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Airdrop tax: Turning lemons into lemonade

How to make the most out of an airdrop tax liability

On the occasion of the latest $DEGEN airdrop, let's talk about taxes. People are celebrating their substantial airdrops they have received, but the taxman is celebrating also and wants his share. So let me give you a few suggestions on how to make the best of the situation. I recommend you read until the end. There will be a twist that I bet most readers are not aware of, and that can be worth a lot of money. I will explain how you can leverage your tax obligation into making tax-free investments in crypto.

First a few disclaimers: This post is US centric. If you're not paying taxes in the US you can stop reading now. And also, I am not a licensed tax adviser or CPA. Don't take anything I write here as tax advice. Everything I say may be wrong. I'm just giving you some suggestions for things to look into and discuss with your tax adviser or accountant. In case of doubt, read the relevant tax law or IRS guidance.

With these disclaimers out of the way, let's start with how the IRS sees airdrops. They see it as income, which you have to declare on your tax return and have to pay ordinary income tax on. Depending on your tax bracket, as of this writing, this could be up to 37% percent in federal tax, plus whatever tax your state demands. California adds another 14.4% in the highest bracket, so if you live in California and make a good income in your day job then over half of your airdop proceeds will go to taxes.

Importantly, the tax bill has to be calculated on the price of the token on the day you claim the airdrop. So, if you claim the token and hold, and then the token price collapses, you will still have to pay the tax bill as if the token had the original value. People have gotten into serious trouble over this, owing way more in taxes than they have liquid capital available. So, before you do anything else, consider whether you have funds set aside to cover this tax liability. If the airdrop amounts to a lot of money compared to the cash you typically have access to then immediately sell enough to offset your tax liability, ideally into USDC so you don't incur any additional taxable events swapping crypto, send the cash to your bank, and then put it into a money market account with 5% interest. In this way, once the tax bill comes due, you'll have the funds at the ready and it won't cause you any headaches. If the airdrop is very substantial you may also have to pay estimated taxes. Here I won't go into this topic, but you should look it up.

Next, you have to think about how you will report this income, as Other Income or as Self Employment. Self Employment incurs an additional tax, but it comes with other perks that are worth it, so I would always try to go the self-employment route if appropriate. You can do this if your business activity is "regular, frequent, and continuous." If you've only got a single airdrop over an entire year then that is probably not the case, but if you routinely farm airdrops and claim $DEGEN every month and maybe do some other things that generate ordinary income then you may very well be able to claim self-employment. I found a good article about the case law in the Journal of Accountancy. And there is also an official IRS publication that compiles all the relevant information for self-employed individuals.

I have heard, but am not sure how true this is, that the IRS is more likely to question income reported as Other Income than as Self Employment. They are concerned about people skirting self-employment tax. In fact, my tax software once gave me a warning that I had too much Other Income reported and that I was going to get audited with this return. I think that if there is any regularity to your activity it's generally safer to claim self-employment.

For the remainder of this post, let's assume you can claim self-employment. This will definitely be the case for any artist or creator who regularly puts out content, receives tips as well as sells NFTs etc., and just generally is generating income on an ongoing basis. (It doesn't have to be a lot of income, it just has to be regular.) I said this comes with perks, so let's discuss the perks. The first perk is the deduction of business expenses. If you're self-employed, you can deduct your business expenses. The IRS writes:

To be deductible, a business expense must be both ordinary and necessary. An ordinary expense is one that is common and accepted in your field of business. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary.

Business expenses are a complicated topic, and people can get (overly) creative in what they deduct and can get in trouble for this, but there are many expenses that you should definitely consider deducting. For example, any expenses you incurred for tax preparation. Do you have to buy the full-service package of TurboTax because your business taxes have gotten complicated? It's a deductible expense next year. Do you need to pay for Koinly to calculate your crypto taxes? Also a deductible expense. And don't forget about gas fees. Did you pay $100 in Ethereum gas to swap your airdrop into USDC and transfer to an exchange? Deductible expense. This is a vast topic and I don't want to go into it in more detail, but it's worth exploring and possibly discussing with a professional tax adviser.

Now the second perk, which I think is even better than the first: A SEP (Simplified Employee Pension) retirement plan. If you are self-employed, you can open a SEP and make contributions to it that you can deduct from your business income. The calculation of how much you can contribute is a bit complicated, and I'll refer you to the relevant IRS documents for detail, but it comes out to roughly 20% of your business income minus expenses or $66k (in 2023), whichever is less. The exact rule is "as much as 25% of your net earnings from self-employment" but those exclude your contribution to the SEP so the calculation is circular. I prefer to think of it as roughly 20% of your income before the SEP contribution. It's important to stay under the limit because if you over-contribute you can create a massive headache for yourself when you have to unwind this position and have to pay taxes on any gains you've made in the interim.

The SEP comes with two perks. First, you won't have to pay any taxes on the airdrop income you contribute to your SEP, and then you also won't have to pay any taxes on gains or trades you make inside your SEP. You will only have to pay taxes once you start withdrawing funds, in retirement. This is a really good deal! If you had a $10k airdrop, you can take about $2k of that and invest into a retirement fund and have it grow tax free. This could ultimately be worth more than the other $8k of the airdrop.

If all the stated requirements apply to you, and you know you're ready to open a SEP, what SEP should you open? How about one where you can buy crypto and make gains and trades tax-free? Well, there are crypto IRAs, for example Alto IRA, where you can do exactly this! A crypto IRA allows you to buy BTC, ETH, and other cryptos and accumulate capital gains tax free. So, if you take the hypothetical $2k from my example, use them to buy blue-chip cryptos in a crypto IRA, and wait a few years, you may end up with a meaningful nest-egg that dwarfs the $8k on which you had to pay income tax. And at a minimum, your crypto investment has to only go up by 3x to compensate you for the taxes you paid on the remainder of the airdrop. (Assume you paid $4k in taxes on the $8k of income, then if your $2k retirement investment goes up by 3x to $6k you've made those taxes back.) I think that's very achievable, and it provides you with some very interesting optionality that you wouldn't have if you didn't have a tax liability from airdrops.

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