant tax treatments. Don’t forget traders can have it both ways and take advantage of the investor’s preferential long-term capital gains rates on securities in held-for-investment accounts, but proper records must be kept. A trader who seeks this benefit must separate the respective brokerage activities into different accounts. Contemporaneous records should document how the trader intends to treat each security at the time of purchase.

The analysis and interpretation of IRS rulings and court decisions is critical in helping taxpayers decide if their activities will qualify for trader status. Before making the Sec. 475 election, talk to a CPA.

Further reading

Blockchain 101

Thousands of years ago, ancient Mesopotamians first developed accounting practices for the purpose of keeping a written record of money and barter transactions. In the intervening millennia, advances in technology and theory has allowed accounting to evolve into an art and a science. The most recent “upgrade” has enabled a revolutionary overhaul of accounting as we know it.

In 2008, an unknown person (or persons) using the pseudonym Satoshi Nakamoto created the first digital currency, Bitcoin. Nakamoto’s groundbreaking whitepaper Bitcoin: A Peer-to-Peer Electronic Cash System paved the way for the establishment of a multi-billion dollar[i] global industry via a distributed database known as a blockchain.

A blockchain is a decentralized public ledger system that stores digital information chronologically in the form of “blocks.” These blocks are inherently linked (“chained”) to one another, and each block plays a role in facilitating anonymous and secure transactions between users, while providing monetary rewards to those who help maintain the public ledger. This chain of blocks contains a record of every single transaction ever in the history of a given cryptocurrency (“coin”). Cryptocurrency coins are virtual assets created by the process of “mining,” which is essentially the process of a computer algorithm solving a complex mathematical equation to validate a single block of the blockchain (think of a batch of transactions), and subsequently broadcasting this record to all other computers connected to this global network (each computer being a “node”). This process creates a single distributed public ledger across thousands of nodes around the globe. If a computer is able to solve the complex equation (via “cryptography”) and prove to the network that its equation validates a block (“proof of work”), the computer’s operator is compensated with a combination of a per-block reward of newly minted coins--“block reward”--and a small percentage of the transactions contained within the block--the “mining fee.” The newly-minted miner rewards tend to decrease over time on a schedule as the monetary value of the coin tends to increase, giving cryptocurrencies an economically deflationary appeal. The monetary value of a coin stems from the active trading between users on public coin exchanges. Technically, cryptocurrency mining creates inflation; however, using Bitcoin as an example, the inflation is controlled. For example, the mining reward for successfully “solving” the first ever block started at 50 Bitcoins, and at every 210,000 blocks (approximately every four years) the mining reward is cut by 50%, up to a total maximum supply around 21,000,000 Bitcoin. As of July 31, 2017, we are currently in block #478446, and the mining reward today is 12.5 Bitcoin (equivalent to approximately $35,000).

The revolutionary aspect of blockchain technology rests in the triple entry accounting concept. Triple entry accounting tweaks the double entry by including a cryptographic seal by a third entry. Today, a seller and a buyer maintain two separate sets of accounting records. A seller books a debit to account for cash received, while a buyer books a credit for cash spent in the same transaction. This is where the blockchain comes in. Rather than these entries occurring separately in independent sets of books, they occur in the form of a transfer between “wallet” addresses within the same distributed public ledger. This process creates an interlocking system of enduring accounting records. Because the entries are distributed and cryptographically sealed, falsifying them in a credible way or destroying them to conceal activity is practically impossible. How it is impossible, well… keep reading!

 
 

Transactions (i.e., transfers of coins from one party to the next) are recorded in blocks on the blockchain. Depending on the coin in question, the size of a block is usually fixed to either the total number of kilobytes or megabytes of transaction data contained within (which is merely a bunch of alpha-numeric characters), or simply a predetermined length of time containing all transactions falling within that time span. Today, there are hundreds of cryptocurrency coins, each with their own unique blockchain and their own unique characteristics as defined within the open-sourced codes of their respective mutually agreed upon distributed algorithms. The total number of cryptocurrencies increases daily.

To visualize a blockchain, imagine a hierarchal grouping of folders on a hard drive. Each block, or sub-folder, within the root “Blockchain data” folder essentially contains a batch of time-stamped transactions representing every transaction of a given cryptocoin over a small span of time, from numerous anonymous parties to the next anonymous parties. All of this data is publicly available and searchable either by block number, transaction ID, or wallet address. Using the example above, the Block002 sub-folder contains a reference to Block001’s encrypted validation code. The encrypted code for Block001 must be incorporated into the encryption of the Block002 validation code by the miner validating the block, along with the encryption of every transaction within Block002, for the block to be considered validated (thus creating a running chain of encryption and validation). This chronological validation process computed by the miners proves not only the validity of the Block002 and all its contents, but also every single block preceding it. Throughout the validation process, miners stamp on their digital signatures documenting their witness and confirmation of the activity on Blockchain. It’s important to note that the miner validation for each block is competitive around the globe. This is due to the high monetary reward for successfully solving the equation. This intense competition renders it highly unlikely for the same individual to validate the two or more times in a row.

This is how the blocks become a chain. Because the system is managed by a peer-to-peer network collectively adhering to a validation protocol, the system is inherently resistant to modification of the data. Once recorded, the data in any given block cannot be altered retroactively without the alteration of all subsequent blocks and a collusion of the network majority. Blockchains can be used to facilitate any financial transaction between multiple parties—not just cryptocurrencies, but transactions in real estate, ordinary property, and financial securities.

What makes a blockchain truly valuable, especially from an accounting perspective, is that each block has a unique identifier. In any given transaction, the unique identification of each party involved is auditable. This unique identification system creates a transparent and verifiable path documenting the historical transfer of value from one individual wallet to the next. Similar to the process of an auditor confirming a cash balance with the bank directly, an accountant could verify a transaction or the balance of a wallet across hundreds of independent, yet identical ledgers.

 

Curious to know more? Click here for a quick primer on blockchain terminology.

 

Due to the blockchain concept’s relative novelty, authoritative regulatory bodies have yet to create blockchain policies specific to the industries they operate in. The IRS’s position on virtual currency (cryptocurrency) in their IRB 2014-16 in April 2014 maintains that for federal tax purposes, virtual currency is treated as property. In June 2017, the Chamber of Digital Commerce petitioned FASB to determine the appropriate recognition, measurement, presentation, and disclosure for digital currencies. This petition considered four different accounting topic methods under which digital currencies could fall (ASC section’s 305, 330, 350 and 825), but no guidance to define exactly what a digital currency is. In July of this year, Accounting Today discussed key foundations that need to be in place before fully adopting blockchain to meet business needs. Among them are standards to be set by the auditors who must rely on the system as audit evidence.

Ethereum is the second largest cryptocoin by market capitalization, but it’s much more than a digital currency. Ethereum helped organize the world’s largest open-source blockchain initiative, the Enterprise Ethereum Alliance. Its purpose is to build a clear roadmap for businesses to learn and leverage the technology and to provide governance for enterprise accountability, features, and licensing models. One of the systems they have helped implement is the smart contract.

A smart contract follows the same principles as a cryptocurrency transaction, but you can layer condition-based code to facilitate, verify, or enforce the negotiation or performance of a variety of financial and non-financial transactions. This effectively and efficiently eliminates a lot of the paperwork and middle-man responsibilities in the world today. Many Fortune 500 companies have already invested billions of dollars in this technology and are members of this organization (e.g., J.P. Morgan, Intel, UBS, Microsoft, ING) who recognize the impact this technology will have on their specific industries and the marketplace. Deloitte and PwC (and now Raich Ende Malter) have started ThinkLab groups in their practices and are working diligently in developing strategies to employ using blockchain.

What does all this mean for us as auditors and tax preparers? Stay tuned—we’ll explain in a future post.

Are you involved in cryptocurrencies? Thinking of getting involved? Contact your trusted advisor, or talk to us at REM.

Special thanks to The Geek Group of Grand Rapids, Michigan, for vetting.

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