The IRS has provided guidance in the form of frequently asked questions on the tax treatment of virtual currency, such as Bitcoin.
Virtual currency may be used to pay for goods or services or held for investment. It is a digital representation of value that functions as a medium of exchange, a unit of account or a store of value.
In some environments, virtual currency operates like “real” currency – that is, the coin and paper money that is designated as legal tender, circulates and is customarily used and accepted as a medium of exchange in the United States or any other country of issuance – but doesn’t have legal tender status in any jurisdiction.
Virtual currency that has an equivalent value in real currency, or acts as a substitute for real currency, is referred to as “convertible” virtual currency. Bitcoin is one example of a convertible virtual currency. Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.
IRS Notice 2014-21 provides that virtual currency is treated as property for U.S. federal tax purposes. And the general tax principles that apply to property transactions apply to transactions using virtual currency.
As a result, the IRS has concluded that:
- Wages paid to employees using virtual currency are taxable to the employee. They must be reported by an employer on Form W-2 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.
- 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.
- A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
If you receive virtual currency as payment for goods or services, you must include as income the fair market value (FMV) of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. If the virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the FMV of the virtual currency is determined by converting the virtual currency into U.S. dollars at the exchange rate in a reasonable manner that is consistently applied.
The amount you include as income becomes your tax basis in the virtual currency. Subsequently, you would realize gain or loss on an exchange of virtual currency for other property.
If the FMV of property received in exchange for virtual currency exceeds your adjusted basis of the virtual currency, you would have a taxable gain. If the FMV of the property received is less than the adjusted basis of the virtual currency, you would have a loss. The character of the gain or loss generally depends on whether the virtual currency is a capital asset to you.
Some people “mine” virtual currency by using computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger. These “miners” realize gross income upon receipt of the virtual currency resulting from the mining activities. The FMV of the virtual currency as of the date of receipt is includable in gross income.
If your activities in mining virtual currency constitute a trade or business, and the mining activity is not undertaken 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 is self-employment income and is subject to the self-employment tax.
If certain conditions are met, IRS information reporting is required for a person who settles payments made in virtual currency on behalf of merchants that accept virtual currency from their customers. In general, a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third-party settlement organization.
A third-party settlement organization must report payments made to a merchant on Form 1099-K, Payment Card and Third Party Network Transactions, if both of the following statements are true for the calendar year:
- The number of transactions settled for the merchant exceeds 200, and
- The gross amount of payments made to the merchant exceeds $20,000.
The notice concludes that taxpayers may be subject to penalties for failure to comply with tax laws. For example, underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties.
In addition, failure to report virtual currency transactions in a timely or correct manner when required to do so may subject taxpayers to information reporting penalties. However, penalty relief may be available to those who are able to establish that the underpayment or failure to properly file information returns had reasonable cause.