Whenever virtual currencies are bought, sold, or traded there are tax implications with the IRS. Virtual currencies such as Bitcoin, Litecoin, and Ethereum have captured the attention of the public, the U.S. government, and entrepreneurs—and they’ve also skyrocketed in price. In early November 2017, Bitcoin’s price soared to over $7,000.
Investors, users, and miners are drawn to virtual currencies for their value, convenience, and some measure of anonymity. Virtual currencies appear separate from a central bank or government, which carries a certain appeal—for both lawful and illicit uses. Despite this perceived separation from government control, the U.S. Treasury still wants its share. In fact, income from virtual currencies is still income in the eyes of the IRS, and they have issued guidance to this effect through Notice 2014-21.
Notice 2014-21 clarifies that for federal income tax purposes, virtual currency is treated as property. With this designation, payments of virtual currency are subject to existing general tax principles. Wages paid in virtual currency are taxable to the employee and deductible by the employer. Further, payments to independent contractors are taxable to the recipient, and may be deductible by the payer. It is important to note: these transactions may require informational reporting through a W-2 or 1099 and may even require tax withholding. As property, the value of these virtual currency transactions is determined by fair market value (FMV) at the date of payment of receipt.
Virtual currency is commonly used for investing, as most merchants do not accept it as a form of payment. The IRS clarified in Notice 2014-21 that any gain or loss from the sale or exchange of virtual currency is also taxable. The nature and treatment of the gain or loss depends on the length of time held, and the business purpose of the asset. If the virtual currency is a capital asset to the taxpayer, then any gain or loss would generally be capital. Generally, virtual currency would be a capital asset (defined by section 1221) except if it is used as inventory held primarily for sale to customers in the ordinary course of business (i.e., a mining operation, or day trading).
The IRS notice also clarifies tax treatment of mining activities. Successfully mining virtual currency creates income to the taxpayer, valued at the date of receipt. Virtual currency miners may also be able to take deductions related to the mining activities. Income from mining could be considered self-employment income, and be subject to self-employment tax, if the activity is not conducted as an employee.
The IRS Notice 2014-21 answers the most common questions regarding virtual currency and taxes, but without further guidance, litigation, and legislation, the more complex issues remain open. Treating virtual currency as property, and not fungible currency, creates more questions than answers. For example, how should loans in virtual currency be treated? Are Bitcoin hard forks taxable events or merely something like a stock split? For questions like these, clarification on Notice 2014-21, or assistance with other tax matters, please reach out to Jeffrey Gershen, Robert Hall or your Aronson tax professional, and watch for further Aronson blog posts regarding virtual currency.