The IRS has put out Notice 2014-21 to advise taxpayers that virtual currency will be treated as property and transactions with such currency are taxable. Bitcoin is an example of virtual currency. It functions as a medium of exchange for a variety of goods and services, but it isn’t actually designated as a legal currency in any jurisdiction.
The IRS has concluded that virtual currency is a form of property that has a fair market value to it. Taxpayers who receive payment in the form of a virtual currency must determine the fair market value on the date of receipt to measure their income subject to tax. So for example an acupuncturist who receives Bitcoin for their services, must determine the amount of US dollars that Bitcoin could be converted to on the date they received the Bitcoin to measure their taxable income from the transaction.
Some of the consequences of this policy include
- Employees who receive virtual currency from their employer are subject to income tax withholding and payroll taxes like social security and medicare.
- Independent contractors and sole proprietor businesses who receive virtual currency have both income tax and self employment taxes to consider.
- Failure to report income on virtual currency transactions would be subject to similar penalties charged on failing to report more traditional transactions.
If a taxpayer holds their virtual currency for a period of time and then converts to US dollars there will likely be a gain or loss on the conversion because the market value of the virtual currency is fluctuating over time. More over, if a taxpayer were to use the virtual currency to purchase other goods, the fair value of the goods would be different then the initial value the taxpayer had in that currency as their “tax basis.” The gain or loss that results from changes in value between real currencies is referred to as, “foreign currency” gain or loss for tax purposes or more commonly foreign exchange gain/loss. However the policy of treating virtual currency as property precludes treating the above mentioned changes in value this way.
Instead, the conversion of virtual currency to the US Dollar is a “sale” of that property. Likewise purchases of other goods or services with the virtual currency are considered a sales of property. Traditionally property held for investment purposes would be considered eligible for “capital” treatment, whereas property held for sale to customers would be ordinary income. The potential for capital treatment on the sale of virtual currency is a double edged sword. If the currency is held for more than one year and is a gain, then an individual taxpayer gets the benefit of a lower tax rate. However if the currency is sold for a loss, the taxpayer may not be able to deduct that loss immediately. Capital losses are generally deductible against capital gains or up to $3,000 of the taxpayer’s ordinary income.
If your business transacts with virtual currency(s), contact me for assistance with the related accounting and tax complexities.