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Annette Nellen
Annette Nellen

Bitcoin taxation: Clarity and mystery

More and more clients own or use virtual currency. Here are the possible tax consequences practitioners need to know.

June 12, 2014
by Annette Nellen, Esq., CPA

Bitcoin, a virtual currency created in 2009, has garnered a lot of attention from the government, investors, entrepreneurs, the media, and others. Consider the following:

  • Regulation: In 2013, the Financial Crimes Enforcement Network (FinCEN) of the Treasury Department issued guidance on what types of virtual currency activities required registration and reporting as “money services businesses” under the Bank Secrecy Act regulations (FIN-2013-G001).
  • Entrepreneurship: A New York Times article, “Why Bitcoin Matters,” (Jan. 21, 2014) by Marc Andreessen, included an editor’s note that Mr. Andreessen’s venture capital firm had almost $50 million invested in startups involved with bitcoin. Bitcoin 2014, an annual conference, attracted over 1,000 attendees from more than 50 countries. In April 2014, the House Committee on Small Business held a hearing on the benefits and risks of bitcoin.
  • Growth: The National Taxpayer Advocate’s 2013 Report to Congress labeled the need for guidance on virtual currency as one of the “most serious” tax problems (pp. 249–255). The report notes that from July to December 2013, bitcoin usage increased from 1,700 transactions per hour to over 3,000, while over 10,000 businesses accept bitcoin. These figures continue to increase. Also, some charities accept donations in bitcoin. In February 2014, the Federal Election Commission approved political committees’ accepting bitcoin contributions (AO 2014-02).

After urging from the Government Accountability Office (GAO-13-516 (4/15/13)) and the National Taxpayer Advocate, in March 2014, the IRS issued basic guidance on the tax consequences stemming from the use of the virtual currency and requested comments on additional areas to address.

This article provides a brief overview of virtual currency, why people want to use it, the recent IRS guidance, outstanding tax issues, and practical considerations for tax practitioners.

Virtual currency defined

A virtual currency might also be referred to as crypto-currency, virtual money, or digital currency. FinCEN defines virtual currency as a “medium of exchange” that is not considered legal tender in any jurisdiction. Typically, a virtual currency is “convertible,” meaning it has an “equivalent value in real currency, or acts as a substitute for real currency.” FinCEN describes two types of virtual currencies: centralized and decentralized. A decentralized currency, such as bitcoin, has no central repository or single administrator (testimony of FinCEN Director Jennifer Shasky Calvery before the Senate Committee on Banking, Housing, and Urban Affairs (11/19/13)). The IRS describes a virtual currency as “a digital representation of value” (see Notice 2014-21).

Bitcoin is a decentralized virtual currency based on cryptography for identifying and verifying transactions. This system enables bitcoin to operate as a medium of exchange without a third-party intermediary to verify that the virtual currency is valid (this process instead involves the “blockchain,” a type of public ledger). For the technical details of bitcoin, see resources linked to at the author’s “Virtual Currencies and Taxation” webpage.

Although bitcoin is by far the most well-known virtual currency, other virtual currencies include litecoin, peercoin, and dogecoin.

Why people use virtual currencies

Using a virtual currency can involve lower transaction costs than using a credit card. Transfers are faster than processing payments by check or credit card. Personal information (other than information a vendor might otherwise collect from a customer) is not transferred along with the virtual currency payment, which can reduce the risk of identity theft.

Vendors might prefer a virtual currency over credit cards because a customer can later improperly tell the credit card company that the charge is incorrect and have it reversed (a “chargeback”). A customer cannot do that with a virtual currency since a decentralized virtual currency is like using cash.

A virtual currency is easy to use as a universal currency globally because users don’t need to convert their currency to that of the vendor’s jurisdiction to complete a transaction. In addition, a virtual currency is cost-effective for payments of less than a dollar.

IRS guidance

Under Notice 2014-21, convertible virtual currency (such as bitcoin) is treated as property for tax purposes (rather than as a foreign currency). The following topics are addressed in the 16 Q&As in the notice:

  • If a person receives virtual currency for rendering services or selling goods, the amount is included in gross income at fair market value (FMV). 
  • As with other forms of payment, Forms W-2, Wage and Tax Statement, and 1099 might be required.
  • FMV is determined as of the date of payment or receipt of the virtual currency. If the virtual currency is listed on an exchange where the exchange rate is determined by market supply and demand, the exchange rate can be used “in a reasonable manner that is consistently applied” (Q&A-5).
  • When a virtual currency is used to purchase goods and services, there will be a gain or loss to the user based on the basis of the virtual currency compared with its FMV when used. The character of the loss and whether a loss is allowable are determined by the usual rules (Sec. 1221 and Sec. 165).
  • A person who “mines” a virtual currency must include the FMV of the virtual currency in income on the date of receipt. (Mining is the process of obtaining bitcoins by using a computer to solve complex mathematical problems.) If mining is an individual’s trade or business, the net earnings are subject to self-employment tax.
  • A person who “contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third party settlement organization (TPSO)” and may be required to issue a Form 1099-K, Payment Card and Third Party Network Transactions, to the merchant and IRS depending on the merchant’s volume of transactions (Q&A-15 and Sec. 6050W).

Open tax issues

The IRS is seeking comments on “the tax consequences of virtual currency not addressed in this notice that warrant consideration.” A sampling of those issues follows:

  • Which exchange rate should be used if more than one is available? Is averaging allowed? This question seems mostly relevant for mining. For transactions denominated in dollars but paid in virtual currency, the value is already established, although the user may not have kept a record or received an invoice (such as for a cup of coffee).
  • When bitcoin is used, it is confirmed (through algorithms and the blockchain). Thus, because a specific “coin” was used or received, it is appropriate to use specific identification to determine the basis of bitcoin used. The first-in, first-out (FIFO) inventory method to determine basis (Regs. Sec. 1.1012-1(c)) is used only for securities. To make it easier for some taxpayers to track a virtual currency’s basis, should they be allowed to use FIFO? Should FIFO be required where a taxpayer does not have sufficient documentation to specifically identify the virtual currency?
  • Does a merchant using an exchanger to convert bitcoin to dollars have gain or loss to report on any difference in value between the bitcoin when received and when converted? Or does the gain or loss belong to the exchanger? The answer likely also depends on the particular facts of the arrangement between the merchant and exchanger.
  • Does Sec. 6045, Returns of Brokers, apply to a person that exchanges a virtual currency for dollars?
  • Is a virtual currency a “commodity” subject to mark-to-market accounting for dealers and traders under Secs. 475(e) and (f)? The Commodity Futures Trading Commission is considering whether it should regulate virtual currencies (see Reuters, “Watchdog Says Considering Bitcoin Regulation” (3/11/14)).
  • Is a virtual currency a foreign financial asset under Sec. 6038D, possibly reportable on Form 8938, Statement of Specified Foreign Financial Assets?
  • Should a “bitcoin wallet” be reported on FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR)?
  • Is one virtual currency considered of like kind to another virtual currency for Sec. 1031 purposes? Is virtual currency considered of like kind to any other type of investment property? How does existing guidance on exchanges of coins and bullion apply to these questions? The chart at the bottom of this column provides brief descriptions of Sec. 1031 rulings involving coins and bullion.
  • Can a de minimis rule be created? Sec. 988(e)(2) allows an exclusion of up to a $200 per transaction for foreign currency exchange rate gain if derived from a “personal transaction.” What about a de minimis rule where an individual can exclude virtual currency gains if at no time during the tax year he or she owns more than $x of the virtual currency? Such a rule would eliminate the need to track basis of the virtual currency for small transactions.

Practical considerations for tax practitioners

As virtual currencies continue to become more and more pervasive, CPAs will find clients—individuals, businesses, and not-for-profits—involved with bitcoin and other virtual currencies. Thus, it should be a standard question to ask all clients whether they mine, own, or use virtual currency. If they answer “yes,” details need to be obtained to determine the tax consequences. The client will very likely need assistance with recordkeeping to allow for proper tax reporting. The practitioner should also learn more about the technical aspects of the virtual currency to better understand the tax consequences. If the client’s virtual currency activity appears to be a business, practitioners may want to ask if the client has reviewed FinCEN rules and state law about any required registrations or consulted with an attorney.

Practitioners should be alert to clients who think use of virtual currency is a way to avoid taxes. While anonymity is an aspect of using virtual currency, there can still be trails through normal business practices and any public ledger that exists for verifying the virtual currency. And, of course, taxpayers must comply with tax laws regardless of the government’s ability to find out about a transaction.

With the IRS’s call for comments, hopefully more guidance will be issued to help practitioners with the myriad issues clients are likely to have as ownership and use of virtual currency grows.

Additional reading

For additional information on virtual currency, see links at the author’s “Virtual Currencies and Taxation” webpage.

Sec. 1031 rulings involving coins and bullion

Ruling Item 1 Item 2 Like kind? Rationale
Rev. Rul.
76-214
Mexican 50 peso gold coins Austrian 100 corona gold coins Yes Both coins are bullion-type, with value measured by their gold content. Neither is considered currency in the issuing country. When they are not circulating currencies, the differences “are primarily of size, shape, and amount of gold content.” Thus, the nature or character of the coins is the same.
Rev. Rul.
79-143 (see also GCM 37811 (1/5/79))
$20 gold numismatic-type coins South African Krugerrand bullion-type gold coins No Although both are gold, the underlying investments are different (bullion-type coins vs. numismatic-type coins). In the GCM, the IRS states that the numismatic coins may be valued for their condition, age, or beauty, in addition to their gold content. In contrast, bullion coins are valued based on the price of gold.
Rev. Rul.
82-96
Gold bullion Canadian Maple Leaf gold coins Yes While the Canadian coin was legal tender in Canada to its face value of $50, it was not being used that way because the gold value was greater than $50. Thus, both coins were viewed as bullion-type coins with similar nature and character.
Rev. Rul.
82-166
(see also GCM 38899 (9/27/82))
Gold bullion held for investment Silver bullion held for investment No Gold and silver are different metals, used in different ways (gold for investment; silver as an industrial commodity). In the GCM, the IRS stated that a taxpayer who exchanges gold bullion for silver bullion “is not in essentially the same economic situation after the exchange as he or she was in before the exchange.” The IRS also noted that gold and silver as commodities were subject to different market forces.
California Federal Life Ins. Co., 76 T.C. 107 (1981), aff’d, 680 F.2d 85 (9th Cir. 1982) Swiss francs U.S. Double Eagle gold coins No The gold coins are of numismatic value, “valued primarily for their rarity, as collector items.” Swiss francs represent a circulating currency. Thus, the items are not of the same nature or character.

 
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Annette Nellen, Esq., CPA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is a member of the AICPA Tax Executive Committee and Tax Reform Task Force. She has several reports on tax policy and reform and a blog.