...well settled rules that govern the taxation of transactions involving the sale or exchange of property, or the issuance of property in exchange for services, also apply to convertible virtual currency.
On March 25, 2014, the Internal Revenue Service issued Notice 2014-21, which addresses the U.S. federal tax consequences of transactions that use convertible virtual currency. For this purpose, convertible virtual currency refers to a medium of exchange that has an equivalent value in real currency, or that acts as a substitute for a real currency. However, virtual currency does not have legal tender status in any jurisdiction. Bitcoin is just one example of a convertible virtual currency which can be digitally traded between users and can be purchased or exchanged into U.S. dollars, Euros and other real or virtual currencies.
The IRS is aware that virtual currencies such as Bitcoin may be used to pay for goods or services, or held for investment. 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 IRS notice sets forth FAQs that explain how convertible virtual currency is treated in various contexts for US tax purposes. The FAQs in the notice assume that the taxpayer's functional currency is the U.S. dollar.
...since transactions using virtual currency must be reported in US dollars, taxpayers will be required to determine the fair market value of virtual currency in US dollars as of the date of payment or receipt.
Notably, the notice explains that virtual currency is treated as property for U.S. federal tax purposes. Hence, the general tax principles that are applicable to property transactions apply to transactions using virtual currency. However, virtual currency is not treated as “currency” for purposes of applying the special U.S. federal tax accounting rules that govern the treatment of foreign currency transactions.
With these background concepts in place, it quickly becomes apparent that the well settled rules that govern the taxation of transactions involving the sale or exchange of property, or the issuance of property in exchange for services, also apply to convertible virtual currency. So, a taxpayer who receives virtual currency as a payment for goods or services must in computing taxable gross income include the fair market value of the virtual currency measured in U.S. dollars as of the date that the virtual currency is received.
As just stated, since transactions using virtual currency must be reported in US dollars, taxpayers will be required to determine the fair market value of virtual currency in US dollars as of the date of payment or receipt. Therefore, if a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate. The usual tax accounting rules that govern the timing, character (ordinary or capital) and IRS information reporting of realization events also apply to transactions involving virtual currency.
The notice also speaks to the tax treatment of taxpayers who "mine" virtual currency (for example, use computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledgers). The notice confirms that such taxpayers realize gross income upon the receipt of the virtual currency resulting from those activities. As stated above, the amount of gross income is equal to the fair market value of the virtual currency as of the date of receipt. Notably, the notice explains that if a taxpayer's virtual currency “mining” activities constitutes a trade or business, and the "mining" activities are 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 such activities may constitute self-employment income and, if so, could be subject to self-employment tax.
It is important to note that a taxpayer who makes a payment using virtual currency is subject to the IRS information reporting and withholding tax rules to the same extent as any other payment made in property.
Thus, a person who in the course of a trade or business uses virtual currency to pay interest income to a “non-exempt” payee, or uses virtual currency to pay for services to an independent contractor, may be required to report such payments to the IRS and the payees. In addition, payments using virtual currency are subject to backup withholding or other forms of tax withholding (for example, foreign payees) 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), or other IRS forms (for example, IRS Forms W-8 or W-9) from the payee in order to avoid penalties or potential withholding agent liability.
As the title of this article implies, “Mining Bitcoins” is really nothing new under the sun. However, taxpayers and the IRS will face new challenges when applying the “old” rules to the new digital realities. Happy mining!
[Bruce Feinstein is principal in the tax group at ParenteBeard, a top 25 accounting firm. He is a highly regarded tax lecturer. He has spoken on a wide range of subjects at the Philadelphia Bar Association Tax Section, Philadelphia Tax Conference, Villanova University, Temple University and the International Fiscal Managers Association. He has also written articles for The AICPA Tax Clinic, The Journal of International Taxation and the Mergers and Acquisitions Tax Journal. He holds a bachelor’s and master’s degree from Temple University and a master’s of law from New York University of Law.
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Any tax advice contained in this communication, unless expressly stated otherwise, was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties that may be imposed on the taxpayer under the Internal Revenue Code or applicable state or local tax law or (ii) promoting, marketing or recommending to another party any tax-related matter(s) addressed herein.
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