Recently, I had a client ask me about accepting payments in Bitcoin due to perceived reduction in transaction costs. Unfortunately, there is a recent IRS ruling that makes the future of Bitcoin as a medium of exchange unlikely – given dramatically negative tax results.
“Bitcoin” is commonly referenced as a “virtual” or “digital” currency. It is really a peer to peer payment processing system, with units of payment measured in “Bitcoin.” Transactions are registered on a public ledger, known as a block chain. A transaction between A and B, for X Bitcoins will, if authenticated, cause a record of a transfer of X Bitcoins from A to B on these ledgers. The value of the currency is not derived from a backing in gold, or by government fiat, but the value perceived by people at large.
One of the touted advantages of Bitcoin, particularly for merchants, was the significantly reduced transaction costs. You see, with Bitcoin, the peer to peer network transaction avoided the middle-man; such as a credit card company or similar clearinghouse. These transaction fees represent a significant cost to merchants.
However, IRS Notice 2014-21 should immediately put a halt to merchants using Bitcoin as a currency for exchange in their otherwise profitable US businesses, as per the IRS, while a Bitcoin is property, it is not currency. Thus, like any property other than currency, Bitcoin carries with it related concepts like basis, and fair market value, and taxable gain.
Specifically, this ruling makes clear that in an exchange involving Bitcoin, an individual will be taxed as they would in any other situation where they exchanged property that is not currency, for other property that is not currency. Thus, when taxpayer “A” receives Bitcoin in receipt for property, taxpayer A must record the fair market value of the Bitcoin. This value will become A’s basis when he later uses the Bitcoin in an exchange.
If a merchant attempts to use Bitcoin as currency in a period where Bitcoin values were rising, from the time the merchant received the Bitcoin, and the time they used it to purchase something else, the gain therein would be taxable to the merchant. Thus, in addition to paying sales tax, taxpayer A may also have income tax to pay for paying in Bitcoin. Further, as property (versus currency) the character of Bitcoin is also relevant and could be taxed at either capital rates or ordinary rates depending on the facts and circumstances of the particular taxpayer.
Thus, for a merchant who is looking to expand or change its payment model, IRS NOTICE 2014-21 makes clear that Bitcoin is absolutely not a viable solution for a merchant whose business is otherwise profitable for the purpose of avoiding transaction costs, because it is not currency. It is essentially bartering, such that any it puts a significant administrative burden on the exchanging taxpayer; and potentially would result in taxable gain for every transaction to the extent property or service received for the Bitcoin, exceeds the value of the Bitcoin on the date it was received, representing gain to the taxpayer. To the extent the exchange of a Bitcoin creates gain, the taxpayer now has a new tax burden it did not have with currency.
Please note that the advice in this article is limited to the value and use of Bitcoin as a currency, based on the recent IRS notice, and does not speak to the value of Bitcoin as an investment vehicle, or Bitcoin “mining,” both of which are beyond the scope of this article.