Bitcoin will be treated like property, not currency, the IRS declared in a Notice (http://www.irs.gov/pub/irs-drop/n-14-21.pdf) issued this week to address the tax implications of mining, spending or receiving virtual currencies. The need to track fair market value and basis adjustments to compute gains and losses for tax purposes introduces record-keeping realities to a virtual world that, until recently, managed to escape extensive regulation by not being controlled by any government.
While the tax treatment is welcomed by many investors who will benefit from paying a lower tax rate on capital gains than they would on ordinary income, the IRS has given fair warning to self-employed Bitcoin miners and independent contractors who may receive Bitcoins for payment that income from virtual currencies must be properly valued and included in gross income and self-employment taxes may apply.
In its Notice, the IRS used a FAQ format to convey the following sixteen pronouncements applicable to virtual currency:
• Property Rules Apply: General tax principles applicable to property transactions apply to transactions using virtual currency.
• No Foreign Currency Gain or Loss: Virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.
• FMV of Virtual Currency Included in Gross Income: A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value (FMV) of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received.
• Basis is FMV of Virtual Currency: The basis of virtual currency that a taxpayer receives as payment for goods or services is the FMV of the virtual currency in U.S. dollars as of the date of receipt.
• FMV Determined on Date of Receipt: Taxpayers are required to determine the FMV of virtual currency in U.S. dollars as of the date of payment or receipt. If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the FMV of the virtual currency is determined by converting the virtual currency into U.S. dollars at the exchange rate, in a reasonable manner that is consistently applied.
• FMV and Adjusted Basis Used to Compute Taxable Gain or Loss: If the FMV of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the FMV of the property received is less than the adjusted basis of the virtual currency.
• Capital Gain or Loss Versus Ordinary Gain or Loss: The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in his hands (e.g., stocks, bonds and other investment property). A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in his hands (e.g., inventory and other property held mainly for sale to customers).
• FMV Determines Income for Miner: When a taxpayer successfully mines virtual currency, the FMV of the virtual currency as of the date of receipt is includible in gross income.
• Earnings from Mining May Be Self-Employment 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 from self-employment resulting from those activities constitute self-employment income and are subject to the self-employment tax.
• FMV Determines Income for Independent Contractor: The FMV of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax.
• FMV Subject to Withholding from Wages: The medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes. Consequently, the FMV of virtual currency paid as wages is subject to federal income tax withholding.
• $600 Threshold for Information Reporting Applies: A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. For example, a person who in the course of a trade or business makes a payment of fixed and determinable income using virtual currency with a value of $600 or more to a U.S. non-exempt recipient is required to report the payment to the IRS and to the payee. Examples of payments of fixed and determinable income include rent, salaries, wages, premiums, annuities and compensation.
• $600 Threshold to Independent Contractor Triggers Form 1099-MISC: A person who in the course of a trade or business makes a payment of $600 or more – including by virtual currency – to an independent contractor is required to report that payment to the IRS and to the payee on Form 1099-MISC. Such payments in virtual currency should be reported using FMV of the virtual currency in U.S. dollars as of the date of payment.
• Backup Withholding Applies and TIN is Required: Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. Therefore, payors making reportable payments using virtual currency must solicit a taxpayer identification number (TIN) from the payee. The payor must backup withhold from the payment if a TIN is not obtained prior to payment or if the payor receives notification from the IRS that backup withholding is required.
• FMV on Date of Payment Used by TPSOs: A third party that contracts with a substantial number of unrelated merchants to settle payments between merchants and their customers is a third party settlement organization (TPSO). A TPSO is required to report payments made to a merchant on a Form 1099-K 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. When determining whether the transactions are reportable, the value of the virtual currency is the FMV of the virtual currency is U.S. dollars on the date of payment.
• Without Reasonable Cause, Underpayment and Failure to File Penalties Apply: Underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties under section 6662. In addition, failure to timely or correctly report virtual currency transactions when required to do so may be subject to information reporting penalties under sections 6721 and 6722. However, penalty relief may be available to taxpayers who establish that an underpayment or failure to properly file an information return is due to reasonable cause.
Virtual currencies are different from traditional forms of legal tender because they are not backed by any government or central clearing house. Of the various virtual currencies, Bitcoin has received the most media attention with the focus most recently highlighting the collapse of Mt. Gox, a major Bitcoin exchange now under bankruptcy protection. Mt. Gox reported in February that it lost 850,000 Bitcoins with a value at that time of over $470 million and then a few weeks later, it reported that it found 200,000 of the missing Bitcoins in a digital wallet.
For background on the creation of Bitcoin and regulatory challenges posed by digital transactions, see Bitcoin Emergence Prompts FinCEN to Issue Guidance on Virtual Currencies (http://www.alacra.com/blog/bitcoin-emergence-prompts-fincen-guidance/).