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Saturday, March 29, 2014

Guidance on taxation of virtual currency

There are tax consequences of mining bitcoin, investing in it or using it to buy or sell goods or services. Prior to the IRS release of Notice 2014-21 this week (3/25/14), we didn't know whether the IRS would treat a virtual currency as currency or property. The IRS has now said - treat it as property. [IRS Information Release IR-2014-36 and Notice 2014-21]

I think that is a good answer.  After all, Bitcoin and other virtual currencies are not used as the currency of any government and generally, are convertible to a currency of a government. For example, you can buy Bitcoin with U.S. dollars and convert it back to U.S. dollars.

So, what does it mean that Bitcoin and other convertible virtual currencies are property? Here are a few tax examples.  Note that these answers would be the same if you were instead using gold (or some other property people might take in exchange for transactions). In these examples, the affected taxpayer would need to use a currency converter.  Here is one example for Bitcoin.  There are others as well; we'll have to see if the IRS "endorses" one for Bitcoin and other virtual currencies.
  • If you mine bitcoin, you generate income equal to the value of the bitcoin when mined. And if you are doing this as a business, you'll also owe self-employment tax. [See Q&A 8 and 9 of Notice 2014-21]  If doing this as a business (and that might not always be easy to determine), how do you treat your related expenses? Given that the IRS is saying that you have income upon obtaining the "mined" currency, that is going to give you basis in that virtual currency equal to what you picked up in income. If you were instead "producing" the virtual currency your basis would be your costs and you'd have a gain when you sold it for more. So, it appears that you are taxed more like a service business (at least at this point in the process) so expenses should be deducted based on your overall method of accounting (rather than capitalized into the basis of the currency). Expenses related to "selling" the bitcoin should be expensed when incurred.  The miner also needs to determine if they can use the cash method of accounting or instead need to use the accrual method.
  • If you buy bitcoin so you can use it instead of dollars, you'll have some extra recordkeeping to handle. For example, you bought 1 Bitcoin (BTC) when it was worth $350. You later use half of that BTC to buy goods and at that time, 1 BTC is worth $400.  You have a $25 gain. A few months later, you use the remaining .5 BTC to buy goods and at the time, 1 BTC is worth $500, you will report a gain of $75.  One piece of good news though ... unless you are a dealer in bitcoin, this income should be capital gain income taxable at lower rates than ordinary income. The tax principle here is that if your wealth has increased and you cash out that wealth (realize it), you have income. When you can use something you paid $350 for to buy $450 of goods,  you have income of $100. This is the same result you'd have if you had converted the bitcoin back to dollars right before making the purchase of the goods in dollars. [See Q&A 6 and 7 of Notice 2014-21]
  • Your employer pays you in bitcoin. You'll have income equal to the value of the bitcoin on the day you receive it. And, yes, the employer will include this income in your W-2. Same answer if you are instead a contractor; it will be included in the Form 1099 your employer gives you. [See Q&A 10-14 of Notice 2014-21]
This guidance has been long awaited. Likely so much attention on bitcoin and the fact that thousands of vendors are taking it, led the IRS to finally issue guidance. Back in October 2006, the Joint Economic Committee of Congress issued a statement that it was studying taxation of virtual economies and currencies and would issue a report. The statement implied that taxes should not apply.  No report was issued. In May 2013, the Government Accountability Office (GAO) released a report on types of transactions involving virtual currency and the need for guidance on the tax issues (see my blog post of 8/29/13).  In 2014, the annual report to Congress issued by the IRS National Taxpayer Advocate (NTA) included a section on digital currency. Similar to the 2013 GAO report, it highlighted that tax considerations exist for some uses of virtual currencies and called for the IRS to issue guidance. 

The NTA report included data on the growth in the use of virtual currencies, thus increasing the need for guidance on the tax considerations. The report noted that in July 2013, there were 1,708 Bitcoin transactions per hour and the market value was $1.1 billion. By December 2013, there were just over 3,000 transactions per hour and the market value of the currency had grown to $12.6 billion.  The NTA's 2008 report to Congress included background on virtual economies and the need for guidance from the IRS.

There are still open issues for both the IRS and state tax agencies to address.  The IRS is seeking comments on additional issues.  Here are a few that come to mind for me:
  • Is mining of Bitcoin viewed as production of property or a service? That answer has a bearing on whether the related costs are added to the Bitcoin mined (as if part of the inventory) or expensed as paid or incurred (depending on your method of accounting). The issue here is that the property is intangible.
  • Will the IRS specify what exchange rate system it requires when there is more than one such converter?
  • When you buy Bitcoin or other virtual currency, will your state impose sale or use tax on it?
  • If a vendor sells services or digital goods to someone and accepts Bitcoin or other virtual currency as payment, will the vendor be required to report the transaction or ask for the customer's name and address?  These types of transactions can be concerns of tax agencies because they can go undetected.  The vendor needs to record it (using the Bitcoin value at the date of each transaction), but will the tax agency want more to help the customer with their Bitcoin gain/loss calculations and to help the tax agencies to even know that they occurred?
  • How will concerns of Treasury regarding illegal activities affect tax reporting? [see for example, remarks of David Cohen of Treasury on 3/18/14, and guidance issued 3/18/13]
What do you think? What other tax issues do you see?

1 comment:

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