Keeping Your Balance: IRS issues guidelines for tax treatment of bitcoins

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By now, you have likely heard about virtual currencies, most notably bitcoin, especially in light of the recent stories about thefts of bitcoins at Mt Gox and other bitcoin exchanges, as well as tales of those getting rich on the rising value of bitcoins. While over the past few years the value of this virtual currency has fluctuated wildly, in recent months, its value as been fairly steady at an exchange rate of about $650 per bitcoin.

While many of us have not yet experienced using bitcoins, it is beginning to become somewhat more mainstream. In early June, the satellite television provider DISH Network announced that it will allow its 14 million subscribers the opportunity to begin paying with bitcoins later this year. Previously, the largest business to accept bitcoins was Overstock.com, the online retail giant that began accepting bitcoins in the beginning of 2014.

Until recently, the tax implications of using bitcoin had been uncertain. So the IRS issued guidance in March relating to transactions using bitcoins and other “virtual” currencies. The IRS recognized that in some environments, it operates like “real” currency — i.e., the coin and paper money of the United States or of any other country, but noted that it does not have legal tender status in any jurisdiction.

The IRS noted that “the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.”

Rather than treating virtual currency as an actual currency, the IRS will treat virtual currency as property. Therefore, the general tax principles applicable to property transactions apply to transactions using virtual currency. What this means in practical terms is that if you receive virtual currency as a payment for goods or services, you must include the fair market value of the virtual currency, as translated to U.S. dollars, on the date of the transaction. If you deal in frequent transactions of bitcoins, you may need to do this computation daily. And once you own bitcoins, you may have further gains or losses on future exchanges.

For example, if you provided a service for which you received 10 bitcoins, on a date where the exchange was $650 to one, you would have $6,500 of taxable income. If two months later you used 2 of these bitcoins to purchase a new laptop worth $1,500, you would have a $200 gain on that exchange. The tax character of gains or losses on bitcoin sales/exchanges depends on whether the bitcoins are deemed a capital asset. If you hold bitcoins for investment or speculation, then the gains/losses would be capital gains or losses. If they were used in the ordinary course of business, then the transaction would result in ordinary gains or losses.

The IRS reminded everyone that the use of virtual currencies is subject to the same information reporting rules regarding issuing Forms 1099s as normal U.S. currency transactions. So payments of $600 or more in a taxable year to an independent contractor for the performance of services is required to be reported to the IRS and to the payee on Form 1099-MISC, Miscellaneous Income, and should be reported using the fair market value of the virtual currency in U.S. dollars as of the date of payment.

What happens if you are paid your salary in bitcoins? The IRS notice clarifies that the medium in which payment for services is paid is immaterial to the determination of whether the payment constitutes wages for employment tax purposes. Consequently, the fair market value of virtual currency paid as wages is subject to federal income tax withholding, Federal Insurance Contributions Act tax and Federal Unemployment Tax Act tax and must be reported on Form W-2, Wage and Tax Statement.

With no central government to issue bitcoins paper money, they are “created” through a competitive and decentralized process known as mining. Miners use special software to solve math problems and are issued a certain number of bitcoins in exchange. The bitcoin protocol is designed in such a way that new bitcoins are created at a fixed rate. The IRS notice states that when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.

If a taxpayer’s “mining” of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings are from self-employment, and subject to the self-employment tax. Of course, they are allowed to deduct the costs of mining the bitcoins in computing their taxable income and self-employment income. bitcoins are created at a decreasing and predictable rate.

The number of new bitcoins created each year is automatically halved over time until bitcoin issuance halts completely with a total of 21 million bitcoins in existence. Before you decide to quit your day job and mine bitcoins, you should know that currently, the electrical costs to power a computer are approaching the value of the bitcoin, and mining may only be profitable with specialized computing equipment.

Finally, if you have utilized virtual currencies prior to the IRS notice in March, and treated your transactions in a manner that is inconsistent with the notice, the IRS reminded us that any underpayments of tax may be subject to penalties unless they are timely corrected. However, relief may be available for failure to properly file information returns if reasonable cause can be established.

Burton S. Speer is a partner in the tax department at Mengel, Metzger, Barr & Co. LLP, and can be reached at [email protected] or (585) 423-1860.