By Chris Davis
On March 25, 2014, the Internal Revenue Service (IRS) released Notice 2014-21 clarifying its position regarding the taxation of virtual currencies such as Bitcoin, Litecoin, and Dogecoin. In summary, the IRS will treat virtual currencies as property, not currency, and therefore any gains realized on virtual currency transactions could constitute taxable income. In addition, transactions in virtual currencies may be subject to information reporting requirements, frustrating those who want Bitcoin to remain free from government interference.
The rules in Notice 2014-21 apply to all “convertible virtual currencies,” with Bitcoin specifically given as an example. This article focuses on Bitcoin, however the rules apply in the same way to all other convertible virtual currencies.
Bitcoin is a virtual currency (also referred to as a digital or crypto currency) that operates without the need for a central bank and is not backed by any physical commodities. The Bitcoin system is maintained by “miners” who use computer power to process transactions and keep the network secure. The transactions are added to the Bitcoin “Block Chain” and miners are rewarded with 25 Bitcoins per Block added to the Block Chain. A Block is added to the Block Chain roughly once every ten minutes. The reward will decrease over time until all 21 million Bitcoins are in circulation which will be around the year 2140. Currently there are around 12,700,000 Bitcoins in circulation. This cap on the number of coins, together with the gradually decreasing reward for mining, is designed to limit inflationary effects on the price. Once a Bitcoin has been mined it can be traded through peer-to-peer technology to other users who receive the transaction in a digital Bitcoin wallet.
Bitcoin was created in 2009, however it really came to prominence in 2013 when prices rose from around $10 per Bitcoin to just over $1,100 per Bitcoin. Since then the price has fallen to around $460 and has proven to be increasingly unstable, with price fluctuations of over 10% a day not uncommon. People buy and sell Bitcoin for a number of reasons, including: (1) to hold it as an investment, like holding stock or gold; (2) to transfer money overseas; (3) to purchase black market goods; and (4) to buy everyday items such as food and coffee. The latter is becoming increasing common. Consumers can now spend Bitcoin in some coffee shops or online at retailers such as overstock.com and Zappos. If you are a client of Royse Law Firm you can even use it to pay for legal services. There are now “Bitcoin ATMs” through which people can acquire Bitcoin like they might withdraw cash from a regular ATM.
In 2013, transactions in virtual currencies increased exponentially. Many taxpayers made large gains but were uncertain how to report the income. With Notice 2014-21, the IRS clarified the tax treatment of transactions in virtual currencies, including Bitcoin. Essentially, the IRS is treating virtual currencies as property and not currency for tax purposes. Notice 2014-21 states that the general tax principles applicable to property transactions also apply to virtual currency transactions. This means that the receipt of Bitcoin represents taxable income which will then form the tax basis of the Bitcoin when it is sold or exchanged for goods and services.
Valuing Bitcoin presents problems due to its constantly fluctuating price. The IRS states that the value is the price of Bitcoin on the day it is acquired or sold and whatever method is used to obtain this value should be consistently applied. The tax consequences of buying and selling Bitcoin depend on the nature of the activities. The main taxable events related to Bitcoin are: (1) receipt of Bitcoin from mining activities; (2) sale of Bitcoin investments; and (3) using Bitcoin as a currency.
Receipt of Bitcoin from Mining Activity
Persons receiving Bitcoin from mining will have taxable income based on the value of Bitcoin in US dollars on the date of receipt. This taxable income represents the tax basis of the Bitcoin. The income will either be capital or ordinary. If the miner is running a business of mining Bitcoin then it is taxable as ordinary income, although presumably expenses of mining, such as electricity cost, could be deducted from the income. If the miner is not an employee then self-employment tax is payable on the earnings.
When the miner sells the Bitcoin there is a taxable gain or loss on sale, being the value of the Bitcoin when sold less the tax basis. Again, this income will either be capital or ordinary depending on whether that person is in the business of trading Bitcoin.
Sale of Bitcoin Investments
Once Bitcoin is mined, it can be bought and sold through Bitcoin exchanges just like stocks or commodities. While Bitcoin can be spent on goods and services (as discussed below), most transactions in Bitcoin are by speculators hoping to buy low and sell high. Bitcoin trading can generate substantial gains and losses. In November 2011, $100 would have bought around 40 Bitcoins. Two years later those 40 Bitcoins could have been sold for around $44,000.
The tax treatment of a gain or loss on the sale of Bitcoin depends on whether the person held the Bitcoin as an investment or as part of a trade of buying and selling Bitcoins. Either way, Notice 2014-21 is unlikely to cause too many headaches. Investors are used to recording purchase and sale prices and likely have detailed records already. The real headache arises when Bitcoin is spent like regular currency.
Use of Bitcoin as a Currency
Use of Bitcoin to Pay for Goods and Services
Using Bitcoin as everyday currency is where the tax reporting is going to get more a lot complicated. Merchants accepting Bitcoin as payment must calculate their income based on the value of Bitcoin at the time of receipt. The IRS does not specify a methodology for valuing Bitcoin, but it whatever one is used must be consistently applied.
Consumers will probably be the group faced with the biggest tax reporting challenges and this is going to be a stumbling block for the wider adoption of Bitcoin and other virtual currencies. When someone pays for a cup of coffee with Bitcoin they are treated as having sold Bitcoin and must account for gain or loss on the transaction. This requires recording the value of Bitcoin on that day and deducting the appropriate amount of basis.
As of the time of writing there is no Bitcoin wallet that can effectively track purchases and sales in a way that automatically calculates any taxable income or loss. Software to calculate this will undoubtedly be forthcoming, probably in the form of a smartphone application, but this will not entirely mitigate the problem. Consumers are not used to considering tax consequences when making purchases of basic goods and services. Furthermore, do consumers really want to be reminded of additional taxable income every time they buy a cup of coffee?
Tax Reporting Consequences When Bitcoin is Used to Pay for Goods and Services
If a business pays an employee or an independent contractor with Bitcoin then all the usual reporting obligations will apply. That means there will need to be W-2 reporting and tax withholding for employees and 1099-MISC or 1099-K forms filed for independent contractors. Payors will also need to request Taxpayer Identification Numbers for all payees which represents a big blow to the anonymity so far associated with Bitcoin payments.
An independent contractor will need to account for self-employment tax and income tax on the receipt of Bitcoin as if the payment had been in US dollars.
The IRS released Notice 2014-21 on March 25, 2014, however the tax treatment dictated therein has full retroactive effect. That means those who bought and sold Bitcoin during 2013 and prior years (and in some cases made large gains) need to report that income on their prior year tax returns. This seems more than a little unfair given that the notice came just a few weeks before the tax return filing deadline for tax year 2013. Taxpayers who sold Bitcoin or used it to purchase goods or services, now need to go back over all prior year transactions and potentially file amended tax returns for any years in which the income was not disclosed in compliance with Notice 2014-21.
The IRS states that it may levy penalties for failure to comply with the tax law concerning virtual currencies, including for transactions prior to the release of Notice 2014-21. The IRS will not mitigate penalties except for reasonable cause and it does not state what could represent reasonable cause in this case. The IRS is well-aware that virtual currencies represent new and uncharted waters, so penalty mitigation for transactions prior to the release of Notice 2014-21 would have been appreciated by many.
With Notice 2014-21, the IRS has put taxpayers on notice that gains from Bitcoin, no matter how they arise, will be considered taxable income. Such treatment makes Bitcoin much harder to use in everyday transactions, although technology may well catch up and help with tax reporting. Bitcoin’s constantly fluctuating price makes it difficult to measure the impact the IRS notice had on its value. On March 25, 2014, Bitcoin traded between $570 and $590 and now it is closer to $450, however the price has also been hit by news of further regulation by China.
Given Bitcoin’s reputation for anonymity it will be interesting to see the extent to which taxpayers begin reporting gains and losses on this and other virtual currencies.