In News Release IR-2018-71 the IRS reminded taxpayers that transactions in crypto-currency are taxable transactions and have to be reported on their income tax returns for the years involved.
In Notice 2014-21 the IRS had issued specific guidance on the taxation of crypto-currency. However, the crypto-currency environment experienced a boom in the latter half of 2017 that likely created a significant number of taxable gains as taxpayers got into the market as it was hot. A key holding of that notice was that virtual currencies are treated as property and not currency.
The news release summarizes the treatment as follows:
Notice 2014-21 provides that virtual currency is treated as property for U.S. federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency. Among other things, this means that:
- A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
- 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 Form 1099-MISC.
- Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2 and are subject to federal income tax withholding and payroll taxes.
- Certain third parties who settle payments made in virtual currency on behalf of merchants that accept virtual currency from their customers are required to report payments to those merchants on Form 1099-K, Payment Card and Third Party Network Transactions.
- The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
The Notice also provided guidance on the treatment of virtual currency mining, generally holding that virtual currency produced by mining produces ordinary income from the operation of a trade or business. Mining is the term used in the crypto-currency arena for the process by which new units of the various crypto-currencies are created.
Roughly summarized, this is done by having computers solve increasingly difficult math problems. For popular crypto-currencies, such as Bitcoin, the computing power necessary to mine new coins now requires large quantities of electrical power, so miners would normally have significant costs incurred in their mining activities.
The news release also comes with a threat for those who fail to report such activities:
Taxpayers who do not properly report the income tax consequences of virtual currency transactions can be audited for those transactions and, when appropriate, can be liable for penalties and interest.
In more extreme situations, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions. Criminal charges could include tax evasion and filing a false tax return. Anyone convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Anyone convicted of filing a false return is subject to a prison term of up to three years and a fine of up to $250,000.
At the time Notice 2014-21 was released, we wrote up the following article on the provisions of that notice.
In recent years there has been the development of a significant “virtual currency” (Bitcoin). The payment system (which is effectively what Bitcoin is) offers anonymity to users and can be used to purchase various items. While gathering attention for use as payments for illegal activities (clearly it offers significant benefits there), some legitimate businesses also use the system since it nicely sidesteps the transaction costs imposed by more traditional payment systems (like credit cards).
The unit of currency (a Bitcoin) fluctuates in price vs. more traditional currencies—in fact, the price has risen and fallen dramatically at times. In fact, after rising above $1,000 per Bitcoin in late 2013, the price fell to below $500 the week of the IRS announcement (though the vast majority of the decline had taken place earlier). But the price is still more than double where it was a year before the IRS announcement. (2018 Note: The price of Bitcoin exploded to many times this 2014 price in 2017 and while it has come down from the extreme highs, it’s still well above that $500 level at the time this article was written in late March 2018).
And we should note the “price” noted above isn’t quite that precise—the numbers above are based on Coindesk’s Bitcoin Price index, which uses an average of two Bitcoin exchanges. So suffice it to say this is extremely volatile and not necessarily easy to tie down a value.
As well, the currency is created by a process known as “mining” which involves solving math problems that are used to provide the security for the system. So while one can buy Bitcoin on various exchanges by giving traditional currency, it’s also possible to create your own Bitcoin (although the processing power needed has grown dramatically, meaning it may cost more in terms of simple electric power than a miner can receive in currency).
However, the taxation of Bitcoin and similar virtual currencies was not necessarily clear. The IRS has moved to resolve some of these issues in Notice 2014-21. The notice was issued in the form of a series of frequently asked questions and answers.
Generally the ruling provides that Bitcoin and similar virtual currencies are property and not currency for federal tax purposes. This has the practical result, given the varying value on a daily basis of Bitcoin, that a user will compute a gain or loss when exchanging Bitcoin for a product, service or traditional currency. How that gain or loss is taxed is determined by the same rules that affect dispositions of property generally—which means determining if the Bitcoin property is investment property, inventory, personal property, etc.
Some of the key rulings include:
- A person who receives Bitcoin (or any other virtual currency—we’ll use Bitcoin here for simplicity) for goods or services must include the value of the Bitcoin in the computation of gross income. The value would be the value of the Bitcoin in U.S. currency at the time it is received (with the practical valuation problem noted above). The IRS does provide, at Q&A5 of the FAQ, that if a currency is listed on an exchange that is established by market supply and demand, that exchange value would be used to determine the fair value in U.S. currency.
- Q&A 6 specifically holds that the holder of Bitcoin who then uses that to acquire a product or service will have a gain or loss on the conversion, again measured by the fair value at the time the Bitcoins are used to acquire the good or service. The gain or loss is measured by comparing that value to the taxpayer’s basis in the Bitcoins surrendered, which would generally be what the taxpayer had paid for the Bitcoin or the value recognized when the Bitcoins were received by the taxpayer in an initial exchange or at the time of mining.
- The gain or loss recognized is determined by the nature of the Bitcoin property in the hands of the taxpayer prior to the exchange.
- If the Bitcoin is investment property (the taxpayer was speculating in Bitcoin, for instance), then there would be a capital gain or loss
- If the Bitcoin is inventory to the taxpayer (as it would be for a Bitcoin exchange), then the gain or loss would be ordinary
- If the Bitcoin is personal property, any gain would be capital in nature (and taxable) but losses would not be deductible. Interestingly enough, the IRS does not mention this type of property in the FAQ
- The taxation of “miners” is outlined in Q&As 8 and 9. A miner recognizes income equal to the fair value of the Bitcoin at the time it is mined and such income would, at least in the view of the IRS, be self-employment income if earned by an individual.
- Employees and independent contractors paid in Bitcoin have income at the time of receipt of the Bitcoin equal to the fair value of the Bitcoin at the time of receipt. The payments are subject to all of the withholding and reporting rules that generally apply to any such payments. Thus, a business paying its employees in Bitcoin would issue W-2s to those emloyees. Similarly, a business paying more than $600 for services to an unincorporated independent contractor during the year would issue a Form 1099MISC to that contractor. As well, the business would need to obtain a Form W-9 from the contractor and a contractor that refused to provide the required information would be subject to backup withholding.
- The IRS also ruled that entities that contract as an intermediary to settle payments between merchants and their customers in virtual currency would be considered a third party settlement organization and required to issue Forms 1099-K if the requirements are met, in the same way as is done for credit cards and organizations like Paypal.
The IRS also provided that there will not be a blanket waiver of penalties for not having treated a transaction under these rules prior to March 25, 2014 (when the ruling was issued). However, the IRS does indicate that the general reasonable cause relief may apply.
Most likely those who reasonably and innocently run afoul of these provisions will be granted relief. But an individual who was using Bitcoin transactions to “stay off the radar” and escape notice will not likely find any relief will be given if their transgressions come to light.
As a practical matter, this ruling is going to make things a bit more difficult for businesses that accept Bitcoins in payment since a gain or loss has to be computed each time the virtual currency is converted to cash or used for paying expenses. And it’s important to note that the ruling provides no “safe harbor” time period where a vendor would be allowed to use the redemption price as the value of the Bitcoin. So prudence suggests that a vendor would probably want to have the Bitcoin converted to cash immediately upon receipt.