Paying Your Taxes in Bitcoin? Maybe Not So Fast

Headlines of FTX and BlockFi collapses and the recent arrest of FTX founder Sam Bankman-Fried on criminal charges have left many in the financial services industry wondering when – not if – regulations will be enacted for the cryptocurrency industry.

After peaking at nearly $67,000 last November, the price of the most popular cryptocurrency, bitcoin, began to plunge. By November 2022, it was worth roughly $16,000, or a quarter of the value from a year ago.[1] The estimated market capitalization for cryptocurrencies during the same period decreased from $2.7 trillion to $833 million.[2]

Clearly, as an investment, bitcoin’s significant fluctuations in value are not for the faint of heart. However, this instability has not stopped state governments from leveraging cryptocurrency’s functionality or pursuing the cryptocurrency industry as an economic driver. This issue brief discusses recent state actions that allow state residents to pay taxes with cryptocurrency as well as the reasons behind the emergence of state incentives for the overall industry.

States Are Moving to Accept Cryptocurrency for Tax Payments

This September, Colorado began to accept cryptocurrency for tax payments.[3] Specifically, taxpayers can now use a state portal to pay a variety of taxes with cryptocurrency, including individual income tax, business income tax, sales and use tax, withholding tax, severance tax and excise tax. An intermediary company, Paypal Cryptocurrencies Hub, instantly converts the cryptocurrencies to dollars so that the state does not expose itself to price fluctuations in the cryptocurrency market. This service costs taxpayers a fee at 1.83% of the payment amount plus $1 per transaction. Colorado Governor Jared Polis has also announced that this option will expand to include payments for driver’s and hunting licenses in the next phase.

Colorado became a frontrunner in this area by formally implementing the tax payment program this year, but it is not the only state that has considered similar approaches. In March, Gov. Ron DeSantis indicated that he believed Florida should allow businesses to pay taxes in cryptocurrencies and directed state agencies to investigate the possibility.[4] Utah also passed a bill that allows government agencies to collect tax payments in cryptocurrency starting in 2023.[5] Several other state legislatures — including Arizona, California, Hawaii, Illinois, New York, Oklahoma and Wyoming — introduced similar proposals but none of them advanced to become law.[6] In addition, about a half dozen other states established committees to research the feasibility of accepting cryptocurrency as tax payments and recommend policy options.

Generally, these proposals all require the state to contract a third-party cryptocurrency payment processing entity — similar to the Colorado law — that converts cryptocurrencies into dollars before depositing proceeds into the state’s accounts, thus avoiding expensive technical infrastructure-building and costly price fluctuations. 

Early State Efforts Had Mixed Results

Although advocacy efforts are now expanding across states, the earliest state and local government attempts to accept cryptocurrency tax payments actually took place a few years ago. In 2018, Ohio began accepting cryptocurrency as tax payments through a portal called OhioCrypto.com. It used a third-party payment processing service provider, BitPay, to convert cryptocurrencies into dollars before remitting proceeds to the state. The program only accepted bitcoin and allowed payments for 23 types of business taxes (though, notably, not personal income taxes).[7]

However, in 2019, the Ohio attorney general issued an opinion indicating that no state statute gave the treasurer authority to use OhioCrypto.com to collect state taxes. As such, the system could not be used without first being approved by the Board of Deposit, a state treasurer governing body. The opinion also found that the treasurer did not go through a required process of soliciting three bids from qualified payment processing service providers. [8]  As a result, the program was shut down within a year. Analysis showed that over this roughly one-year period, fewer than 10 companies paid taxes with cryptocurrency through the portal.[9]

At the local level, the Seminole County Tax Office in Florida began accepting cryptocurrency payments in 2018, also through BitPay. The program ended in a fiasco as the county tax collector was found to have used public funds to finance his own blockchain company. The now-former tax collector was eventually indicted by the Justice Department for a series of offenses that could potentially lead to a decade-long prison sentence. [10]

2022 Highlighted the Potential Challenges of Accepting Cryptocurrency Payments

Although accepting cryptocurrency as tax or public service payments gained momentum in 2022, this policy was not without opposition. Primarily, the recent plummet in its value may have dwindled taxpayers’ interests in using cryptocurrency as a payment method. In addition, although a third-party cryptocurrency payment processor arguably insulated states from value fluctuations, it also inserted an additional layer between the state revenue agency and taxpayers — thereby creating more administrative complexity.[11]

The lack of clear federal regulatory framework and guidance also made many skeptical as to whether state governments should be leading the way in accepting cryptocurrency tax payments. Some state leaders are concerned that policymakers may not fully understand the technology and the associated digital assets before making related decisions. Instead, they argue, it is the fear of missing out or falling behind other states in terms of competitiveness that has driven states to consider cryptocurrency-related measures.[12]

In addition, the low utilization of Ohio and Florida’s Seminole County pilot programs made many practitioners wonder whether accepting cryptocurrency is even generating fiscal benefits for state and local governments. Some also question why cryptocurrency is an acceptable form of tax payment while shares of stock, bonds or other tangible properties are not allowed.

Finally, it is not entirely clear whether paying state taxes in cryptocurrency is considered a realization event for federal income tax purposes. Because the IRS considers cryptocurrency as property, paying taxes with cryptocurrency is akin to selling a property and then using the proceeds to fulfill tax obligations. As a result, using cryptocurrency to pay taxes at the state or local level may trigger federal capital gains taxes.

Other State and Local Initiatives Reveal Broader Economic Motives

If accepting cryptocurrency tax payment does not generate significant tax revenue, adds complexity and faces an uncertain legal landscape, it is curious why so many states are adopting this option. One possible explanation is that these states would like to attract the cryptocurrency industry and its associated investments. On a broader scale, some of these efforts extend to blockchain businesses, the underlying technology that powers cryptocurrency. Many states believe these companies create jobs, attract skilled workers and have the power to transform state economies. As a result, some states have implemented cryptocurrency-favorable legislation or signaled that they are supportive of the industry.

State and local governments that are interested in attracting or developing the cryptocurrency industry have been pursuing a variety of approaches, including tax and non-tax incentives to encourage investment. Although media headlines still report different rankings as to which states are more crypto-friendly, a technology-savvy workforce, low electricity costs, flexible regulations and the approval of state officials are all generally seen as attractive to the industry. [13]

Whether or not the cryptocurrency industry can deliver on these economic promises is debatable. In August 2022, the city of Fort Worth launched a program to mine bitcoin, putting a mining machine in the city’s data center. It also touted itself as the first U.S. city to mine cryptocurrency.[14] But to date, the program has only netted $1,000 after electricity costs. However, the announcement of this program did generate more than 753 million media impressions, giving Forth Worth significant publicity as a business-friendly hub. The city’s mayor continues to emphasize that it is critical Fort Worth support innovation, and its acceptance of cryptocurrency as an economic driver is clearly perceived as such by many in the media and public.

States Are Offering Incentives to the Cryptocurrency Industry

Several states now offer tax incentives to attract data centers, including the ones used in mining cryptocurrency.[15] In addition, some states offer sales tax exemptions, either for electricity purchased for mining or for the sale of certain equipment and machinery (e.g., Kentucky,[16] Michigan, Ohio and Wyoming), while others offer property tax relief (Montana) and still others offer income tax credits in addition to sales tax exemption (Illinois). Several states — including Alabama, Arizona, Georgia, Illinois, Kentucky and Missouri — proposed tax breaks for the industry in 2022, but the legislation did not advance.[17]

The US Remains a Major Crypto Mining Center — For Now

After China outlawed cryptocurrency mining in May 2021, a substantial number of miners migrated to the U.S. In fact, industry statistics show that the U.S. accounts for about one-third of global bitcoin mining since the Chinese ban.[18] Many mining companies relocated to Texas for its attractive industry incentives, including sales tax exemptions on electricity used in data centers and assistance in workforce training. Some local governments in Texas also provide property tax abatements to the mining facilities.[19] However, the high usage of electricity does have Texans concerned as to whether the power grid can handle the extra demand from the industry, especially when the state’s population is increasing at a significant rate and its grid has come under fire for failing in recent years. A Texas Comptroller study projected that, by 2030, miners in Texas would consume as much energy as the city of Houston.[20] Although supporters expect the extra demand will incentivize additional investment in energy infrastructure or accelerate the transition to renewable energy, others are worried the infrastructure upgrades and additional demand could raise the electricity costs for average customers before any benefits are realized.

Finally, large-scale cryptocurrency mining operations are essentially data centers with thousands of interconnected network servers. Unlike manufacturing facilities or semiconductor foundries that take years to construct, data centers can relocate their network servers every bit as quickly as they can get them up and running. For these reasons, as cryptocurrency prices fluctuate and mining companies adapt, the stream of revenue provided by this industry may not be as reliable as expected.     

Conclusion: Many Issues Need to be Addressed Before Cryptocurrency is Widely Adopted

In a 2015 World Economic Forum survey, technology experts predicted that governments would begin collecting taxes through blockchain by 2023.[21] Although states have yet to directly use the technology for tax collection, recent state actions indicate that this prediction has indeed begun to materialize. However, states are still experimenting with accepting cryptocurrency for tax payments, and these efforts remain in the nascent stage. The recent drop in value of cryptocurrencies may deter the interests of potential users. In addition, the near-collapse of FTX and BlockFi show that, although cryptocurrency and blockchain can foster innovation, engage entrepreneurs and potentially improve equality, sufficient rules and oversights are necessary to ensure a comprehensive and effective supporting ecosystem.

Because a sizable number of states are racing to be viewed as crypto-friendly to attract investors and businesses, the ability to pay taxes with cryptocurrency will probably continue to be employed as an initiative that sends positive signals to the public and cryptocurrency industry. However, many factors — including added complexity, limited revenue and low utilization — need to be addressed before cryptocurrency tax payments gain widespread adoption.

Endnotes