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Startup Central

Navigating the Form 1040 Digital Asset Question: A Guide for Startups

Promise Legal Staff

• 3 min read
Navigating the Form 1040 Digital Asset Question: A Guide for Startups

As digital assets become more mainstream, the IRS’s annual Form 1040 now opens with a pointed question about your crypto activity. For startup founders, attorneys, and finance teams, understanding when—and how—to answer this question is crucial. This guide walks you through the history, wording, and reporting requirements, and offers best practices to keep your startup compliant.

1. Background

History of the Virtual Currency Question (2020–2023)

In 2020, the IRS debuted a question on virtual currencies to capture unreported crypto income. Early versions used the term “virtual currency,” reflecting industry jargon at the time. Over subsequent years, the question was refined for clarity, and in 2023 the IRS officially replaced “virtual currency” with the broader term “digital asset.”

Global Classification of Digital Assets

Beyond U.S. tax forms, international bodies are also adapting. The IMF’s BPM7 now categorizes digital assets into:

  • Fungible Tokens like Bitcoin and Ethereum (interchangeable units)
  • Non-Fungible Tokens (NFTs) such as digital art or collectibles
  • Assets with Liabilities like stablecoins pegged to traditional assets
  • Platform-Based Tokens that represent “equity-like” interests across borders

This global framework underscores the growing importance of consistent terminology—hence the IRS’s shift to “digital asset.”

2. Question Wording on Form 1040

At the top of Forms 1040, 1040-SR, and 1040-NR you’ll find the question (wording varies slightly by year):

At any time during the tax year, did you: (a) receive (as a reward, award or payment for property or services); or (b) sell, exchange, or otherwise dispose of a digital asset (or a financial interest in a digital asset)?

By placing this question first, the IRS signals the priority of digital asset reporting.

3. When to Answer “No”

  • Buy and Hold: You only purchased or held crypto without any disposition or receipt of new coins.
  • Internal Transfers: You moved assets between wallets you control, without triggering on-chain fees denominated in crypto.

If neither condition applies, answer “No” and proceed. Otherwise, you must check “Yes” and prepare to report.

4. When to Answer “Yes”

Answer “Yes” if you engaged in any of the following during the year:

  • Received crypto as payment for goods, services, rewards, or bounties
  • Sold, exchanged, gifted, or paid with crypto (including transaction fees paid in crypto)
  • Earned crypto through mining, staking, liquidity rewards, or airdrops
  • Received tokens from a hard fork or platform split
  • Held a financial interest in another party’s digital asset (e.g., custodial or pooled accounts)

5. How to Determine Your Answer

To avoid guesswork, follow this step-by-step flow:

  1. Review your wallet and exchange statements for incoming and outgoing crypto transactions.
  2. Identify any receipts of new tokens (airdrops, staking rewards, hard forks).
  3. Check whether you paid any network fees in crypto (a taxable disposition).
  4. If any activity above applies, answer “Yes.” Otherwise, “No.”

Note: The IRS plans a Feb 2025 questionnaire update with more examples to guide taxpayers.

6. Reporting Requirements for Crypto Transactions

If you answered “Yes,” prepare to report your digital asset transactions:

  • Recordkeeping: Track dates of acquisition and disposal, units transacted, fair market value (FMV) in USD, cost basis, and transaction details.
  • Forms:
  • Gain/Loss Calculation: Short-term (≤1 year) gains taxed as ordinary income; long-term (>1 year) at preferential rates.

7. Common Pitfalls & Best Practices

Common Pitfalls

  • Missing Small Transactions: Even buying coffee with crypto is a disposition.
  • Unreported Airdrops or Fork Tokens: All token receipts are taxable income when received.
  • Ignoring Fees: Network fees paid in crypto reduce basis and may trigger taxable events.

Best Practices

  • Maintain a Detailed Ledger of every crypto transaction, including off-chain events.
  • Use Tracking Software like CoinTracker, Koinly, or TokenTax to automate reporting.
  • Stay Updated on IRS guidance via the IRS Digital Assets portal.

8. Implications for Startups

  • Token Grants & Employee Compensation: If you issue tokens as part of pay packages, report their FMV as compensation income when vested or transferred.
  • Crypto Fundraising: Accepting investment in digital assets triggers valuation and accounting challenges. Perform AML/KYC diligence to avoid regulatory scrutiny.
  • Accounting & Valuation: Traditional financial frameworks may not accommodate tokenized transactions; refer to the AICPA practice aid for guidance.
  • Client Advising: Lawyers and advisors should document crypto policies, employee communications, and board approvals to support tax positions.

9. Recent IRS Guidance & Resources

  • IR-2023-12: Reminder to report all digital asset income on 2022 returns (link).
  • IR-2024-18: Updates on virtual currency regulations.
  • FAQs on Virtual Currency Transactions: Expanded examples under Notice 2014-21 (link).
  • Publication 544 (Sales & Exchanges) and Publication 525 (Taxable Income) (link).
  • Notice 2014-21: Foundational guidance treating crypto as property (link).

10. Conclusion & Action Steps

  • Conduct a Transaction Audit before filing to identify all disposals and receipts.
  • Implement Robust Recordkeeping and crypto tax software for ongoing compliance.
  • Seek Specialized Advice from crypto-savvy tax professionals or attorneys to navigate complex scenarios.

By staying informed and proactive, startups can confidently answer the Form 1040 digital asset question and maintain tax compliance in an evolving digital economy.