If I were a freelance worker getting paid in cryptocurrency, would I have to claim my earnings as income? What if I never convert it to dollars?
You owe as if it converted immediately to USD.
When you are paid in other currencies - Euros, Bitcoin, gold, actual chickens - you are required to do an immediate valuation in USD at the contemporary exchange rate.
You must then record your income for that date as that value in USD. That is income at that time for all tax purposes.
It is better to do this contemporaneously. It can be a chore at tax time to "go back" and compute the conversion rate months ago.
This value is coined at the time, and is irrevocable regardless of what happens to the non-USD asset. IRS is only concerned with what would have happened if you had converted it to USD immediately. So if the chickens die, Bitcoin tanks, real estate parcel fails to clear environmental review, etc... too darn bad.
On March 13, Sue is paid 10 BTC. BTC trades for $10,000 on March 13. Sue records $100,000 income in the tax books. Sue holds the BTC.
Being self-employed, Sue must file quarterly tax payments on Form 1040-ES. Sue's tax for June 15 computes to $20,000 and must be paid, even if Sue doesn't have $20,000 and hasn't cashed out any of the BTC yet. IRS doesn't care about your cash flow.
This is the lament of every game show winner who wins valuable prizes and then discovers they must pay taxes in cash! So they often don't drive away with the new car, and instead take a comparable cash prize.
Sue's least bad option is often to "file honestly, but not pay" and eat the interest and penalties. This is not as awful as it sounds, and is a viable way to "take a short term loan" to cover your taxes. IRS doesn't break knee caps and never calls except by prearrangement... and even with penalties their interest rate may be better than credit cards. They are slow to action because most taxpayers sort it out themselves in a year. Just don't push it out for years...
However, by June 15, Bitcoin's value has tanked to $1000. Sue still owes tax on $100,000 income*. IRS doesn't care that Sue's investment didn't work out.
Scenario 1. Sue desperately sells the BTC to raise money for the taxes. (mistake). IRS considers this a "buy/sell" of a security, using the acquisition value as the cost basis. So Sue files a Schedule D. Purchased March 13 for $100,000 cost basis. Sold June 15 for $10,000 proceeds. This posts as a $90,000 capital loss which is tax deductible according to the rules for that.
BTC then recovers to $20,000 by the following April 1, because businessman Meelon Usque keeps tweeting about it.
Scenario 2: Sue didn't bother selling the BTC in June because it's worthless. However, now that it blew up, Sue sells the 10 BTC on April 1. Cost basis is $100,000 on March 13 last year, proceeds are $200,000 on April 1 next year. That is a $100,000 capital gain, and it posts on next year's taxes.
So in Scenario 2, Sue got $200,000 worth of Bitcoin. Paid tax on $100,000 of it last year (as salary at salary tax rates), and paid tax on the other $100,000 next year (as long term capital gains, since "staying in it" is treated as an investment.)
Might as well convert to USD on paycheck day
Note that if Sue had immediately sold the BTC back on March 13, took the $100,000 USD, and immediately bought $100,000 worth of BTC, that would be treated exactly the same by the IRS. Therefore, transaction costs and inertia aside, there is no tax reason to stay in the currency you are paid in. You might as well immediately convert to USD (since it's immediate, it doesn't count as an investment), then take the USD and select what YOU think is the best investment.
And while you're at it, you might as well take out what you'll need to pay your taxes. E.G. Sell the BTC immediately for $100,000, then buy $80,000 of VTI, GPB, Doge, chickens, or whatever your investment preference is.
For instance, if you choose an investment that makes sense to stay over a year in (e.g. VTI), you get to pay long-term capital gains instead of short-term.
An exception: fake income was never income in the first place
However, if you later discover the currency was fake at the time you were paid, e.g. gold was only gold-plated lead, etc. ... then you were never paid in the first place, and you retroactively delete that income from your accounting books, and amend your taxes accordingly.
* An arbitrary number based on other facts in Sue's life.
If I were a freelance worker getting paid in cryptocurrency, would I have to claim my earnings as income
Yes. There are people getting different kinds of payments as salary: car benefit, phone benefit, stock options, US dollars, even cryptocurrencies these days. All of these count as salary and you must pay taxes for them.
What if I never convert it to dollars?
If you never convert it to dollars, then the situation is probably far better if you consider the ultimate goal in life to minimize your taxes. The situation however is far worse if you consider the ultimate goal in life to maximize your wealth.
Firstly, you have to pay taxes for receiving the salary.
Secondly, you WILL observe cryptocurrencies to crash as they are the worst speculative bubble in existence today.
Thus, the crashing cryptocurrencies count as capital losses. If you happen to have any capital gains, most taxation systems let you subtract the capital losses from holding cryptocurrencies from the taxed amount.
So, you will suffer heavily (cryptocurrency crash), but hey, at least you get to pay less capital gains taxes from your other investments!
According to the IRS FAQ on Virtual Currency, you do need to pay taxes on this. See Question/answer #9:
Q9. Do I have income if I provide someone with a service and that person pays me with virtual currency?
A9. Yes. When you receive property, including virtual currency, in exchange for performing services, whether or not you perform the services as an employee, you recognize ordinary income. For more information on compensation for services, see Publication 525, Taxable and Nontaxable Income.
Also see Question/answer #13:
Q13. How do I determine my basis in virtual currency I receive for services I’ve provided?
A13. If, as part of an arm’s length transaction, you provided someone with services and received virtual currency in exchange, your basis in that virtual currency is the fair market value of the virtual currency, in U.S. dollars, when the virtual currency is received. For more information on basis, see Publication 551, Basis of Assets.
Publication 525 states, in part:
Virtual currency. If your employer gives you virtual currency (such as Bitcoin) as payment for your services, you must include the FMV of the currency in your income. The FMV of virtual currency paid as wages is subject to federal income tax withholding, Federal Insurance Contribution Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2. Notice 2014-21, 2014-16 I.R.B. 938, describes how virtual currency is treated for federal tax purposes and is available at IRS.gov/irb/2014-16_IRB#NOT-2014-21. For further information, see IRS.gov/virtualcurrency .
You should go to the current page each year to verify this has not changed, as virtual currency is a constantly evolving topic, and the IRS may publish new rules at any time on the matter.
Note that a freelance worker will have slightly different details on how reporting and in particular withholding works; however, Pub. 525 is the place to look in any event.