Contractor vs. Employee: How the IRS Decides — and What Happens If You Get It Wrong

Home Bookkeeping Crypto Tax Payroll About Resources Blog Contact Client Portal Get Started ☰ ☰ Home› Blog› Contractor vs. Employee: How the IRS Decides — and What Happens If You Get It Wrong Small Business Contractor vs. Employee: How the IRS Decides — and What Happens If You Get It Wrong By Jamie Waters, QuickBooks Advanced ProAdvisor & Crypto Tax Specialist • August 2025 • 10 min read Calling someone a 1099 contractor doesn’t make them one. The IRS uses a multi-factor test that looks at control, financial arrangement, and the nature of the relationship — and misclassification has real consequences. Why This Matters: The IRS Takes Misclassification Seriously When you misclassify an employee as an independent contractor, you avoid payroll taxes — employer Social Security, Medicare, and FUTA. The IRS knows this and specifically audits for it. If the IRS reclassifies your 1099 workers as employees, you can owe back payroll taxes, interest, and penalties going back three years — or six if the IRS finds the misclassification was intentional. The Department of Labor also enforces misclassification rules independently, with separate penalties and back-wage requirements under the Fair Labor Standards Act. This is not a gray area where “everyone does it.” It’s one of the IRS’s most productive audit targets. The IRS Common Law Test The IRS uses a multi-factor analysis based on three broad categories of control: 1. Behavioral Control Does the company control how the worker does the job — not just the result, but the method? Does the company provide training on how to do the work? (Employee indicator) Does the company dictate when, where, and how the work is done? (Employee indicator) Does the worker use their own methods and tools? (Contractor indicator) 2. Financial Control Does the company control the business aspects of the worker’s job? Is the worker paid a fixed wage or salary regardless of hours? (Employee indicator) Does the company reimburse expenses? (Employee indicator) Does the worker have a significant investment in their own tools/facilities? (Contractor indicator) Can the worker profit or lose money based on how they manage the work? (Contractor indicator) Does the worker offer services to the general market? (Contractor indicator) 3. Type of Relationship Is there a written contract? (Contractor language helps but doesn’t control) Does the company provide employee benefits (insurance, pension, vacation pay)? (Employee indicator) Is the relationship permanent or indefinite? (Employee indicator) Is the work a key aspect of the company’s regular business? (Employee indicator) The contract doesn’t control the classification. Calling someone a “1099 contractor” in an agreement doesn’t make them one. The IRS looks at the actual working relationship, not the label. The ABC Test (Used by Many States) Many states — including Washington — use a stricter standard called the ABC test, particularly for wage and hour purposes. Under this test, a worker is an employee unless ALL THREE of the following are true: A: The worker is free from control and direction in performing the work B: The work is performed outside the usual course of the hiring business, or outside all places of business C: The worker is customarily engaged in an independently established trade, occupation, or business Washington state uses the ABC test for purposes of the Washington Industrial Insurance Act (workers’ comp) and unemployment insurance. If a worker fails any prong, they are an employee for state purposes — even if the IRS would classify them as a contractor. Real-World Scenarios Situation Likely Classification Why Graphic designer who works for multiple clients, sets their own hours, uses their own equipment Contractor Passes behavioral, financial, relationship tests Full-time worker doing the company’s core work, on a set schedule, with company tools — paid via 1099 Employee Control over method and schedule, integral to business IT consultant on a 6-month project, works with other clients, invoices by the hour Probably contractor Defined scope, independent operation — but check state rules Delivery driver classified as contractor by gig platform Contested — state-dependent Many states are reclassifying gig workers under ABC test If You’re Already Misclassifying: Section 530 Relief If you’ve been misclassifying workers but can show you had a reasonable basis for doing so (industry practice, a prior IRS audit that didn’t raise the issue, or a court case), you may qualify for Section 530 relief — which allows you to avoid back payroll taxes even if the workers are reclassified. The conditions are specific and the documentation requirements are strict. The Bookkeeping Angle Misclassification has bookkeeping consequences beyond the payroll tax exposure. If workers are reclassified, their compensation moves from “contract labor” (Schedule C expense) to “payroll” — a different line with different tax treatment, different reporting, and different accounts on the balance sheet (payroll liabilities). If you have 1099 contractors who should be employees, this affects your P&L, your balance sheet, your payroll tax deposits, and your state reporting. It’s also worth noting: if you’re paying people as contractors who should be employees, your books likely aren’t set up to track payroll liabilities correctly. That’s something a Bookkeeping Diagnostic will catch. $500 FLAT Not Sure How Your Workers Should Be Classified? A Bookkeeping Diagnostic reviews how you’re recording contractor and payroll expenses — and flags anything that looks like it could create exposure. We don’t give legal advice, but we know what the IRS looks for. Get My Bookkeeping Diagnostic Not sure where to start? A $500 diagnostic gives you a clear picture of what’s wrong and exactly how to fix it. Get the $500 Diagnostic Our Services Monthly Bookkeeping Catch-Up & Cleanup Crypto Tax Reconciliation Payroll Bookkeeping Diagnostic $500 Crypto Diagnostic $500 Free Resources Monthly Bookkeeping Checklist Crypto Tax Prep Checklist QBO Setup Checklist Mileage & Expense Tracker More from the Blog Bookkeeping Behind on Your Books? Here’s What Catch-Up Looks Like What the cleanup process actually involves and how long it takes. Bookkeeping How to Know If Your Books Are Actually Reconciled There’s a big difference between entered and reconciled. Bookkeeping The Right Way to

FTX, Celsius, and Crypto Exchange Bankruptcies: How to Handle the Tax Treatment

Home Bookkeeping Crypto Tax Payroll About Resources Blog Client Portal Contact Us ☰ Home› Blog› FTX, Celsius, and Crypto Exchange Bankruptcies: How to Handle the Tax Treatment Crypto Tax FTX, Celsius, and Crypto Exchange Bankruptcies: How to Handle the Tax Treatment By Jamie Waters, QuickBooks Advanced ProAdvisor & Crypto Tax Specialist • July 2025 • 10 min read Lost assets on FTX, Celsius, BlockFi, or Voyager? The IRS hasn’t issued specific guidance, but existing tax law gives you options. Here’s how the three main theories work — and what documentation you need. The Core Tax Question: When Is a Loss Actually a Loss? For FTX, Celsius, BlockFi, Voyager, and similar bankruptcies, the threshold question is: when do you get to recognize the loss? The IRS has not issued specific guidance on crypto exchange bankruptcies, so practitioners apply existing tax law — specifically the rules governing worthless securities, theft losses, and bad debts. The answer depends on which theory applies to your situation — and that depends on what you had on the platform (securities vs. loans vs. custody assets) and when you’re filing. Three Legal Theories, Three Different Results Theory 1: Worthless Securities (IRC § 165(g)) If your crypto was held in an account structured as a security, you can claim a capital loss in the year the security becomes worthless. The challenge: most crypto held on centralized exchanges is not a security — it’s either a loan to the platform or held in custody. The exception may apply to equity tokens or certain lending products. Theory 2: Theft Loss (IRC § 165(c)(3), Rev. Rul. 2009-9) If the exchange’s collapse involved fraud — and FTX clearly did — you may qualify for a theft loss under IRC § 165(c)(3). However, the Tax Cuts and Jobs Act of 2017 suspended most personal theft losses through 2025. The exception is Ponzi scheme losses under Rev. Rul. 2009-9 and Rev. Proc. 2009-20, which remain deductible as ordinary losses. Whether FTX qualifies as a Ponzi scheme for this purpose is a factual and legal question. There is significant practitioner consensus that it does, given the findings in the criminal case. This is an area where you want your CPA to make a documented, defensible determination — not an assumption. Audit risk: High. Theft loss claims — especially large ones — draw IRS scrutiny. Documentation is critical. Theory 3: Bad Debt (IRC § 166) If your crypto was loaned to the platform (which is how most exchange deposits are legally structured), the loss may be treated as a bad debt — specifically a non-business bad debt, which results in a short-term capital loss, deductible only against capital gains plus $3,000/year. What About Bankruptcy Distributions? When you receive a distribution from a bankruptcy estate, you have a realization event. The amount distributed is treated as proceeds. Your cost basis is what you paid for the assets originally (or what you reported as income if you received them through staking, mining, etc.). Example: You had 1 ETH on Celsius, cost basis $2,000. Celsius distributes assets worth $800 equivalent. Proceeds: $800 Basis: $2,000 Capital loss: $1,200 (character depends on holding period) If you already claimed a loss in a prior year under a theft loss or worthlessness theory, and you then receive a distribution, you may have to recognize income on the recovery. This is the “tax benefit rule” under IRC § 111. Watch out: If you claimed a loss in 2022 and received an FTX distribution in 2024, you may owe tax on the recovery amount. This is one of the most common errors we see in amended returns. Year-by-Year Timing: What to Do When Event Year to Recognize Treatment Platform freezes withdrawals Not yet — still open question No loss recognized until determinable Platform files bankruptcy Potentially — depends on theory Document everything; consult CPA You receive a distribution Year of distribution Proceeds of sale; recognize gain/loss Claim is fully settled (or abandoned) Year of settlement Remaining loss recognized Documentation: What the IRS Will Want to See If you’re claiming any kind of loss related to a crypto exchange failure, document: Account statements showing your balance at the time of freeze/bankruptcy Cost basis records for the assets (purchase dates, prices paid) Your claim filed with the bankruptcy court (if applicable) Any distributions received and their reported value The legal theory your CPA used and why it applies to your situation This documentation needs to survive an IRS examination. “I lost money on FTX” is not a defensible tax position. The theory, the calculation, and the records all matter. In Koinly / CoinTracker: How to Record This Most crypto tax software doesn’t handle bankruptcy scenarios cleanly. The most common approach: Mark the frozen assets as a “lost” or “stolen” transaction at the date of the triggering event When you receive a distribution, import it as a separate acquisition at the distribution value Reconcile the net gain/loss manually if the software doesn’t support bankruptcy workflows natively We’ve processed FTX, Celsius, BlockFi, and Voyager scenarios across Koinly, CoinTracker, CoinLedger, and ZenLedger. The workflows differ and the default handling in most platforms is wrong — it needs to be overridden manually. $500 FLAT Had Assets on FTX, Celsius, or Another Failed Exchange? Our Crypto Tax Diagnostic reviews your transaction history, identifies what you had on affected platforms, and tells you exactly how the losses should be reported — including which theory applies and what documentation you need. Get My Crypto Tax Diagnostic Not sure where to start? A $500 diagnostic gives you a clear picture of what’s wrong and exactly how to fix it. Get the $500 Diagnostic Our Services Monthly Bookkeeping Catch-Up & Cleanup Crypto Tax Reconciliation Payroll Bookkeeping Diagnostic $500 Crypto Diagnostic $500 Free Resources Monthly Bookkeeping Checklist Crypto Tax Prep Checklist QBO Setup Checklist Mileage & Expense Tracker More from the Blog Crypto Tax FIFO, HIFO, or Spec ID: Which Method Saves You the Most? Your cost basis method determines how much tax you owe on

Are Staking Rewards Taxable Income? What the IRS Actually Says

Home Bookkeeping Crypto Tax Payroll About Resources Blog Client Portal Contact Us ☰ Home› Blog› Are Staking Rewards Taxable Income? What the IRS Actually Says Crypto Tax Are Staking Rewards Taxable Income? What the IRS Actually Says By Jamie Waters, QuickBooks Advanced ProAdvisor & Crypto Tax Specialist • June 2025 • 10 min read Rev. Rul. 2023-14 settled it for most practitioners: staking rewards are ordinary income at receipt. Here’s what that means for your tax return — and what it doesn’t. What Does the IRS Say About Staking Rewards? The IRS settled this question — at least officially — in Revenue Ruling 2023-14. Staking rewards are ordinary income in the year you receive them. The amount of income is the fair market value of the tokens at the time of receipt. This mirrors the treatment of mining rewards established in IRS Notice 2014-21. The IRS has consistently treated newly created crypto — whether mined or staked — as income at receipt, not at sale. Rev. Rul. 2023-14: Taxpayers who stake cryptocurrency and receive rewards must include those rewards in gross income at their fair market value on the date of receipt. What About the Jarrett Case? You may have heard about Joshua Jarrett, who argued that staking rewards are newly created property — not income — and therefore not taxable until sold. The IRS initially issued a refund to settle the case, then tried to reclaim it. The Sixth Circuit ultimately ruled against the IRS’s attempt to force the refund back. Here’s the practical reality: the IRS issued Rev. Rul. 2023-14 after this litigation specifically to clarify its position. The ruling applies nationwide regardless of the Jarrett outcome. Unless you are prepared to litigate your own case in federal court, staking rewards are taxable income at receipt. Audit risk of not reporting staking income: High. The IRS receives 1099-MISC from Coinbase and other exchanges for rewards above $600. How Staking Income Is Calculated Your taxable income from staking equals: quantity of tokens received × fair market value per token at time of receipt. This creates a cost basis in those tokens equal to the income you recognized. When you later sell, swap, or spend them, you calculate capital gain or loss using that cost basis — the difference between what you reported as income and what you sold for. Staking Rewards: Ordinary Income vs. Capital Gains Event Tax Treatment Rate Receiving staking rewards Ordinary income Your marginal rate Selling staking rewards (held < 1 year) Short-term capital gain Your marginal rate Selling staking rewards (held > 1 year) Long-term capital gain 0%, 15%, or 20% What About Liquid Staking (stETH, cbETH, etc.)? Liquid staking tokens add another layer. When you stake ETH and receive stETH, two questions arise: (1) is the receipt of stETH a taxable exchange of ETH? (2) are the rebase rewards that accrue to stETH taxable income? The IRS has not issued specific guidance on liquid staking tokens as of mid-2025. Most practitioners treat the initial exchange of ETH for stETH as a taxable disposition and the rebases as ordinary income at receipt, consistent with Rev. Rul. 2023-14. This is the conservative, audit-safe approach. DeFi Yield: Same Rules, More Complexity Yield farming, liquidity mining, and DeFi lending rewards follow the same framework as staking: income at receipt, at fair market value. The complications are practical: Rewards may accrue continuously, requiring you to track FMV at each distribution Some protocols pay in new tokens that have no liquid market at issuance — creating valuation questions Providing liquidity to AMMs (Uniswap, Curve, etc.) may trigger a taxable exchange when you deposit or withdraw Impermanent loss is generally not a deductible loss until you actually withdraw from the pool How to Track Staking and DeFi Income Most crypto tax software can handle staking rewards if your data is complete. The problem is completeness. Exchanges often don’t export reward history accurately, on-chain rewards from DeFi protocols require manual import or API integration, and some rewards appear as token transfers rather than clearly labeled income events. We work with Koinly, CoinTracker, CoinLedger, ZenLedger, Awaken Tax, and Summ. If you have multi-protocol DeFi activity, we can identify what your software is missing and reconcile the gaps. $500 FLAT DeFi or Staking Rewards You’re Not Sure How to Report? Our Crypto Tax Diagnostic audits your transaction history across wallets and protocols — including staking, yield farming, and liquid staking — and tells you exactly where your tax exposure stands. Get My Crypto Tax Diagnostic Not sure where to start? A $500 diagnostic gives you a clear picture of what’s wrong and exactly how to fix it. Get the $500 Diagnostic Our Services Monthly Bookkeeping Catch-Up & Cleanup Crypto Tax Reconciliation Payroll Bookkeeping Diagnostic $500 Crypto Diagnostic $500 Free Resources Monthly Bookkeeping Checklist Crypto Tax Prep Checklist QBO Setup Checklist Mileage & Expense Tracker More from the Blog Crypto Tax FIFO, HIFO, or Spec ID: Which Method Saves You the Most? Your cost basis method determines how much tax you owe on every crypto sale. Crypto Tax FTX and Celsius Bankruptcy: How to Handle the Tax Treatment Bankruptcy distributions, frozen assets, and how to document losses correctly. Bookkeeping How to Know If Your Books Are Actually Reconciled There’s a big difference between entered and reconciled. Credentials & Recognition Bugaboo Bookkeeping LLC 2001 West 6th StAberdeen, WA 98520 253-353-2040 info@bugaboobookkeeping.com Services Bookkeeping Crypto Tax Payroll Bookkeeping Diagnostic — $500 Crypto Diagnostic — $500 Company About Resources Blog Contact Client Portal Schedule a Call Serving clients nationwide Remote. Async. Cloud-based. QuickBooks Advanced ProAdvisorTop 100 ProAdvisor 2025Top CAS Accounting ProAdvisor of the Year 2025 © 2026 Bugaboo Bookkeeping LLC. All rights reserved. | Privacy Policy | Bookkeeping and tax preparation services. Not legal advice.

FIFO, HIFO, or Spec ID: Which Crypto Cost Basis Method Saves You the Most?

Home Bookkeeping Crypto Tax Payroll About Resources Blog Client Portal Contact Us ☰ Home› Blog› FIFO, HIFO, or Spec ID: Which Crypto Cost Basis Method Saves You the Most in Taxes? Crypto Tax FIFO, HIFO, or Spec ID: Which Crypto Cost Basis Method Saves You the Most in Taxes? By Jamie Waters, QuickBooks Advanced ProAdvisor & Crypto Tax Specialist • May 2025 • 10 min read Your cost basis method determines how much tax you owe on every crypto sale — and most investors never change it from the default. Here’s how FIFO, HIFO, and Specific Identification actually work, when each one wins, and what the IRS requires you to document if you switch. Most crypto investors are assigned FIFO (First In, First Out) by default and never think about it again. That default decision can cost thousands of dollars in unnecessary taxes every single year. Here’s how the three main cost basis methods actually work, when each one makes sense, and what the IRS requires you to do if you want to switch. What Is a Cost Basis Method? When you sell cryptocurrency, your taxable gain is the difference between your sale price and your cost basis — what you originally paid for the coins you’re selling. If you’ve bought the same coin at different prices over time, you need a rule for determining which coins you’re selling. That rule is your cost basis method. The IRS allows several methods for cryptocurrency. The most common are FIFO, HIFO, and Specific Identification. Each produces a different taxable gain — sometimes dramatically different. FIFO: First In, First Out Under FIFO, the first coins you bought are treated as the first coins you sell. This is the IRS default if you don’t specify otherwise. When FIFO works in your favor: If the crypto market has gone down since your earliest purchases, FIFO lets you realize a loss on those early high-cost coins. Also, if your oldest holdings are long-term (held over one year), FIFO gives you access to the lower long-term capital gains tax rates. When FIFO hurts you: In a bull market, your oldest coins likely have the lowest cost basis and the largest gain. Selling those first maximizes your taxable gain when you’d rather sell higher-cost, shorter-term lots instead. HIFO: Highest In, First Out Under HIFO, the coins with the highest cost basis are treated as sold first. This minimizes your taxable gain in almost all market conditions because you’re always selling the lots where you paid the most. When HIFO makes sense: HIFO is typically the best choice for tax minimization in active trading situations, especially when you have a mix of purchase prices and markets have risen. It consistently produces the smallest short-term gain (or largest loss) on each sale. The catch: HIFO is a form of Specific Identification, which means it requires per-lot tracking and adequate identification. You must be able to document which specific lots you’re selling at the time of the sale. Broad-based HIFO without that documentation is not permitted by the IRS. Specific Identification (Spec ID) Specific Identification lets you choose exactly which lots you’re selling — not based on a rule, but based on your strategic selection. You might sell the lot that creates a long-term gain to access the lower tax rate, or sell a high-cost lot to minimize gain, or harvest a specific loss to offset gains elsewhere. This is the most flexible method and the most powerful tax planning tool. It’s also the most documentation-intensive. IRS requirements for Spec ID: Per IRS guidance (Rev. Proc. 2024-28 and prior guidance), you must be able to demonstrate that you: Specifically identified the unit being sold at the time of the transaction Have records showing the acquisition date, acquisition price, and the specific unit (lot) sold Maintained that documentation contemporaneously — not reconstructed after the fact Rev. Proc. 2024-28 update: For tax years beginning January 1, 2025 and after, taxpayers must use wallet-by-wallet and account-by-account cost basis tracking rather than universal tracking across all wallets. This is a major change that affects how Spec ID and HIFO are applied in crypto tax software. Side-by-Side Comparison Method Best For Documentation Required Tax Impact FIFO Long-term holders; declining markets Minimal — IRS default Can be high in bull markets HIFO Active traders minimizing gains Per-lot records required Lowest short-term gains Spec ID Strategic tax planning Per-transaction lot selection Most flexible Can You Switch Methods? Yes — but not retroactively, and not mid-year for the same wallet. Under Rev. Proc. 2024-28, you can change your cost basis method going forward, but you must do so before January 1, 2025 for the new per-wallet rules to apply cleanly. If you’re switching methods now, document the election clearly and ensure your crypto tax software supports the change. One important note: you generally cannot use FIFO for one exchange and HIFO for another within the same tax year unless you’re using a consistent Spec ID approach. The IRS expects consistency. What Your Crypto Tax Software Actually Does Tools like Koinly, CoinTracker, CoinLedger, and ZenLedger all support multiple cost basis methods — but they don’t all implement them identically. Before relying on any software’s output, you need to verify: Which method is selected for each wallet/exchange Whether the software is applying per-wallet tracking (required post-2024) Whether DeFi transactions, staking rewards, and bridge transfers are handled correctly Whether lost or dormant wallet transactions are accounted for We’ve reviewed thousands of crypto tax reports and the single most common error is the wrong cost basis method being applied silently — often defaulting back to FIFO after a software import or account merge. The Bottom Line Your cost basis method is one of the highest-leverage decisions in crypto tax planning. FIFO is the default, but it’s rarely optimal for active traders. HIFO and Spec ID can save thousands — if you have the records to support them. If you’re not sure which method is applied to your portfolio, or if you’ve never