IRS Puts Bitcoin Investors on Notice

The Internal Revenue Service has issued guidance on the use of virtual currencies such as Bitcoin, saying they should be treated as property rather than as currency for federal tax purposes.

In the notice, the IRS offers answers to frequently asked questions from tax practitioners on virtual currencies, which have been gaining adherents and increased investment in recent years, despite some high-profile criminal cases and the collapse of prominent Bitcoin exchanges like Mt. Gox after hacker attacks were blamed for the disappearance of $460 million from their coffers (see IRS Says Bitcoin Counts as Property for Tax Purposes).

The shutdown of the site Silk Road, along with later successors, and the arrest of its founder on money laundering and murder conspiracy charges, also have not helped the digital currency’s reputation.

The FAQs issued Tuesday by the IRS show the agency intends to treat the virtual currency as taxable property. The guidance provides basic information on the U.S. federal tax implications of transactions in, or transactions that use, virtual currency.

In some environments, virtual currency operates like “real” currency, the IRS noted, such as 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, the IRS pointed out, virtual currencies like Bitcoin do not enjoy the status of being legal tender in any jurisdiction. Indeed, Bitcoin has often been accused of facilitating international criminal enterprises such as money laundering, drug dealing and prostitution by skirting the traditional banking channels. Even the technology’s supposed creator has disavowed his involvement with it.

The IRS notice provides that virtual currency is treated as property for U.S. federal tax purposes as opposed to regular currency. Thus the general tax principles that apply to property transactions also apply to transactions using virtual currency like Bitcoin. That means that wages paid to employees using virtual currency are taxable to the employee and must be reported by an employer on a Form W-2, and they are also subject to federal income tax withholding and payroll taxes.

Payments using virtual currency made to independent contractors and other service providers are also going to be taxable and self-employment tax rules generally apply, according to the IRS. In addition Bitcoin payers may need to issue a Form 1099, as business payers often do. The character of gain or loss from the sale or exchange of virtual currency will depend on whether the virtual currency is a capital asset in the hands of the taxpayer. A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property, according to the IRS.

I talked with a tax expert who has been closely following Bitcoin’s rise and he sees some advantages of the IRS weighing in on the technology. “A lot of people dealing in Bitcoin didn’t know what the consequences were, so at least people now know what the consequences are of using it,” said Steve Brecher, a senior adviser at the accounting firm WeiserMazars. “Knowing the consequences is useful. Some people have been making assumptions about it and proceeding, and they may have guessed right. There were some people who were probably hopeful it might get a different treatment. But at least they know what the treatment is.”

Some investment experts, such as the Winklevoss twins who were involved in the founding of Facebook, were already anticipating this type of treatment when they formed their Winklevoss Bitcoin Trust.

Even though IRS guidance may reduce some of the coolness factor in Bitcoin, it may also make it a somewhat safer bet as regulators try to get a handle on the technology. Incidents like the Mt. Gox meltdown and the Silk Road shutdown have shaken investor confidence in the technology and led to wild volatility on the Bitcoin markets that remain open.

With the IRS weighing in, and the Treasury Department’s Financial Crimes Enforcement Network also coming out with rules last year on virtual currencies, the exchanges may become less subject to criminal manipulation. New York State is also looking at issuing regulatory rules, Brecher pointed out. “Even though Bitcoin originally started outside of any regulatory scheme, I think it probably presents more confidence, so I think how it’s used may depend on the implications. Are you really going to go into Pizza Hut and buy a pizza with your Bitcoin if you have to worry about the tax consequences? I’m not sure you are.”

And with regular IRS forms like the W-2 and 1099 now being required, the money will be more traceable.

That could be a bad thing for the criminals, but a good thing for the average investor concerned about losing their life savings on the latest market bubble.

Do you think Bitcoin transactions should be taxable?

Michael Cohn is editor-in-chief of AccountingToday.com.

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