US issues guidance clarifying tax treatment of bitcoin and other virtual currencies

While bitcoin and other virtual currencies are becoming more popular and have garnered a lot of attention in the media, the US tax rules that apply to them have been unclear, including the basic question of whether they are treated as a currency or as property. The Internal Revenue Service (IRS), the US tax agency, on Tuesday issued its first guidance on the topic, in the form of 16 questions and answers (Notice 2014-21).

The IRS warns that, “In general, 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.” The notice provides that, while virtual currencies such as bitcoin operate like real currencies in some situations, they do not have the status of legal tender in any jurisdiction, so the IRS will treat them as property, rather than currency, for US federal tax purposes. 

This means that the general tax principles that apply to property transactions will apply to transactions using virtual currency. In computing gross income, a taxpayer who receives virtual currency as payment for goods or services must include the fair market value (FMV) of the virtual currency (measured in US dollars) as of the date the virtual currency was received.

Taxpayers can have gains and losses on the exchange of a virtual currency for other property, and the character of the gain or loss will depend on whether the virtual currency is a capital asset in the taxpayer’s hands. However, because virtual currency is not treated as currency, it does not generate foreign currency gain or loss for US federal tax purposes.

The notice discusses the tax aspects of “mining” bitcoins, the process of obtaining bitcoins by solving complex mathematical problems. The IRS says 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 [the taxpayer’s] 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 from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute self-employment income and are subject to self-employment tax.

The notice also discusses the use of virtual currency as payment of wages or for services:

• Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on an IRS Form W-2, Wage and Tax Statement, and are subject to federal income tax withholding and payroll taxes.
• Payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply. Normally, payers must issue IRS Form 1099.

Also, payments made using virtual currency will be subject to the same information-reporting rules as any other payment made in property.

The IRS warns that taxpayers who treated virtual currencies inconsistently with the notice before the date the notice was issued will not get penalty relief unless they can establish that their underpayment or failure to properly file information returns was due to reasonable cause.

The IRS is asking for comments on other aspects of virtual currency transactions that should be addressed in future guidance.

—Alistair M. Nevius (anevius@aicpa.org) is the CGMA Magazine’s editor-in-chief, tax.