On 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.