Recently the IRS provided guidance that virtual currency, such as Bitcoin, would be treated as property for federal tax purposes. Notice 2014-21 addressed many issues surrounding the use of virtual currency in the form of frequently asked questions. Before looking at the tax treatment of virtual currency, a bit of background about Bitcoin. If after reading this article, you are having trouble understanding Bitcoin or how virtual currency works, I recommend visiting the Bitcoin website. Please understand that this author does not possess a Bitcoin wallet or any Bitcoin. In fact, according to the Bitcoin map, there is not a vendor accepting Bitcoin within 20 minutes of my home or office.
Bitcoin is a virtual currency which sometimes operates like real currency in that it may be accepted as a medium of exchange but is not legal tender in any jurisdiction. An individual can get started with Bitcoin by installing a Bitcoin wallet on a computer or mobile phone which essentially acts as a address to receive Bitcoin, similar to an email address.
Once you have a wallet, you may buy Bitcoins on the exchange, receive them as payment, earn them for mining (discussed below), or exchange them with someone else. Bitcoins are created (think of the Fed printing money) as a result of a process called mining. Mining is the process of processing Bitcoin transactions which is performed by individual Miners and their computer software and specialized hardware. Miners may be all over the world and they are compensated for their Mining by payment in Bitcoin.
Once you obtain Bitcoin, the value changes just like stock on the stock market. Your Bitcoin may be used or spent with a vendor who accepts payment in Bitcoin. In sum, Bitcoin is like shares of stock: you may buy it or receive it in exchange for goods or services, the value changes according to the market for Bitcoin, and you may exchange it for cash or for goods or services.
Tax Treatment of Bitcoin
The IRS provided guidance that Bitcoin and other virtual currency would be treated as property for federal tax purposes. This means that virtual currency received for goods or services must include the fair market value in U.S. dollars on the date of receipt in computing gross income. This fair market value becomes the taxpayer’s basis in the virtual currency. The taxpayer recognizes gain or loss upon spending or exchanging the virtual currency and the character is determined the same as other property (i.e., if the virtual currency is a capital asset, gain or loss will be capital). Fixed and determinable payments such as rent, salaries, and annuities, of $600 or more per year must be reported to both the IRS and the payee, generally on a 1099. Further, these payments may be subject to backup withholding.
For Miners, the tax consequences are a little more complex. Miners have gross income upon the receipt of virtual currency for successfully Mining (think payment for services). If the Miner is not an employee and the activities constitute a trade or business, the Miner may be subject to the self-employment tax. If the Miner is an employee, the virtual currency received constitutes wages which should be reported on a W-2 and are subject to withholding. Miners may be required to report to the IRS payment settlements between merchants and their customers.
Taxpayers who fail to comply with the guidance pronounced in Notice 2014-21 may be subject to penalties. The penalties at issue are the accuracy related penalties for underpayment of tax and information reporting penalties for failure to correctly report transactions. Penalty relief may be available to taxpayers who are able to show their underpayment or failure to file information return was due to reasonable cause.
I hope you have found this article informative. If you have questions about the tax treatment of Bitcoin or are concerned about reporting virtual currency transactions you should consult your tax advisor.