Bitcoin Taxation - Clarity and Mystery

GAO, Virtual Economies and Currencies (May 2013)

In March 2014, the IRS finally released important guidance on taxation of virtual currency, such as Bitcoin. The key point made in the guidance (Notice 2014-21) is that such currency should be treated as property rather than a foreign currency. That is helpful.  I blogged on that earlier (3/29/14) and I've got a short article in the AICPA Tax Insider (6/12/14) - Bitcoin taxation: Clarity and mystery.  In the article, I note the importance of these issues.  If you are a tax practitioner and don't think you need to deal with it, I'd be surprised if none of your clients uses bitcoin. In fact, a new standard question to ask of people you prepare returns for needs to be: Do you own or use a virtual currency, such as Bitcoin?   There are also a lot of dollars going into Bitcoin and other virtual currency start-ups - one could be your client.

There are still some significant issues for the IRS to address. I note several in the article.  A key one is how to track the use of the virtual currency so you can calculate the gain or loss and whether short-term or long-term, every time it is used. The IRS regulations on basis (section 1012) suggest use of FIFO, but that rule only addresses securities. Thus, the default is specific identification.  Does this mean you'd have to truly identify the bitcoin you used (if feasible - and that may depend on how you hold the bitcoin) or can you just identify on your own which bitcoin you think you used (and that would really need to be done at the time used, rather than when later filing your return).

Please see the article for other issues and activities. I've also got a webpage with links to tax and other information about virtual currency (including some primers on how these crypto-currencies work).

There are also some state tax issues (I'll have more on that later). In June 2014, the California Board of Equalization issued a notice to help retailers who use a virtual currency. There are state income tax questions about sourcing.

What do you think about the tax issues?

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?

Taxes and Virtual Currency

Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks, GAO-13-516, May 2013

There has been a lot of mention in recent news stories about Bitcoin. Reuters reported this week that the Treasury Department's financial crimes group (FinCEN) hosted a meeting with the Bitcoin Foundation ("Regulators, Bitcoin group discuss virtual currency," 8/26/13). USA Today reports that the Senate Homeland Security and Government Affairs Committee began investigating virtual currency a few months back and recently sent letters to some federal agencies to learn how they regulate such currencies ("Government eyes regulation of 'Bitcoins'" (8/26/13). There have also been recent stories about virtual currencies and Ponzi schemes and money laundering, which obviously leave negative connotations about these currencies although some, like the Bitcoin, are being used for legitimate business transactions.

What is "Bitcoin"? It is a means for transacting business that has its foundation in software code and enough people willing to use it as a medium of exchange. A March 2013 release from FinCEN stated the following regarding virtual currencies (such as Bitcoin): "In contrast to real currency, "virtual" currency is a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency does not have legal tender status in any jurisdiction."

There are a few well known virtual currencies including the Linden dollar in Second Life and Amazon coins. Virtual currencies vary in terms of where they are usable (only in the online game or website), whether they can be exchanged for real currency, and how they are created or obtained.

In May 2013, the GAO released a report about virtual economies and currencies and the need for guidance from the IRS on when their use may generate tax consequences.It provides a helpful background for understanding

I have a short article - "Real taxes in the virtual economy" (AICPA Tax Insider, 8/15/13) which provides additional background on virtual currencies, the GAO report, other government activities, and some of the tax issues. There are also website references to learn more about bitcoin and other virtual currencies.

How could there be any tax relevance you might ask? Well, what and when is the income tax effect of someone who "mines" Bitcoins? What about the costs they incur in obtaining Bitcoins? (An April 2013 BBC article noted high energy costs of performing the computer calculations needed to obtain new Bitcoins.)   If you use virtual currency to play games or buy and sell virtual goods and services and later convert the virtual currency to cash or other property with a value greater than the amount originally invested, you'll have income.

Please take a look at my article and the GAO report.

What do you think?  Do you or would you use a virtual currency rather than "real" currency?

GAO Report on Virtual Economies and Currencies - GAO conference call on June 19

This week, the GAO released a report on a lurking e-commerce taxation topic - Virtual Economies and Currencies - Additional IRS Guidance could Reduce Tax Compliance Risks, GAO-13-516 (May 2013).  

The topic might seem odd at first because "virtual" means the opposite of "real." Is there tax on unreal things? Yes, there can be, and there might be other tax issues as well. Here are a few that I've been noting in presentations for the past few years: 

• How and when do events and transactions in virtual worlds generate tax obligations? 
• Is any of the bartering for virtual items taxable? 
• Are virtual game players “in business”? 
• Are “virtual” items “property”?  If yes, how valued?
• Reporting obligations.  For example, PLR200532025 addresses 1099 filing for an operator of online game-playing tournaments 
• Location of transactions 
• Any foreign currency issues?

The report refers to "closed-flow" and "open-flow" arrangements. Closed-flow is like playing the game of Life (the Milton Bradley board game).  You may become a millionaire, but as long as it is all play money and you are not paid or able to exchange anything for real money, there are no tax consequences. In an open-flow arrangement, real money, goods or services enter the picture, as do tax consequences.

I'll have more on the report and topic later, but want to note that there is a conference call scheduled by GAO for June 19.  Per an email message I received from GAO: 

"On June 19, 2013, GAO Director Jim White will respond to questions about our report on bitcoin and taxes. There is no need to respond in advance and participation is open to all.

When:  Wednesday June 19, 2013, at 2:00pm ET 
Where: http://www.ustream.tv/channel/gaolive 
How to Submit Questions: Users may submit questions in advance by emailing them to AskGAOLive@gao.gov.  During the chat, users may submit questions in three ways:

·         Email: AskGAOLive@gao.gov

·         Twitter: use the hashtag #AskGAOLive, or

·         Ustream: use the chat box next to the video.

    Also, please note that Internet Explorer v.7 and earlier cannot view the chat, so it’s best to use IE v.8 or 9 or another browser such as Firefox, Chrome, or Safari to participate."

So, check out the report and June 19 call and come back here and post your comments.  Thanks.

Virtual Tax Dollars

This is post is partly light-hearted, but also notes an area in need of guidance. I saw a Bloomberg News item in the Mercury News today (2/15/11, pg D3) on game-maker Zynga. It notes that people can play their Facebook games for free but the company makes money from people buying "virtual goods." That means people are spending real money buying pretend goods, supporting a viable company.

I think governments have missed opportunities here. Why don't they create web games where people can buy virtual items - a tax return showing you are a multi-millionaire? A private island? Pay your virtual accountant to prepare your return? Pay someone to set you up in a tax shelter? Perhaps the government could lower the deficit this way.

Well, it also reminds me that in 2006, the Joint Economic Committee issued a press release (10/17/06) saying that they were studying tax issues of virtual money and would issue a study. But it was never issued.

In 2008, the National Taxpayer Advocate's annual report to Congress included a section on the need for the IRS to issue guidance on virtual worlds. The report noted a "“serious problem” and that “the IRS should proactively address emerging issues such as those arising from “virtual worlds.”” (2008 Report, page 213-226) No guidance has been issued.

There are not only perhaps some money-making opportunities for the government with virtual items, but the need to update the tax law guidance to be sure people know possible tax consequences of playing virtual games, having virtual money, and more.