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Bitcoin – The IRS stated it is taxable. Now what?

BitcoinOn March 25, 2014, the Internal Revenue Service (IRS) released Notice 2014-21 stating that virtual currency is treated as property. In English, this means that virtual currency like Bitcoin will be subject to income tax just like it is treated as cash or property.  The taxability will depend on the type of transaction and how it is received.  The type of tax treatment will be similar based on current transactions dealing with cash and existing tax laws.  Let’s look at three common examples:

Employment & Independent Contractor Relationship:  We all know, that if you work for someone as either a employee or independent contractor and you are paid in cash, that the cash amount is taxable as compensation or income.  Thus if you work for someone and they pay you in Bitcoin or another virtual currency, the IRS is now stating that transaction is taxable based on the fair market value (FMV) on the day of receipt (assuming the taxpayer is using the cash basis of accounting).  If a taxpayer is using the accrual method of accounting, income would be triggered differently.  Thus the employee or contractor would be taxed just like they received cash.  Some items to consider are:  (1) Will you receive a W-2 or 1099-k?, (2) The income most likely would be subject to self-employment tax, or Federal and state withholding, payroll tax and don’t forget additional Medicare tax (AKA Obamacare), (3) Tracking the income at the date of receipt will provide a tax basis / cost, (4) Tracking a gain or loss on the date of conversion from Bitcoin to cash or property.  Thus, there are many things to consider.  The fact that virtual currency will eventually be converted into cash or property creates an additional step not generally created if paid in cash.

Mining Operation: If you own or are a partner in a mining operation then the mining operation will generate income when a Bitcoin or virtual currency is mined.  Depending on the entity structure type  (i.e. sole-proprietorship,  C Corporation, S -Corporation, Partnership, LLC) the taxability of the income will be treated differently.  When a business is in the business to generate a profit, then expenses to run the business can be deductible against the income.  Side note, there are exceptions if the business is deemed illegal.  Anyway, thus in a virtual mining operation, the hardware, software, utilities and other operating expense can be used to reduce the taxable income.  Then depending on the entity structure, the income will be taxed differently.  The mining operation taxability is similar to any other for profit business, but again, another step is created due to a virtual currency being used.  Since virtual currency mining isn’t like normal manual labor mining, the tax issue of this business being active or passive is more relevant.  This again, can change the tax results.  For example, will Net Investment Income Tax (NIIT) / (AKA: Obamatax) be due?

When the virtual currency is mined, the FMV of that currency will generate income.  That currency value on that date should be tracked as it will generate income and also create a tax basis for the currency.  If the virtual currency is exchanged into US dollar, then the transaction has ended and income is generated.  However, if the virtual currency is held for a period of time, then the business should keep track of the FMV on the date it was mined and generated income.  Later when the virtual currency is exchanged into US currency, that transaction will create another taxable transaction based on currency exchange tax laws.  Thus tracking the virtual currency from mined date to exchange date is very important.  As with any business it is also important to make sure the business is properly tracking and supporting expenses and chooses the entity structure wisely.  For example, an S Corporation structure can generate less tax than a sole proprietorship or partnership / LLC.  Entity structures need to be throughly reviewed  based on the business operation and consideration of the partners / shareholders.

Let’s discuss an example.  A mining operation generates three (3) bitcoins.  The value of those bitcoins on the day they are mined is $700 a coin, so income under the new IRS ruling would be  $2,100 for that week. If the bitcoin is exchanged into cash on the mining date, then the income step is over. However, if the bitcoin isn’t exchanged into dollars on the mining date then the company needs to track the bitcoin and later when it is exchanged into cash at $800 a coin, there would be $300 of additional income.  However, if the exchange rate  is $600 a coin, there would trigger a $300 loss.  The mining income and exchange income should be tracked separately due to various tax laws.

If you are part of a pool mining operation, then the above still needs to be considered and then other tax items like, passive versus non-passive come up slightly differently.  Also, the pooling operating agreement should have an operating agreement, explanation about tax ramifications and who is the tax matters partner.  All these items discussed come up with any business.

Investing in Virtual Currency:  If an individual invests in virtual currency, then the transaction should be treated just like any other investment.  For example, buying a stock.  The opportunity to be taxed at the lower long term capital gains rate is possible.  The long term capital gains tax rates are generally either 15% or 20%, and then one must not forget the Net Investment Income Tax (NIIT) / (AKA Obamatax).  The individual will need to track their cost basis / tax basis, the date of purchase, the date of sale and the sales price.  The holding period will determine if the transaction will qualify for the reduced long term capital gains rate or not.

In summary, now that the IRS has taken the position that they will treat virtual currency like property from a tax law perspective, income tax now becomes an issue that virtual currency holders didn’t really have to worry about in the past.  It will be interesting to see any debate about the IRS notice and to see how the community will deal with the IRS notice.  Will the community provide the IRS with W-2’s, and 1099’s, or not?  Will the community report virtual currency holdings or not?  It is hard for the IRS to track transactions if they are not reported, but this IRS notice is telling the taxpayer, the law, and the taxpayer would need to comply.

If we look at how aggressive the IRS has been over the last five years regarding offshore bank accounts then one could argue that this taxation on virtual currency is here to stay. The community and network of virtual currency has also provided support that the currency is valuable and easily converted into good and world currencies.  So, if you are involved with virtual currencies, now is the time to speak with your tax advisor and create a plan on how to deal with the taxation and create a strategy just like any other successful business.

The IRS notice can be found at http://goo.gl/ONYs4y as of today.  However, if the link doesn’t work, go to www.irs.gov and search the website for Notice 2014-21.  Please feel free to ask questions and comments.  Please contact us if we can be of assistance.

7 IRS Triggers

As we have written previously, IRS audits have significantly increased.  Having an audit is not fun.  It can consume a lot of ones time and money if you hire a professional to represent you.  We seen a lot of audits which in our opinion shouldn’t have been triggered but because the tax return has a certain trigger the taxpayer has to deal with it.  To often we see sloppy mistakes that taxpayers and tax preparers make which triggers the audit.  So review these items and consider if your tax return should be done differently or by a different person if you have any of these items.

  1. Loss from a flow through (S Corporation, Partnerships, LLCs):  We have seen an significant increase in audits in which the tax return is taking a deduction for a loss from a flow through.  The loss may be justified, but the IRS is looking for these attributes more often and they are finding mistakes.  Once selected, they will look for a calculation that should be part of the tax return that shows that the taxpayer has adequate tax basis to take the loss.  There must be tax basis to take the loss.  Too often we have seen that the tax preparer has not prepared the proper tax basis calculation and thus triggered the audit.  Most of the taxpayers didn’t know that the tax preparer didn’t’ prepare all the necessary forms.  So, if you have losses from flow through, double check with your tax preparer.  This issue can also be expanded to the flow through and all the shareholders or partners and for multiple years.
  2. Large decreased in taxable income:  Even though most of the country has just came out of the recession, and most of us had to work harder and earned less, the IRS is still pulling tax returns for audit when the taxable income as decreased significantly.  If your taxable income decreased significantly, please make sure you take extra care that your tax return is correct, so if you are audited, it will go smoother.
  3. Real Estate Professional:  Real Estate professional is a tax status that if met can allow a taxpayer to use that loss against other non rental income.  Typically rental losses are considered a passive activity and outside of some minor rules, is only able to be offset against other passive income.  So, if a taxpayer has rental losses, and has other non passive income, certain rules have to be met to net the amounts together and thus pay tax on the net.  The real estate professional status continue to be a hot audit item.
  4. Not reporting income:  The IRS computers receive information on taxpayer that typically deals with income and certain deductible items like mortgage interest.  If the IRS computers show a larger amount of income than reported on your tax return, your chances of an audit have significantly increased.  If the amount is small, the IRS may just send you a letter, but if the amount is large, you will probably have to deal with an audit.  So, make sure you review all your W-2’s, 1099, even including your investment transactions. Even if the amount reported isn’t fully taxable your tax preparer should be aware of the income and properly report it to agree with the IRS computers.
  5. Being Self-Employed (Sole Proprietorship):  The IRS audits self employed taxpayers more often than others.  They have statistics that these taxpayers as a whole try to reduce taxable income illegally.  They also have seen that these taxpayers typically don’t’ have the best records, so they audit them and find more tax dollars to send back to Washington D.C.  If you are self employed that is fine, make sure you have good accounting records.  Try using a simple program like Quick Books to keep track of your income, expense, and liabilities which include credit cards.  We highly recommend that self employed set up a DBA bank account and have separate credit cards for just the business.  This makes it easier to track business transactions.  Our opinion is that if your net income is approaching $100,000 or larger, you should consider incorporating and electing S Corporation.  Generally your income tax can be decreased, you can create some asset protection and your audit risk should be reduced.
  6. Foreign Bank Accounts:  The IRS is still allocating a lot of resources to find taxpayers that have foreign bank accounts and haven’t properly reported them. If a taxpayer has a foreign bank account or even signature authority they need to properly complete the proper forms to disclose them.
  7. Research Credit:  The tax code allows tax credits for money spent on research costs.  The government wants to create an incentive for the US taxpayer to strive to create new or better technology.  However, too often have we seen that the company didn’t properly follow the rules to support the research credit.

A lot of audits could have been alleviated if the tax return was prepared properly.  Also, the taxpayer needs to be prepared for an audit.  This means one must keep organized records.  We recommend using an accounting software program that is appropriate for your business.  Depending on the type of business you have, you will need to create some best practices to be more organized in accounting.  For example, if you purchase goods or services with cash, make sure you keep the receipts.  Taxpayers that have organized books and records can complete an examination much quicker.  So be prepared if you are audited.

The IRS isn’t the only one taxpayers need to be prepared for.  Depending on your business, make sure you are prepared for state audits, sales tax audits, and payroll audits.  All the government agencies are out there looking for more tax revenue.

How long to keep your income tax records?

Audits (or as the IRS calls them examinations) have been up over the past five years.  I’m sure someone in goverment has told the IRS to find more money as we all know the Federal government has a lot of debt to pay down.  So, if a taxpayer wants to be prepared for an audit, how long should they keep their documents?   Our general answer is four years.  In general, the IRS has three years (the regular statue of limitation) from the filing date to audit a tax return.  Most states have four years to audit as they want time to see if the IRS audits a return.  If the IRS audits a tax return and there are changes which require a taxpayer to pay more tax rest assured that the Federal government will tell the state(s). Then it is the states turn.

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Are those emails from the IRS real?

Many of our clients and I’m sure a lot of other taxpayers have received emails from the IRS.  Well, I’m here to tell you ignore them.  They are not real.  The IRS does not make initial contact with any taxpayer or tax advisor through email.  The IRS has been communicating this statements since 2006.  Read the link to the IRS website below.  The IRS does have email, but they barely even use it with tax professionals due to these sorts of issues and for security purposes. Continue reading