Virtual Currency Treated as Property for Tax Purposes.
(Parker's Tax Library April 11, 2014)

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. In other words, it's electronic money. Virtual currency may operate like "real" currency i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance. However, it is not backed by any government and does not have legal tender status in any jurisdiction.

Virtual currency may be used to pay for goods or services, or held for investment. Virtual currency users generally recognized that certain transactions involving virtual currency would have tax consequences, but the lack of guidance created a great deal of uncertainty over which transactions would have tax consequences, and what those consequences would be. In Notice 2014-21, the IRS has set out its position on the federal tax consequences of transactions in, or transactions that use, virtual currency. According to the IRS, for federal tax purposes, virtual currency is treated as property rather than as currency. Thus, general tax principles that apply to property transactions apply to transactions using virtual currency.

OBSERVATION: Treating virtual currency as property means that "virtually" every transaction involving virtual currency has federal tax consequences.

For purposes of Notice 2014-21, the term "virtual currency" refers only to "convertible" virtual currency that is, virtual currency that has an equivalent value in real currency, or that acts as a substitute for real 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. Also, for purposes of the notice, the taxpayer's functional currency is assumed to be the U.S. dollar, the taxpayer is assumed to use the cash method of accounting, and the taxpayer is assumed not to be under common control with any other party to a transaction. The IRS cautioned that no inference should be drawn with respect to virtual currencies not described in Notice 2014-21.

Virtual Currency Received as Payment for Goods or Services

Under Notice 2014-21, a taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date the taxpayer received it. The basis of virtual currency a taxpayer receives as payment for goods or services is the virtual currency's fair market value in U.S. dollars as of the date of receipt.

For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Thus, taxpayers must determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt. 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 that in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.

Gain or Loss upon an Exchange of Virtual Currency for Other Property

According to the IRS, if a taxpayer uses virtual currency to "buy" other property, and the fair market value of property the taxpayer receives in exchange for the virtual currency is greater than the taxpayer's adjusted basis of the virtual currency, the taxpayer has taxable gain. Conversely, if the fair market value of the property the taxpayer receives is less than the adjusted basis of the virtual currency, the taxpayer has a loss.

The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the taxpayer's hands. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the taxpayer's hands. For example, stocks, bonds, and other investment property are generally capital assets.

A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the taxpayer's hands. Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset.

"Mining" of Virtual Currency

Virtual currency "mining" is the process by which a taxpayer is awarded new units of virtual currency. For example, with Bitcoin, when a taxpayer spends computing power to perform certain recordkeeping services, such as validating Bitcoin transactions and maintaining the public Bitcoin transaction ledger, the taxpayer receives new bitcoins in exchange. Under Notice 2014-21, when a taxpayer successfully "mines" virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in the taxpayer's gross income.

Further, if a taxpayer's mining of virtual currency constitutes a trade or business and the taxpayer does not engage in the mining activity as an employee, the net earnings from self-employment (generally, the gross income from carrying on a trade or business less allowable deductions) resulting from those activities constitute self-employment income and are subject to the self-employment tax.

Virtual Currency an Independent Contractor Receives for Performing Services

Generally, self-employment income includes all gross income an individual derives from any trade or business he or she carries on as a non-employee. Thus, according to the IRS, the fair market value of virtual currency an individual receives for services he or she performs as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax.

Virtual Currency Paid by an Employer for Services

Generally, the medium in which remuneration for services is paid is immaterial in determining whether the remuneration constitutes wages for employment tax purposes. Thus, the fair market value of virtual currency paid to an employee as wages is subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on the employee's Form W-2, Wage and Tax Statement.

Foreign Currency Gain or Loss

Virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.

Information Reporting

According to Notice 2014-21, a payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. For example, a person who in the course of a trade or business makes a payment of fixed and determinable income using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a tax year must report the payment to the IRS and to the payee. Examples of payments of fixed and determinable income include rent, salaries, wages, premiums, annuities, and compensation.

Generally, a person who in the course of a trade or business makes a payment of $600 or more in a tax year to an independent contractor for the performance of services must report that payment to the IRS and to the payee on Form 1099-MISC, Miscellaneous Income. Payments of virtual currency that must be reported on Form 1099-MISC should be reported using the fair market value of the virtual currency in U.S. dollars as of the date of payment. The payment recipient may have income even if the recipient does not receive a Form 1099-MISC as some payments do not have to be reported on Form 1099-MISC even though they are taxable.

Generally, 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 (TPSO). A TPSO must report payments made to a merchant on a Form 1099-K, Payment Card and Third Party Network Transactions, if, for the calendar year, both (1) the number of transactions settled for the merchant exceeds 200, and (2) the gross amount of payments made to the merchant exceeds $20,000. When completing Boxes 1, 3, and 5a-1 on the Form 1099-K, transactions in which the TPSO settles payments made with virtual currency are aggregated with transactions in which the TPSO settles payments made with real currency to determine the total amounts to be reported in those boxes. When determining whether the transactions are reportable, the value of the virtual currency is the fair market value of the virtual currency in U.S. dollars on the date of payment.

Backup Withholding

According to the IRS, payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. Thus, payors making reportable payments using virtual currency must request a taxpayer identification number (TIN) from the payee. The payor must backup withhold from the payment if it does not obtain a TIN before payment or if the payor receives notification from the IRS that backup withholding is required.

Treating a Virtual Currency Transaction in a Manner Inconsistent with Notice 2014-21

On the issue of whether taxpayers are subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with Notice 2014-21 before March 25, 2014, the IRS stated simply that taxpayers may be subject to penalties for failure to comply with tax laws. Thus, for example, underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties under Code Sec. 6662. In addition, failure to timely or correctly report virtual currency transactions when required to do so may be subject to information reporting penalties under Code Sec. 6721 and Code Sec. 6722. However, penalty relief may be available to taxpayers and persons required to file an information return who are able to establish that the underpayment or failure to properly file information returns is due to reasonable cause. (Staff Editor Parker Tax Publishing)

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Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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