Jay Weill is a partner at Sideman & Bancroft in San Francisco representing people and entities in both civil and criminal matters involving the IRS. Weill was the former Chief of the Tax Division at the US Attorney’s Office in San Francisco.
Weill has co-authored this piece with Brian Klein, a partner at the litigation boutique Baker Marquart LLP and chair of the Bitcoin Foundation’s legal advocacy committee.
Death and taxes are the two certainties of life, so the old saying goes. On 25th March, three weeks before the US 15th April tax filing deadline, the US Internal Revenue Service (IRS) finally issued guidance regarding the taxation of bitcoins and other digital currencies in what the IRS, in typical IRS-speak, calls Notice 2014-21.
One could almost have believed that the IRS had forgotten about bitcoins and other digital currencies. But really, everyone should have seen this day was coming. Indeed, it was long overdue.
The IRS could have treated digital currency as either currency or property. It chose to treat it as property, imposing the general tax principles relevant to property transactions on those of digital currency. This means that digital currencies will be taxed as ordinary income or as assets subject to capital gains taxes, depending on the circumstances. The choice has far-reaching tax implications that will affect anyone who uses digital currency.
In the notice, the IRS co-opted FinCEN’s definition of digital currency:
“Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”
It goes on:
“The sale or exchange of convertible digital currency, or the use of convertible digital currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.”
This is very understated. The tax consequences are far-reaching and depend on how one uses digital currencies. The following provides a thumbnail sketch of certain tax consequences for US taxpayers.
Employers and employees
Employee wages in digital currency are subject to federal and state income tax withholding, and by law should be reflected on both employers’ and employees’ tax returns. Such payments are required to be reported to the IRS on your business and payroll tax returns and must further be reflected on IRS Forms W-2 issued to each employee and filed with the IRS. In turn, the employee must report to the IRS and state tax authorities the wages he or she receives in digital currency on his or her personal tax returns.
For each, the reported amounts – the wages reported paid or received and the payroll taxes withheld – will be calculated using the fair market value of the digital currency in US dollars on the date paid or received.
Businesses paying independent contractors with digital currency must report amounts on Form 1099 – the document used to report other forms of income than wages or salaries – and supply the forms to tax authorities and their independent contractors.
Like employees, independent contractors are taxed in the same manner as if the amounts were received in US dollars. They must report amounts received as income on their tax returns and pay self-employment tax.
The IRS’ treatment of digital currency as property is a boon to taxpayers holding it as a long-term investment – that is, holding it for more than a year. This is so because when investing in or undergoing transactions in foreign currency, the gains are taxed at the ordinary income tax rate; whereas with digital currency treated as property, the taxpayer can benefit from the lower capital gains tax rate.
Moreover, like any other commodity, if the digital currency loses value instead of making gains then the taxpayer can claim a capital loss, which would help lessen the tax bill. The character of gain or loss generally depends on whether the digital currency is a capital asset in the hands of the taxpayer.
According to the IRS, if the taxpayer holds digital currency as capital – such as stocks or bonds or other investment property – gains or losses are realized as capital gains or losses. But where such currency is held as inventory or other property mainly for sale in a trade or business, then ordinary gains or losses are generally incurred.
Taxpayers who obtain digital currency through mining must include the fair market value of the digital currency, as of the date of receipt, when reporting their gross income on tax returns.
This creates an enormous task for frequent miners who have to go back and see what the values of the bitcoins were on the dates they were mined. If the mining activities make up a trade or business, and the miner is not an employee, then the net earnings resulting from the activities constitute self-employment income that’s subject to self-employment tax.
When an exchange sells digital currency to a customer as a part of a trade or business, its gross income will equal the value for which the digital currency was sold.
Catch-all for payors
Any disposition of digital currency is a taxable event, including the use of digital currency to acquire another asset, to pay for services, in retail transactions and investments where the merchandise received or investment has a higher value than the payor’s basis in the digital currency.
And, payments made using digital currency are subject to the same tax reporting and backup withholding as other payments made in property.
The character nature of the tax
The IRS notice left many unanswered questions as well.
For example, any person or business that receives more than $10,000 in one transaction or a series of transactions must identify the person involved to the IRS via Form 8300. Since digital currencies, like bitcoin, are not recognized as currencies by the IRS, does a car dealer have to report an automobile purchased with bitcoins?
US individual and business taxpayers alike should consult with their tax advisors about the implications of their particular digital currency transactions. They will now have to track their digital currency purchases in order to correctly prepare and file their 2013 tax returns due on 15th April, as well as potentially amend 2012 and earlier tax returns.
The IRS notice also invites comment from the public. Undoubtedly, the IRS will receive an extensive amount of feedback. In light of the path the IRS chose, one that requires extensive tax compliance efforts, the IRS should expect much of it to be extremely negative – and rightfully so.
IRS CIRCULAR 230 DISCLOSURE: To ensure compliance with Treasury Department and IRS regulations, we inform you that any federal tax advice contained in this communication is not intended or written by the parties to be used, and cannot be used for the purposes of (i) avoiding penalties that may be imposed on the taxpayer under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.