Cryptocurrency mining is the process by which transactions are verified and added to the block chain. Anyone with access to the Internet and suitable hardware can participate in mining. The mining process involves compiling recent transactions into blocks and trying to solve a computationally difficult mathematical solution. The miner who solves the mathematical solution gets to place the next block on the block chain and claim the rewards, which are typically new releases crypto coins. The business of mining has become very attractive to many cryptocurrency investors.
In general, as per IRS Notice 2014-21, cryptocurrency mining activities would generate business income and not capital gains. Accordingly, if one uses a Self-Directed IRA or Solo 401(k) Plan to invest in a cryptocurrency mining operation, the income generated could be subject to the Unrelated Business Taxable Income tax (UBTI or UBIT), which can go as high as 37% in 2018. The reason for this is the IRS is treating the activity of mining cryptocurrency, or verifying cryptocurrency transactions on the blockchain, as akin to active services and not passive in nature, such as buying or selling cryptocurrencies, which would be subject to capital gains tax.
Tax Cuts & Jobs Act & Cryptocurrency Mining
One of the major elements of the 2017 Trump tax plan, which became known as the Tax Cuts & Jobs Act, was the reduction in the maximum corporate tax rate from 35% to 21%. The corporate tax reduction has been warmly received by corporate America. For retirement account investors looking to invest in cryptocurrency mining ventures, the maximum corporate tax rate reduction can also prove to be quite positive. However, under the new tax plan, an investor can have her Self-Directed IRA or Solo 401(k) Retirement Plan invest in a C corporation and use that C corporation to block the application of the Unrelated Business Taxable Income tax (UBTI) and reduce the liability from 37% to 21%. A C Corporation is able to block the application of the UBTI tax because a C Corporation is an entity that is subject to a corporate level tax and is not treated as a passthrough entity, such as an LLC. As a result, the C Corporation would be subject to corporate level tax on the mining activities and then all dividends would be sent to the shareholders. Whereas an LLC is not subject to any entity level tax at the Federal income tax level and the members (owners) are subject to the tax on the passthrough income. Therefore, since a C Corporation has already paid tax on the business income generated, the IRS will not require the shareholder to pay it as well. This is how a C Corporation shareholder that is an IRA or a 401(k) Plan can shield themselves from the application of the UBTI tax.
The “C Corp Blocker” strategy involves the retirement account holder establishing a C Corporation and then investing the retirement funds into the C Corporation before the funds are ultimately invested into the planned investment. For example, if a retirement account investor is seeking to invest retirement funds into a mining business operated through an LLC, she can establish a C Corporation, invest her IRA funds through the C Corporation, and then have the C Corporation invest the funds into the mining LLC. All income received by the C Corporation would be subject to the new reduced corporate tax rate of 21%, which is less than the 37% maximum UBTI tax rate and less than the old maximum corporate tax rate of 35%.
IRS prohibited Transaction Rules & Cryptocurrency Mining
The Internal Revenue Code does not describe what a Self-Directed IRA or Solo 401(k) Plan can invest in, only what it cannot invest in. Internal Revenue Code Sections 408 & 4975 prohibits “disqualified persons” from engaging in certain type of transactions. The definition of a “disqualified person” (Internal Revenue Code Section 4975(e)(2)) extends into a variety of related party scenarios, but generally includes the IRA holder, any ancestors or lineal descendants of the IRA holder, and entities in which the IRA holder holds a controlling equity or management interest. The purpose of these rules is to encourage the use of retirement accounts for accumulation of retirement savings and to prohibit those in control of retirement accounts from taking advantage of the tax benefits for their personal account.
Because cryptocurrency mining is so passive in nature and will likely not involve a “disqualified person”, much like buying stocks or mutual funds, Self-Directed IRA and Solo 401(k) Plan investors should be able to do so without triggering the IRS prohibited transaction rules pursuant to IRC 4975. However, the application of the UBTI tax could make it tax inefficient, which is why the C corporation blocker strategy has become so much more appealing after the passage of the Trump tax plan in December 2017.
Other than structuring the investment as a loan and not an equity investment, which would generate interest income not subject to the UBTI tax, an equity investment of retirement funds into an active mining business operated via an LLC will have some tax implications. However, employing a C Corp Blocker strategy can be helpful in blocking the UBTI tax from applying and minimizing the tax rate to a maximum tax rate of 21%, significantly less than the UBTI maximum tax rate of 37%.