Virtual Currency Transactions and Bitcoin Investment Issues under U.S. Tax Law
“Virtual currency” is a digital representation of value that can be exchanged into traditional legal tender. For example, bitcoins may be purchased and converted into U.S. dollars. Bitcoins can also be used to pay for goods or services, or they can be held for investment like a capital asset. If bitcoin is held as a capital asset, then it is treated similar to stocks and bonds for tax purposes. This means that the taxpayer will recognize a capital gain or loss upon the sale or exchange of the virtual currency.
Virtual Currency Reporting Requirements
Every time a person spends or uses virtual currency, each purchase or use is treated as an independent disposition of property that triggers the realization of gain or loss. Each realization of gain or loss is a taxable event that may need to be reported as income to the IRS by a party to the transaction. For example, a payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
Generally, businesses are required to report any payments that they make to employees or independent contractors if the virtual currency is valued at $600 or more. Payments of virtual currency that are required to be reported should be reported using the fair market value of the virtual currency in U.S. dollars as of the date of payment. Likewise, the payment recipient should include the fair market value of this payment in gross income upon the date of receipt.
Similarly, third parties that contract with unrelated merchants to settle payments, such as PayPal and Steam, are required to report payments made to a merchant if, for the calendar year, both (1) the number of transactions settled for the merchant exceeds 200, and (2) the gross amount of payments made to the merchant exceeds $20,000. This is significant because merchants that receive these payments, which are reported by third parties, are not subject to future John Doe summonses, i.e., subpoenas for the financial records of individuals that are unknown to the IRS.
Coinbase Litigation (July 2017 Update)
Coinbase is an online platform that deals in virtual currency. It exchanges currency on behalf of its users and provides digital wallets for bitcoin. On November 17, 2016, the United States filed a petition to serve a John Doe summons on Coinbase, Inc. The original summons sought information regarding anyone who, at any time, conducted transactions in a virtual currency between 2013 and 2015. Coinbase has a financial interest as a company to ensure that the IRS investigation does not negatively impact its financial profits or its valuation. Its user base, on the other hand, has a very personal interest in maintaining their privacy in the financial documents that the IRS is seeking to obtain with the John Doe summons.
After the Court heard oral argument in U.S. v. Coinbase, Inc., the IRS narrowed its subpoena. In particular, the IRS now only seeks information for users with at least the equivalent of $20,000 in virtual currency transactions for any taxable year during the 2013-2015 period. Further, the IRS does not seek records for users for which Coinbase reported payments made to merchants during this period or for users whose identity is otherwise known to the IRS. As a result, the John Doe summons will no longer target most of the users operating in compliance with virtual currency reporting requirements.
What if I hold my Bitcoin overseas?
It is unclear whether holding bitcoin in a foreign exchange (as opposed to a U.S. exchange like Coinbase) is a foreign financial account that requires the taxpayer to file a Report of Foreign Bank and Financial Accounts (FBAR). To date, the IRS has not published guidance on the treatment of virtual currency in accounts overseas, so practitioners are prone to err on the side of caution by over-reporting. This demonstrates the continuing need for the IRS to publish additional guidance to clearly define the rules under which taxpayers may face penalties for noncompliance.
In fact, in May of 2017, the Senate Committee on Finance and the House Committee on Ways and Means asked whether the IRS will consider a de minimis exemption or other action to remove practical obstacles to the use of virtual currencies. For example, some tax practitioners propose that Congress codify a de minimis exception for gain and loss, or even limit the recognition of gain or loss to when investors “off-ramp,” meaning when they convert their virtual currency back into U.S. dollars.
This is because the current tax treatment, where every purchase or use is treated as a disposition of property, is considered by some to be too burdensome for the day-to-day transactions for which most virtual currencies were intended. Instead, taxpayers are being incentivized by the current tax treatment to hold onto their virtual currency like a capital asset in order to receive the more preferential tax treatment available for capital gains.
Remaining Issues under U.S. Tax Law
Taxpayers require additional guidance regarding several types of virtual currency transactions, including the determination of fair market value during periods of high volatility, the treatment of the costs of mining and acquiring virtual currency, and other property transaction rules as they apply to virtual currencies. Clear guidance in this area will improve taxpayer compliance, protect taxpayer privacy, lower transaction costs, and boost economic efficiency. As a result, this is one of the areas of tax law where practitioners agree that clients would benefit greatly from further statutory and regulatory clarification.Disclaimer: This blog and website are public sources of general information concerning our firm and its lawyers, as well as the information presented. They are intended, but not promised or guaranteed, to be correct, complete, and up-to-date as of the date posted. This blog and website are not intended to be, and are not, sources of legal opinion or advice. The materials, information, and communications on this blog and website do not apply to any particular person, entity, or situation, and do not apply to you or to your specific situation. You will need to consult with an attorney and/or other appropriate professional about your specific situation. Thank you.