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The Tax Lawyer

The Tax Lawyer: Spring 2022

U.S. State Taxation of Cryptocurrency- Involved Transactions: Trends and Considerations for Policy Makers

Casey Warren Baker, Thomas Norton, and Ralph E. McKinney

Summary

  • This Article examines legal doctrines relating to state-level taxation of cryptocurrency-involved commercial transactions in the United States, including constitutional limitations and current state approaches to income, sales and use, and property taxation systems.
  • The vast majority of states defer to federal policy on taxation of income derived from such transactions as limited guidance is available from only a handful of states with regard to sales and use tax obligations, and no states have legislatively addressed cryptocurrency within state ad valorem property tax systems.
  • State policy makers and practitioners must consider the constitutional boundaries established by the four-prong test of Complete Auto Transit, Inc. v. Brady in developing state tax systems that can effectively reach cryptocurrency-involved transactions.
  • As cryptocurrencies become more widely used in commerce, state legislatures should consider the unique tax aspects of the digital assets.
U.S. State Taxation of Cryptocurrency- Involved Transactions: Trends and Considerations for Policy Makers
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Abstract

This Article examines legal doctrines relating to state-level taxation of cryptocurrency-involved commercial transactions in the United States, including constitutional limitations and current state approaches to income, sales and use, and property taxation systems. Thus far, state tax policy is underdeveloped with regard to transactions involving cryptocurrency. The vast majority of states defer to federal policy on taxation of income derived from such transactions as limited guidance is available from only a handful of states with regard to sales and use tax obligations, and no states have legislatively addressed cryptocurrency within state ad valorem property tax systems.

As commercial adoption of virtual currency grows, state policy makers and practitioners will need guidance in developing and navigating tax and regulatory systems. In particular, state policy makers and practitioners must consider the constitutional boundaries established by the four-prong test of Complete Auto Transit, Inc. v. Brady in developing state tax systems that can effectively reach cryptocurrency-involved transactions.

I. Introduction

Cryptocurrencies and other virtual currencies are among the most polarizing current topics in finance and commerce. Proponents hail the technology as the key to unlocking more efficient transactions in a global marketplace, free from third-party control and manipulation by central banking authorities. Detractors insist that cryptocurrencies facilitate fraud and illicit activities, while simultaneously contributing to environmental collapse and climate change.

Much of the scholarly discussion of cryptocurrency regulation in the United States focuses on federal efforts, but the federal regulatory approach to cryptocurrency in the United States is inconsistent. At various times, federal authorities have been open to considering cryptocurrency as federally regulated banking activities, securities, or currency. Some federal regulators view cryptocurrency as a medium of exchange. Others question the usefulness of cryptocurrency as either a medium of exchange or a store of value. Yet, Congress has looked to taxes on cryptocurrency transactions as a significant revenue source for new spending, suggesting that federal policy makers are moving toward greater legitimization of cryptocurrency use. Indeed, the Infrastructure Investment and Jobs Act enacted in November 2021 expands cryptocurrency information reporting obligations for brokers and persons accepting cryptocurrency in commercial transactions. Presumably, the intent is to use the information to drive expanded tax enforcement.

Even as federal regulatory efforts evolve, states retain the authority to regulate cryptocurrency. In 2020, at least a dozen states introduced bills to regulate or study the regulation of cryptocurrencies, with Wyoming and New York identified as prominent models. As states are considered laboratories for regulatory experimentation, these state approaches should be monitored to anticipate evolving policy and responses among federal, state, local, and private parties.

This mindset has guided the approach of this Article. Federal tax enforcement has emerged as a potential avenue of federal cryptocurrency regulation. The Service refers to virtual currency (including cryptocurrency) as a “medium of exchange,” but refuses to grant the digital assets the status of “currency.” Instead, the Service treats cryptocurrency as property that can be exchanged for goods and services. Scholars have criticized this approach as impractical for sustained commercial use of cryptocurrency.

This Article will look at state tax systems as potential laboratories of democracy in the development of tax systems that facilitate the use of cryptocurrency as a medium of exchange. To that end, the work primarily considers the state tax implications for users of cryptocurrency purchasing goods and services in the online marketspace, sometimes referred to herein as “cryptocurrency-involved transactions.” Specifically, the Article considers the impact of state income taxation, sales and use taxation, and ad valorem personal property taxation on persons who hold cryptocurrencies for use in such commercial transactions. The Article first sets out some constitutional parameters and potential limitations on state taxation before turning to an examination of specific state approaches.

The Article concludes with general observations of trends in state tax efforts as well as with some considerations for policymakers as state tax systems evolve with regard to cryptocurrency. Because little existing scholarship on state-level taxation of cryptocurrency-involved transactions exists, practitioners advising clients as to the consequences of the use or acceptance of cryptocurrency in commercial transactions will find the information helpful as well.

II. Terminology

Before turning to the legal analysis, it is helpful to review certain terms as used within this Article. Technically, “cryptocurrencies” are a subset of a broader class of digital assets known as “virtual currencies.” Virtual currencies trace their origins to the virtual economies existing within multi-player online video game worlds. In some video games, players can convert real world currency to virtual currency for in-game use, and then “cash out” virtual currency for real currency. These virtual currencies have been labeled as “bidirectional” or “open-flow” virtual currencies by certain observers.

Cryptocurrencies emerged in 2009, with Bitcoin serving as the first decentralized open-flow virtual currency outside of a virtual economy. Instead of a central in-game register to maintain account balances and verify in-game transactions, Bitcoin utilizes distributed ledger technology known as the “blockchain.” Via the blockchain, each unit of Bitcoin contains a method of determining its entire history of ownership. When one unit of Bitcoin is transferred to a new owner, cryptographic mathematical techniques are used to confirm ownership of the transferor and update the blockchain with the new owner’s identity—hence the name, “cryptocurrency.”

Thus, the regulation and taxation of “virtual currencies” would include “cryptocurrencies,” but the inverse is not necessarily true. Nevertheless, Bitcoin, a cryptocurrency, is the most widely known and used virtual currency, so “cryptocurrency” has become a generic term for any virtual currency used in commercial transactions. As such, this Article will use the terms “cryptocurrency” and “virtual currency” interchangeably, unless otherwise specified.

III. Constitutional Limits on State Taxation

In the United States, a state typically has broad authority to tax property, transactions, activities, privileges, and revenue (and, relatedly, the persons and businesses that engage in or enjoy them) within its jurisdiction, but certain constitutional limitations apply. The shift toward a more digital marketplace has forced courts and scholars to re-examine longstanding rules that govern tax and regulatory jurisdiction, as the traditional rules were better suited to a physical marketplace.

The most notable limitation on a state’s ability to tax interstate commerce is nexus. Nexus combines elements of Commerce Clause and Due Process analysis to provide a constitutional test for whether a state may impose a tax-related duty—such as payment, collection, or remittance—on a particular person, business, or transaction. Both the Commerce Clause and Due Process Clause separately limit a state’s ability to tax a transaction, but recent scholarship finds that any distinctions between the limitations of the two clauses as they relate to nexus have largely evaporated.

In 1977, the Supreme Court handed down Complete Auto Transit v. Brady, which laid out the four prongs of the constitutional nexus test. In the absence of Congress speaking on the matter, a state is permitted to tax a transaction if (1) the taxed activity is sufficiently connected to the state, (2) the tax is fairly apportioned among potential taxing states, (3) the tax does not unfairly discriminate against out-of-state economic activity, and (4) the tax revenue is related to state services provided.

A. Prong One: Sufficient Connection to the Taxing State

In 1992, the Supreme Court addressed the first prong of the Complete Auto test by laying down a bright-line rule in Quill Corp. v. North Dakota. Under Quill, for state sales and use taxes, a remote seller was sufficiently connected to the taxing state under Commerce Clause analysis only if there was some physical presence within the state attributable to the seller. Quill Corp., a direct sales office supply company, solicited business through the mail and sent products to North Dakota. The company had no offices, employees, or significant personal property deployed to North Dakota. The Court ruled this was not sufficient nexus to impose the duty to collect and remit North Dakota sales and use taxes because Quill Corp. needed either physical presence or other “substantial nexus.”

But the Quill holding was never extended to state income taxes (or other types of business activity taxes (BAT)), so in the years following the decision many states enacted income tax, business privilege tax, and gross receipts tax schemes that imposed tax obligations on out-of-state entities with no in-state physical presence. Instead, these statutes focused on “economic presence.” State courts mostly upheld these state income tax and BAT systems, and the Supreme Court did not grant certiorari to review any challenge thereto. As a result, states could require extra-territorial entities to fulfill income tax and BAT obligations—even when the tax was measured by sales—but could not impose a sales and use tax collection obligation directly upon a seller unless a physical presence could be established.

While this was one workaround for taxing states, states that wished to collect sales tax revenue from out-of-state sellers continued to test the limits of the Commerce Clause. Despite the physical presence standard, many states adopted laws to reach more than just entities with a strict physical presence. Three primary doctrines emerged: affiliate nexus, click-through nexus, and economic nexus.

Affiliate nexus is a doctrine which asserts an out-of-state business has what is akin to physical presence if it has a sufficient connection with a physically present in-state affiliate. States differed in their definitions of an affiliate; however, most states passed these types of laws to reach out-of-state vendors. Click-through nexus is similar to affiliate nexus in that the state is asserting jurisdiction over an out-of-state seller based on their connection with an in-state referral service. Both of these doctrines served to subject out-of-state sellers to in-state sales tax collection and remittance obligations.

However, the biggest boon to nexus was economic nexus. Economic nexus gained constitutional legitimacy in 2018 with the Supreme Court’s decision in South Dakota v. Wayfair, Inc. In that case, South Dakota was particularly concerned about sales tax revenue because it has no personal income tax. South Dakota passed a more aggressive nexus law requiring out-of-state sellers to collect and remit sales tax if they had so-called economic nexus.

In Wayfair, the Supreme Court overruled Quill ’s holding that a physical presence was necessary to establish sufficient nexus under the first prong of Complete Auto. In doing so, the Court specifically highlighted the growing importance of digital commerce in the interstate economy compared to that existing when Quill was decided. South Dakota established sufficient economic nexus with Wayfair because, under the South Dakota statutory scheme, Wayfair was required to remit sales tax only when it had either more than 200 individual transactions or over $100,000 of in-state sales volume. According to the Court, the first prong of Complete Auto was satisfied because “[t]his quantity of business could not have occurred unless [Wayfair] availed itself of the substantial privilege of carrying on business in South Dakota.”

Most states that have spoken on the issue have adopted very similar statutory requirements to that of South Dakota, many with a sales threshold (measured in dollars) or an alternative numerical transaction limit, others with only a sales volume limit. As of July 2021, only one state that has a statewide sales tax does not have an economic nexus requirement and that state, Missouri, adopted legislation that will create an economic nexus standard as of January 2023.

B. Prong Two: Fair Apportionment Among States

The second prong, requiring the fair apportionment of tax revenue among states that may tax the assessed activity, was more thoroughly discussed by the Supreme Court in Oklahoma Tax Commission v. Jefferson Lines. In that case, Oklahoma imposed a tax on the sales of “transportation for hire,” which was paid by the buyers but collected and remitted to the state by sellers of transportation. Jefferson Lines, Inc., a common carrier and bus operator, collected and remitted the tax for sales of intrastate travel but not for interstate travel. All sales at issue in the case took place in Oklahoma, where the seller maintained a physical presence, so the first Complete Auto prong was not at issue.

Instead, the arguments addressed whether Oklahoma could collect sales tax for the entire purchase of services where only a portion of those services would be provided in the taxing state. Because any state through which the bus traveled could, theoretically, establish sufficient physical presence and tax the transaction, the bus operator argued that Oklahoma could tax only a pro-rated portion of the sales proceeds based on the percentage of total travel occurring in Oklahoma.

Under the second Complete Auto prong, a state tax must be apportioned among taxing states to ensure that each taxes “only its fair share of an interstate transaction.” Essentially, a state may not impose taxes in such a way that a taxpayer is potentially subject to paying tax on the same transactional value more than once. However, a distinction exists between leveling successive taxes upon distinct events in the stream of commerce and leveling substantially similar taxes upon the same event. Imposing a tax upon the buyer at the point of sale is distinct from imposing a tax on the seller on gross income derived from the sale; likewise, taxing the buyer on the purchase is distinct from taxing the property itself based upon its sale value. Thus, apportionment between distinct taxes is not necessary—apportionment is required only to the extent substantially similar taxes are imposed upon the same taxable event that occurs in multiple states.

In Jefferson Lines, the Court applied two tests to determine whether the apportionment requirement was violated. First, the “internal consistency” test supposes that every state adopts the tax in question and then asks whether the taxpayer would potentially be subject to taxation in multiple states for the same transaction or event. If so, the tax unconstitutionally burdens interstate commerce.

Second, the “external consistency” test looks at the economic justification for the state’s claim on the taxed event. If the state’s tax is imposed on value or an event attributable to economic activity outside of the state, the tax may be an overreach. In this analysis, the event taxed must be compared with the measure of the economic activity attributed to the state. Thus, a tax on business income based on proportionate in-state gross sales is constitutional, as is a business franchise tax based on a formula derived from business payroll, property, and sales within the taxing state. But a tax on business gross receipts is not constitutional if the receipts are not apportioned among the states in which the economic activity generating the receipts occurs.

In Jefferson Lines, the Court found that the sales tax at issue did not violate the apportionment prong of Complete Auto. According to the Court, the Oklahoma tax was internally consistent because it only applied to sales in Oklahoma for travel originating there—if every other state adopted the same tax, the transaction would nevertheless only be taxed in the state in which the ticket was purchased. Likewise, the tax was externally consistent, despite the total allocation to Oklahoma, because the elements of sale (i.e., payment for and delivery of the ticket, along with commencement of the services) comprised an event entirely local to Oklahoma. That is, even though a part of the services rendered was interstate, the transaction that was taxed—the sale—occurred in Oklahoma.

In reaching its conclusion, the Court relied heavily on an earlier decision in Goldberg v. Sweet, which may be illustrative for cryptocurrency-involved transactions because of its implications for interstate wire transmissions. Goldberg involved an excise tax imposed by Illinois on telephone calls originating or received within the state and billed to an Illinois service address. The taxing statute offered taxpayers an offsetting credit to the extent the taxpayer paid a tax in another state on the same call that triggered the Illinois tax.

As to the second Complete Auto prong, the Court found the tax fairly apportioned under both the internal consistency and external consistency tests. However, two key considerations were noted. First, the credit provision within the tax minimized the risk of multiple taxation. Second, the Court recognized that a strict apportionment formula would not be administratively or technologically workable when the transaction involves “intangible electronic impulses.” With respect to this second consideration, the Court found it significant “that Illinois’ method of taxation is a realistic legislative solution to the technology of the present-day telecommunications industry.” Thus, the Supreme Court appears willing to offer taxing states some grace so long as the method of apportionment is reasonable in relation to technological limitations. This may be important to the cause of tracking and taxing cryptocurrency-involved transactions.

C. Prong Three: Nondiscrimination Against Out-of-State Parties

Goldberg also offers a good discussion of the third Complete Auto prong, which prohibits a state from imposing a tax on interstate commerce if the tax discriminates against out-of-state transaction participants. The Court contrasted the Illinois tax with a Pennsylvania tax deemed unconstitutional in American Trucking Associations v. Scheiner. Scheiner involved a Pennsylvania law which imposed lump-sum annual taxes on the operation of trucks and truck tractors operating on Pennsylvania highways. The Court found the tax discriminatory because in-state trucks traveled more miles than out-of-state trucks that might only occasionally operate in Pennsylvania.

The Court in Goldberg found that the Illinois tax was not comparable to the unconstitutional Pennsylvania tax for two reasons. First, the Illinois tax was only due from persons with a service address within Illinois—accordingly, the full tax was apportioned to in-state persons, with no discrimination against out-of-state persons. Second, the Court again cited the technical difficulty of tracking exactly how much of an interstate phone call might take place in Illinois; in contrast, drivers could more easily track their actual mileage in Pennsylvania to determine the discriminatory impact.

D. Prong Four: Fair Relation to Benefits of State Services

Turning finally to the fourth Complete Auto prong, the Court in Goldberg considered whether the Illinois tax was fairly related to the taxpayer’s presence in the taxing state. This prong is meant to ensure that persons with remote relationships to the taxing state, who do not benefit from state-provided services, do not bear the brunt of the state’s tax burden. However, according to the Court, the tax imposed on an interstate transaction does not have to bear a direct relationship to the services provided by the state regarding the taxed activity. Rather, so long as the tax relates to covering the costs of all governmental services from which the taxpayer may benefit directly or indirectly, the test is satisfied. Because the taxpayers in Goldberg not only subscribed to telephone services but also received the benefit of general governmental services in Illinois, the Court found the tax valid under the fourth prong.

In considering the constitutionality of a state tax imposed on a transaction completed using cryptocurrency, no reason exists to believe Complete Auto would not apply. However, in a world in which the use of cryptocurrency in commercial transactions is growing, a state may not be able to establish economic nexus over a transaction—even under Wayfair’s relaxed standard—as the buyer’s location may not be easily identifiable. In such a case, only the seller’s home state may have a substantial economic nexus to tax the transaction. Thus, states may encourage the commercial use of cryptocurrency in order to broaden the number of entities and transactions to which a particular tax may apply. But as more and more commerce is hosted and conducted on “the cloud”—that is, on the internet itself rather than on servers with a physical location—these jurisdictional issues compound, as even the seller’s physical location may not be clear.

State tax systems must also consider the limitations presented by the apportionment, nondiscrimination, and reasonable relationship prongs. As cryptocurrency use in commercial transactions grows, states may experiment with different administrative, enforcement, and collection approaches. While Goldberg recognizes that technological advances may complicate strict compliance with Complete Auto’s requirements, the case also stands for the proposition that states are offered some grace for good faith efforts at compliance in the face of those technological barriers. Nevertheless, it does appear that there must be some in-state connection to the transaction in order for tax collection and remittance obligations to be valid—presumably, either the buyer or seller must be in-state, and some portion of the transaction must be conducted in the state.

E. Other Constitutional Considerations

Nexus is hardly the only constitutional limitation on state taxation. For example, under concepts of federalism, one must reconcile the state-level conceptualization of “property” against federal interests. Generally, “property” is determined with reference to state law. However, in law, “property” is not just the thing itself, but rather the rights that one possesses to the thing. Thus, although state law may determine the property rights of an owner, federal law may nevertheless impact those rights via regulation, taxation, or levy.

Furthermore, the Constitution gives Congress a monopoly on the regulation of currency. Cryptocurrency, as a medium of exchange, could be viewed to violate that monopoly. Significant academic discussion has analyzed cryptocurrencies as counterfeit currency on these grounds. Yet, states retain the authority also to regulate counterfeit currency as fraudulent activity, rather than as a direct regulation of the currency itself. A parallel could be drawn to interstate commerce; even in the face of comprehensive federal regulation, states nevertheless maintain authority to tax transactions within their respective jurisdictions. State taxation of cryptocurrency-involved transactions as a part of commerce, rather than distinct from commerce, could be justified as furthering the states’ interests in monitoring and regulating counterfeit or fraudulent activity.

In summary, when considering state-level taxation of cryptocurrency activities, one must consider the distinction in taxation of transactions involving cryptocurrency versus taxes specifically targeting cryptocurrency. Cryptocurrency has certain features—such as enhanced anonymity, ease of transfer, and volatility—that impact its overall utility in the commercial world. These features can complicate the extension of traditional tax schemes to cryptocurrency-involved transactions, which may tempt policy makers toward taxing cryptocurrency regardless of its function in commerce.

Nevertheless, the current analysis focuses on the application of conventional state tax approaches—income taxation, sales and use taxation, and ad valorem property taxation—to persons using cryptocurrency for commercial transactions. The law regarding such approaches is fairly well developed throughout the United States. Analysis of existing law is cleaner than speculation as to the form that a theoretical state tax specifically targeting cryptocurrency (regardless of function) might take.

In the next two Parts, this Article reviews state tax systems and trends with regards to cryptocurrency. However, the conclusion of the Article will return to constitutional concerns in order to provide some considerations for policy makers as to the development of cryptocurrency transaction taxation systems.

IV. State Tax Systems Applied to Cryptocurrency-Involved Transactions

If a person holds and uses cryptocurrency as a replacement for legal tender in customary transactions, what are the possible state tax consequences under existing law? Although state tax systems can vary significantly, three primary tax systems predominate in states: state income taxation, state sales and use taxation, and state ad valorem property taxation.

A. Income Taxation

The largest source of state funding is still the personal income tax, which in 2020 accounted for $423.1 billion, or 38% of state tax revenues. As of 2021, 42 states plus the District of Columbia tax residents’ personal incomes in some manner. Of those 43 jurisdictions, 37 adopt federal definitional constructs in determining the income subject to taxation, and six use their own varying definitions of income.

Thus, for the majority of states, the taxability of cryptocurrency under personal income tax systems requires an analysis of the federal tax conceptualization of cryptocurrency. Currently, the leading authority on income taxation of cryptocurrency at the federal level is Notice 2014-21.

In the notice, the Service limited its discussion to “convertible virtual currency.” Convertible virtual currency has an equivalent value in legal tender or can substitute for legal tender. In contrast, nonconvertible virtual currency has no value outside of its intended application.

The Service then proceeds to single out convertible virtual currencies and subjects them to taxation as property. Like other property, the receipt or purchase of virtual currency has varying tax treatments depending on context. In the majority of transactions, convertible virtual currencies are likely to be treated as capital assets. Unlike ordinary income which is taxed when earned, a capital transaction is taxed upon the sale or exchange. Pursuant to section 1001(c), all realized gains or losses must be recognized on the sale or exchange of property. The gain or loss realized is calculated by taking the amount realized less the adjusted basis. The amount realized is usually the fair market value of all the property, money, or combination thereof received in a transaction. The adjusted basis is typically the cost basis or what was paid for the assets plus or minus adjustments.

To illustrate the tax consequences, assume that a taxpayer takes $100 of cash and exchanges it into a convertible virtual currency such as Bitcoin. The taxpayer would have a cost basis of $100 in the Bitcoin, and her holding period begins. Unlike other assets, very few, if any, adjustments are required for virtual currency transactions. Once the taxpayer either sells or exchanges the Bitcoin, she will trigger a capital gain or loss. For example, if the taxpayer sold the Bitcoin for $150 of cash, she would realize and recognize $50 of gain. If she held the Bitcoin for more than one year, it would be a long-term capital gain. If the holding period were shorter than one year, it would be considered a short-term capital gain. All of the above information is typically reported on the taxpayer’s individual Form 1040 under Schedule D Capital Gains and losses.

The receipt of virtual currency can also trigger ordinary taxable income. For instance, if the person in question is a contractor and accepts payment in virtual currency, the contractor would recognize income at ordinary rates. The contractor’s basis would be the amount of income recognized. When the virtual currency is sold or exchanged, the gain or loss would be the amount realized less the basis. Thus, the contractor would have two taxable transactions: the first when the virtual currency is received as payment, and the second when the virtual currency is sold or exchanged. This tax treatment is similar to miners of the virtual currency. Miners recognize ordinary income when they mine the virtual currency and presumably incur tax on the gain when the virtual currency is sold or exchanged. Depending on the holding period, the seller would either have a short-term or long-term capital gain or loss.

The Service approach complicates the use of cryptocurrency in commercial transactions. Unlike the use of currency, the use of cryptocurrency to purchase a product or service will result in income tax consequences to the buyer because the transfer of the cryptocurrency is a disposition of a capital asset. When the buyer uses the cryptocurrency to make the purchase, the buyer must determine both the basis of the cryptocurrency exchanged and the fair market value of the goods or services acquired.

Tracking the basis of fungible cryptocurrency units could prove especially problematic. The necessary recordkeeping to assure tax compliance may be economically prohibitive. Notice 2014-21 does not provide guidance as to how to determine the basis of any cryptocurrency units acquired, which could lead to gaming of the tax system by users.

The 37 jurisdictions that have incorporated federal income tax definitions into their state income tax systems likewise incorporate these policy complications for cryptocurrency users. While states routinely adjust their income tax systems to include or exclude items of income in differentiation from the federal calculations, as of July 1, 2021, none of the 37 jurisdictions have done so for cryptocurrency. As a result, these states have effectively ceded to the federal government control over a significant portion of cryptocurrency tax policy.

Likewise, among the remaining six states that impose some type of income tax, none expressly address cryptocurrency in their taxing statutes. Of the six, Alabama, Arkansas, and Mississippi all have broad definitional constructs of income, paralleling the federal definition even if not expressly incorporating it. Thus, tax authorities in these three states would likely consider the federal approach when considering whether to impose income tax on a disposition of cryptocurrency.

New Jersey and Pennsylvania specifically enumerate the categories of income subject to taxation and have no broad definitional construction. Nevertheless, both impose income tax on net gains or income derived from the disposition of intangible property. As of July 1, 2021, neither state, via statute or caselaw, has specifically determined that cryptocurrency is intangible property for the purposes of income taxation, but no reason exists to believe either would take the position that cryptocurrency is exempt. Both states, in other contexts, have given “property” a broad construction. Thus, both states would likely consider the use of cryptocurrency in a commercial transaction an event triggering state income tax consequences.

The final state, New Hampshire, imposes income tax only on interest and dividends. The New Hampshire Supreme Court has previously found that taxation of interest and dividends is distinct from the taxation of gains on the disposition of property. Thus, while a person receiving cryptocurrency as payment on an investment may be liable for income tax in New Hampshire, a buyer using cryptocurrency to complete a commercial purchase—the focus of this analysis—would not.

Therefore, of the 43 jurisdictions that impose some form of income taxation, 42 will likely assess income tax on a person using cryptocurrency to acquire goods and services. And of those 42, under current law the vast majority likely will defer to the federal government’s policy. A clear opportunity exists among the states for differentiation by those jurisdictions that wish to assert their policy making power in the encouragement or discouragement of the commercial use of cryptocurrency.

B. Sales and Use Tax

States, especially those with either no income tax or a modest income tax, often rely on sales and use tax to fund government operations. As of 2020, 46 different states plus the District of Columbia had sales tax collections at a state or local level. Sales and use tax produced $346.8 billion in revenue, which accounted for 31% of all state tax collections. The reliance on sales tax revenue coupled with the changing sales tax landscape has created a myriad of collection and enforcement issues.

1. Sales Tax and Use Tax: The Basics

Generally, sales taxes are typically designed as a consumption tax levied on the end-user of a good or specifically enumerated service. As a result, many states have various exemptions to reduce the impact of the regressive nature of the tax or exempt some purchases to reduce a pyramiding effect of taxing goods multiple times throughout its life cycle to end consumers. The sales tax base is typically the purchase price of the good multiplied by a rate. Rates vary by state and locality. Some states are as low as 2.9% and can range up to 7.25%; the addition of local rates in many states increases the combined state and local tax rate in some areas to over 10%. Sales tax receipts are often allocated between the state and the locality that has jurisdiction.

Use tax is the tax on consumption, use, or storage of a taxable good or service for which no sales tax has been paid. Most state laws impose use tax in tandem with sales tax to capture either the sale or use of all goods in their jurisdiction (i.e., where no sales tax has been paid, use tax is usually due). Use tax rates generally mirror sales tax rates.

As a general principle, states with a sales and use tax regime wish to expand their base and increase compliance. Doing so increases revenue without a correlating rise in the tax rate. Raising the tax rates can be politically detrimental especially when it comes at the expense of everyday taxpayers.

To expand the sales and use tax base, states must first obtain sufficient nexus with the seller and the transaction. States, by and large, like to establish nexus with the seller of goods in order to force the seller to collect and remit sales tax from the consumer of the good. If sellers fail to collect or do not have to collect sales tax, it then falls on the consumer to remit the compensating use tax to the taxing jurisdiction. Because most people do not know or care about potential use tax liability, many do not pay their share of tax. This problem tends to be more acute in areas with significant discrepancies in sales tax rates. For instance, people who live close to the Vermont-New Hampshire border will frequently travel to New Hampshire for larger purchases to avoid sales tax. Even within a state, some Chicago residents will travel to the suburbs to avoid the substantially higher local sales tax rate in the city.

2. Marketplace Facilitators

As discussed above, the Wayfair decision enhanced states’ abilities to reach many different out-of-state vendors and force them to collect and remit sales tax on purchases in their jurisdiction. States no longer need to rely on consumers to report purchases from out-of-state vendors for use tax purposes. Instead, states can directly expand their sales tax revenues by targeting the out-of-state vendors with direct collection and remittance obligations.

Given the expanded “economic nexus” authorized by Wayfair, most states utilize another tool called marketplace facilitator laws. A marketplace facilitator is a third-party host that provides a platform from which vendors sell their products. Instead of seeking to collect sales tax from each of the sellers, states with these laws shift the burden to collect and remit sales and use tax to the marketplace facilitators. Marketplace facilitator laws allow further expansion of the sales tax collections because it is easier to establish an economic nexus over a large marketplace facilitator than multiple smaller sellers conducting business through the facilitator.

A business such as Amazon may not only sell goods and services directly but may also permit others to exchange goods and services through its website. In the absence of a marketplace facilitator law, Amazon would collect and remit sales tax only on the items it sells. When merely acting as a third-party matching buyer and seller, Amazon did not collect and remit sales tax for such transactions. Once states shifted the burden to collect and remit sales tax to marketplace facilitators, Amazon was then required to collect and remit sales tax on not only the products it sells but also the sales with respect to which it acts as the facilitator connecting the buyer and seller of goods.

After the first pioneering states were successful in forcing facilitators to collect and remit sales tax, many other states followed suit. As of June 30, 2021, only five states have not passed marketplace facilitators laws, with most laws passed in early 2019. The National Conference of State Legislators has even issued model legislation. The Multistate Tax Commission has created a “Wayfair Implementation and Marketplace Facilitator Work Group” that actively develops guidance. The Working Group issued a final white paper on the topic on July 1, 2020.

As part of these laws, a critical debate centers on the definition of a marketplace facilitator. Some states have a narrower focus, and some are far more expansive. Of the states with marketplace facilitator laws, at least 16 have added language about virtual currencies to their statutes by defining a marketplace facilitator to include an entity providing a virtual currency that buyers are allowed or required to use to purchase goods.

While some commenters have reached the conclusion that such statutes include third-party-developed cryptocurrency such as Bitcoin, some uncertainty exists whether that was the intent. The operative word in most of the statutes is “provides.” Because the intent of these laws may have been limited to reach only those facilitators who create their own virtual currencies, the statutes may not apply to those who simply allow for payment in virtual currencies. Thus, the use of cryptocurrencies in marketplace facilitator transactions may not significantly impact the sales tax base or collection and remittance obligations as currently defined.

3. Cryptocurrencies and Sales Taxes

In order for a state to impose sales tax obligations, a nexus or some minimum connection must exist to allow the state to impose the tax. As discussed above, this connection is usually established through either physical presence or economic nexus. The next step is to define the sales tax base, which creates potential collection and enforcement issues when dealing with virtual currencies.

Typically states define their sales tax base as the sales price or purchase price. This concept can be clouded when discounts, rebates, vouchers, coupons, commissions, gratuities, and the like are involved. Although considerable precedent exists with respect to mixed transactions in which taxable goods and nontaxable services are purchased together, cryptocurrency transactions will likely pose similar enforcement difficulties.

Furthermore, the Service’s conceptualization of convertible virtual currencies as property could cause administrative confusion because the Service effectively taxes cryptocurrency transactions as barter transactions. It may be advantageous for states to maintain consistency in the treatment of cryptocurrency dispositions for both income tax and sales tax purposes, but barter transactions have a long-storied history in taxation and have been used as a tax avoidance mechanism.

Many states tax laws are sufficiently expansive to include barter transactions or have specific language that incorporates barter transactions into the sales and use tax scheme. For those that do not have such laws, many of these transactions could escape taxation. As virtual currency becomes more ubiquitous, existing sales tax laws should be expanded to capture these transactions.

4. State-by-State Comparison

Several states have provided guidance about how to measure the sales tax base in a transaction and to ensure compliance with sales tax obligations for cryptocurrency-involved transactions. The most notable approaches are those of New York and Kansas, which offer some fundamental differences. The other states generally follow the trends of one of those two states.

New York’s guidance is found in Technical Memorandum TSB-M-14(5)C, (7)I, (17)S, which was issued on December 5, 2014. In New York, virtual currency is considered intangible property, which does not trigger sales tax obligations for the acquirer of the virtual asset. However, if a virtual currency is exchanged for a taxable good or service, sales tax accrues. The vendor of the taxable good or service must record in its books the value of the virtual currency received at the time of each transaction along with the amount of sales tax collected. The guidance directs that values should be converted to U.S. dollars, but no instruction is provided as to the method of conversion. The taxing authorities of Wisconsin, New Jersey, and Michigan largely follow New York’s reporting and collection scheme.

In contrast, Kansas guidance provides that “with respect to each retail sale, sales tax is measured by the fair retail market value of the property or service received in payment for the property or service sold, and will be calculated using the list price in U.S. dollars of a good or service, not the value of the virtual currency.” Kansas offers no guidance as to recordkeeping.

At one time, California clearly followed the Kansas model. In 2014, the California State Board of Equalization stated in guidance that “if a retailer enters into a contract where the consideration is virtual currency, the measure of the tax for the sale of the product is the amount allowed by the retailer in exchange for the virtual currency (generally, the retailer’s advertised price of the product).” However, under legislation adopted in 2017, all the statutory duties of the former Board of Equalization moved to the California Department of Tax and Fee Administration (CDTFA).

As of December 2021, the CDTFA has not indicated whether the Board of Equalization’s previous guidance is rescinded or remains in effect. California sales tax regulations expressly direct that a transaction in which virtual currency is given as consideration for tangible personal property is to be treated as a barter exchange. Under California’s barter regulations, a vendor receiving property as compensation is taxable upon his “gross receipts.” The definition of “gross receipts” incorporated into the barter regulations states that “‘[g]ross receipts’ mean the total amount of the sale or lease or rental price, as the case may be, of the retail sales of retailers, valued in money, whether received in money or otherwise,” with “sale or lease or rental price” including “[a]ll receipts, cash, credits and property of any kind.”

These definitional constructs suggest that the vendor will be assessed sales tax on the value of the cryptocurrency received rather than advertised price, although the regulations and statutes do not completely settle the issue of valuation. The authors are certain that users of cryptocurrency and tax professionals would appreciate clear guidance as was previously provided by the California taxing authorities.

Washington’s guidance provides vendors accepting cryptocurrency an option: immediately convert the cryptocurrency to U.S. dollars to determine value or reference a “reliable cryptocurrency pricing index” to determine convertible value. In either event, Washington requires vendors accepting cryptocurrency to maintain a dated record of the cryptocurrency transfer from the buyer to the vendor, a copy of the sales invoice issued from the vendor to the buyer, and a dated record of the cryptocurrency’s value. (Washington’s guidance applies to both the sales tax collected by the seller and the amount of business and occupation (B&O) tax due on the seller’s gross receipts from the transaction.) Missouri has not offered detailed guidance but has specified that the acquisition of Bitcoins is not a taxable event because sales of intangible assets are not taxed in that state.

From the above guidance, two major commonalities become apparent. First, all states that have spoken on virtual currency follow the federal treatment of virtual currency (i.e., it is not a currency but rather intangible personal property). Second, each state that has spoken on the issue has concluded that the purchase of virtual currency should not be subject to tax because the purchaser is acquiring intangible property.

Thus, the major distinction is in the measurement of the tax base. The New York approach measures the base according to the value of the cryptocurrency received converted to U.S. dollars, whereas the Kansas approach bases the value of the transaction on the price that the vendor would generally charge for the product or service. Among the other states that have issued guidance on the matter, most follow the New York approach.

C. Ad Valorem Personal Property Tax

Property tax is a significant source of state revenue for all states, but property tax systems vary widely across the United States. Several states have included cryptocurrency within the scope of “property” in other contexts, potentially subjecting the digital assets to ad valorem taxation. But among the different state property tax systems, a key distinction is the type of property upon which the tax is assessed—real property, tangible personal property, or intangible personal property. Because of its digital nature, cryptocurrency—to the extent considered property—is generally considered intangible property.

In the United States, few states impose an ad valorem tax on intangible property. Alabama imposes an ad valorem tax on all real and personal property but then exempts certain types of intangible property such as governmental bonds, mortgage loans, and bank deposits from taxation. Likewise, North Carolina imposes a broad tax on all types of intangible personal property unless specifically excluded. Mississippi, South Dakota, and Tennessee follow the same general pattern of broadly imposed taxes on intangible property, with specific exemptions.

In contrast, other states impose ad valorem tax only on limited classes of intangible assets. Iowa does not impose a tax on any personal property except upon certain “moneys and credits” held by credit unions. Kansas has a broad exemption for “[m]oney, notes and other evidence of debt,” with “money” defined as “gold and silver coin, United States treasury notes, and other forms of currency in common use.” Kentucky exempts all intangible property of individuals from taxation except for money on deposit at financial institutions as of January 1 of each year.

The taxability of cryptocurrency as property will depend on the conceptualization of cryptocurrency within more traditional intangible property labels. Cryptocurrency is clearly intangible property, but is it “money”? “Currency”? Some as-of-yet unrecognized form of intangible property? As more states recognize cryptocurrency firms as financial institutions, might cryptocurrency qualify as bank deposits?

These questions just scratch the surface of the range of questions involved, some of which will likely require legislative action to answer. Thus far, that legislative action has been limited. Two states, Nevada and Wyoming, have explicitly listed cryptocurrency as tax-exempt assets, but neither imposes tax on intangible property. Likewise, a bill was introduced in the 2021 Alabama legislative session that would have added cryptocurrencies to the express list of exempted assets, but no action has been taken on the bill.

V. Identified Trends

From the above discussion, some major themes emerge. As to state income taxation, the vast majority of states defer to federal policy, effectively forfeiting state policy making authority absent specific statutory adoption. State legislatures have thus far not yet spoken as to whether federally recognized gain on cryptocurrency disposition is or is not recognized as income at the state level. Likewise, among the states that impose ad valorem property tax on intangible personal property, none has legislatively addressed cryptocurrency within its property tax regime. Without legislative clarity, conceptualizing cryptocurrency within or outside of the various categories of taxed or untaxed classes of property may prove difficult.

As to sales and use taxation, with an increasingly digital economy, the use of virtual currency is likely to become more common. States that wish to tax virtual currency transactions need to ensure that their existing tax laws establish nexus and cover virtual currency transactions. States will have to grapple with increasingly complex nexus facts, such as transactions occurring entirely online in which the buyer, the seller, or both have unclear physical and even economic ties to a particular location. Most states probably have broad enough sales and use tax statutes to cover these transactions, but each state should consider its existing legislation in light of these considerations.

In addition, taxpayer compliance is much easier to achieve if the existing laws are well defined and easy to follow. States and businesses alike would benefit from greater guidance in order to identify the transactions that are taxable and the value involved, to properly report the transaction on a return, and to document the cryptocurrency user’s financial position with regard to the asset.

Generally, most states that have spoken on this issue focus not on the virtual currency but the other side of the transaction. That is, at least as to questions of taxability and sourcing, sales tax implications are based on the property purchased and not the form of payment. This represents what we believe to be the best approach for states to adopt if they have not already. In the absence of specific legislation, this allows existing precedent to dictate what goods or services are taxable and allows the transaction to fit within the established framework.

Determining the value of the transaction is likely to be the most nuanced area of the analysis. As discussed previously, the issue of how to determine the value of the transaction has largely followed one of two models, exemplified by the Kansas method—basing taxed value on the value of the goods sold—and the New York method—basing taxed value on the value of the cryptocurrency exchanged.

Each of the models has its benefits and drawbacks. The New York model offers some administrative consistency for a business accepting cryptocurrency, as a vendor or seller of taxable goods or services must, in computing gross income, determine the fair market value of the cryptocurrency as of the date received for federal tax purposes. Thus, these vendors will have determined that value in terms of U.S. dollars anyway in order to determine their taxable income and their basis in the virtual currency.

However, virtual currencies are notoriously volatile, with significant intraday price swings common. Likewise, there may be significant differences between bid-price and ask-price for a given cryptocurrency on a given exchange, or across different exchanges. Without specificity as to when value should be determined or what stated price or index should be referenced, some users of cryptocurrency will likely engage in gamesmanship to underreport income and sales tax base.

The Kansas model avoids this gamesmanship problem by focusing on the U.S. dollar value of the good or service exchanged for the virtual currency. The value of a good or service exchanged should be easier to prove because the vendor presumably will have a separate U.S. dollar price. Nevertheless, administrative difficulties could arise when variations occur between the value of the cryptocurrency (needed for income tax purposes) and the U.S. dollar value of the goods or services sold (needed for sales tax purposes).

VI. Considerations for Policy Makers

States, as laboratories of democracy, should feel empowered to embrace cryptocurrency within their taxing systems. Importantly, however, state taxation of interstate transactions implicates Commerce Clause analysis. Because the Constitution vests Congress with the authority to regulate interstate commerce, congressional action will control. Observers have noted that, given the complexities of interstate taxation in modern digital markets, Congress is in the better position to develop a cohesive state taxation system for interstate commerce.

In the absence of federal legislation, states should begin with Complete Auto’s four-prong test when reimagining tax systems for cryptocurrency-involved commercial transactions. Even pre-Wayfair, states could constitutionally tax in-state residents’ income, sales, and property; post-Wayfair, states can more easily reach an out-of-state seller’s economic activity with state residents in order to impose sales tax obligations. Nevertheless, some of the peculiarities of cryptocurrency-involved transactions may complicate analysis under Complete Auto.

For example, after Wayfair, physical presence is no longer necessary to establish nexus; a remote seller’s substantial economic activity within the state is sufficient to establish economic nexus for tax collection and remittance purposes. However, this presupposes that the buyer’s physical location is known to be in-state. Even after Wayfair, the state of Ohio, for instance, could not tax a transaction between an Indiana seller and a Pennsylvania buyer simply because the wires carrying the digital transaction pass through Ohio.

A buyer’s physical location may not always be known in a cryptocurrency transaction if the product or service sold is also delivered digitally. At least one observer has suggested that when the buyer’s location is unknown, only the seller’s state should be permitted to collect sales tax on the transaction. However, such an approach would effectively revert the tax system to a pre-Wayfair model based on the seller’s physical presence. Also, it is possible that the seller’s location may be unknown.

To avoid this, states wishing to tax a cryptocurrency-involved transaction based on the buyer’s location must establish that the buyer is within the taxing state’s jurisdiction. Verification that an in-state buyer did in fact own and use cryptocurrency to make the purchase, triggering the various taxes associated therewith, is an administrative problem.

For income and ad valorem property taxes, states can work with federal tax enforcement and forensic specialists to identify residents owning and using cryptocurrency and assess the taxpayers directly. Service enforcement agents claim to be able to identify supposedly anonymous users of cryptocurrency, and federal law expressly authorizes the disclosures of federal tax returns and return information to states for administrative purposes. Interstate tax administration compacts among states could also help administration.

However, sales taxation is more difficult to enforce as the collection and remittance obligations typically fall on sellers. If the seller does not know a buyer’s physical location because the item purchased is not physically delivered, the seller will not know to collect and remit sales taxes to the buyer’s taxing state (or possibly even whether the seller has met economic activity thresholds for nexus with that state). Thus, the taxing state will need to develop some mechanism for assuring that a remote seller can verify whether or not a buyer is located in the taxing state.

A taxing state may be tempted to assume that all sales by a seller with sufficient economic nexus are presumed to be in-state unless otherwise demonstrated, thereby capturing all sales not taxed by other states. However, such an approach would implicate the Complete Auto apportionment prong. Again, Goldberg is instructive. In Goldberg, the tax at issue was only levied on telephone calls charged to an in-state service address. The Court concluded the tax was internally consistent under the apportionment prong only because of the in-state service address requirement, which established a physical in-state location associated with the telephone calls. While Goldberg does provide some grace as to apportionment in light of technological limitations of administration, an assumption that all sales are made into a particular state unless the seller can prove otherwise probably stretches that grace too far.

One possibility is mandatory registration of cryptocurrency wallets. The ownership and use of cryptocurrency involves two codes: the public key and the private key. “The public key, a lengthy set of numbers and letters,” can be thought of as an “address to which the cryptocurrency unit” will be transferred. The private key, which is also a mathematical code, acts as a “signature” to validate the transfer. Keys are associated with individual cryptocurrency wallets, which store the mathematical codes on behalf of the cryptocurrency users. Wallets can be hardware-based or software-based, and software-based wallets can exist on the user’s local computer, on virtual web platforms, or even on tangible media with a QR Code.

Requiring residents to register their wallets may be justified under state money transmitter or anti-counterfeiting laws. Most notably, New York has already required virtual wallet providers (among other cryptocurrency service providers) to register and obtain a state license. This could give states the ability to connect specific transactions (via the public key and wallet) to individual cryptocurrency users to assess use tax on any uncollected sales tax. However, the registration of a digital wallet reduces the privacy of purchases since the public ledger can be viewed.

Alternatively, states could attempt to shift the administrative burden of verifying buyer addresses to the out-of-state seller, as sellers are in a better position, compared to states, to collect the required information. Key information the collection of which could be mandated includes the buyer’s city, state, and zip code.

However, enforcement of these requirements could be problematic. A state could not forbid out-of-state sellers from accepting cryptocurrency from in-state residents without implicating the Complete Auto nondiscrimination prong. Furthermore, there is no guarantee that buyers would be honest in their address reporting, and the rise of virtual private networks complicates the tracking of internet protocol addresses. In fact, the anonymity of cryptocurrency is among the primary draws for use.

VII. Conclusion

In considering state taxation of cryptocurrency-involved commercial transactions, the most striking observation is how little states have addressed the emerging technology. The authors anticipate that this will change as state legislative efforts have accelerated in recent years despite the relative lack of statutory adoption. Practitioners should likewise be mindful of the evolving cryptocurrency regulatory landscape in advising clients as to potential tax liabilities from commercial use.

As cryptocurrencies become more widely used in commerce, state legislatures should consider the unique tax aspects of the digital assets. Developing a method to establish constitutional nexus is a key consideration given the anonymity associated with cryptocurrency. Partnerships among the states and with federal tax enforcement agencies will help with the identification of users of cryptocurrency. In the absence of more explicit statutory direction, cryptocurrencies will persist as the metaphorical square peg jammed into the round hole of state taxation.

    Authors