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March 31st, 2014
IRS Will Treat Virtual Currencies as “Property”
In Notice 2014-21 issued on March 25, 2014, the IRS announced that it will treat virtual currencies (such as Bitcoin) as "property" for U.S. federal tax purposes. The Notice applies to payments of compensation to employees or independent contractors using convertible virtual currency (as defined below), and to exchanges of convertible virtual currency for other property. The Notice also affects so-called "miners" of convertible virtual currency. Here's a summary of what you need to know.
Definitions. The IRS Notice defines virtual currency as "a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value" and notes that in certain cases, it might "operate like 'real' currency -- i.e., 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 -- but it does not have legal tender status in any jurisdiction." The IRS Notice is careful to limit its application, however, to what it refers to as "convertible virtual currency," which it defines as "virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency." (The IRS Notice directs taxpayers to the Financial Crimes Enforcement Network (FinCEN) Guidance on the Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (FIN-2013-G001, March 18, 2013) for a more comprehensive definition of "convertible virtual currencies.") The Notice cites Bitcoin as an example of a convertible virtual currency. The latter clause of the definition of "convertible virtual currency" - "or that acts as a substitute for real currency" - is likely to raise a number of questions. For example, there currently are a number of digital representations that function as a medium of exchange within electronic games (e.g., game credits, points, gold, etc.), but that are not convertible into real currency. Arguably, these game units constitute a "substitute for real currency" (and thus "convertible virtual currency") because a game player can transfer them to another player within a closed game system and receive in exchange, outside the game system, consideration in the form of other property. It is unclear whether the IRS intended this result, but it may have intended that the transaction outside the system be taxable.
What Are the Tax Implications? The Notice provides several illustrations of the impact of defining convertible virtual currency as "property."
- Employee or independent contractor compensation. A payment in convertible virtual currency of wages to an employee or compensation to an independent contractor will constitute taxable income to the recipient measured by the value of such convertible virtual currency as of the date it is received. If a convertible virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, its value is determined by converting it into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied. Payments of wages to an employee in convertible virtual currency must be reported by the employer on a Form W-2 and are subject to federal income tax withholding and payroll taxes, and payments of compensation to other service providers in convertible virtual currency are subject to Form 1099 reporting requirements and generally are subject to self-employment taxes.
- Exchanges. An exchange by one taxpayer of convertible virtual currency for other property owned by another taxpayer will have tax consequences to both taxpayers. The taxpayer transferring convertible virtual currency will have a gain or loss measured by the difference between the taxpayer's adjusted tax basis of the convertible virtual currency exchanged and the fair market value of the other property received in the exchange. The character of such gain or loss as capital or ordinary will depend on whether the convertible virtual currency is a capital asset in the taxpayer's hands. Stocks, bonds and other investment property are common examples of capital assets, while inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset. The taxpayer transferring other property must include in gross income the fair market value of the convertible virtual currency received in the exchange.
- "Mining." An acquisition of convertible virtual currency by an individual taxpayer who successfully "mines" it realizes gross income as a result of those activities. The amount of such income is measured by the value of the convertible virtual currency as of the date of its receipt, and if such taxpayer's "mining" constitutes a trade or business and his "mining" activity is not undertaken as an employee, his net earnings from such activities will constitute self-employment income subject to self-employment tax. As an example of a taxpayer who "mines" convertible virtual currency, the IRS Notice refers to a taxpayer who "uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger."
One of the IRS Notice's more interesting observations is that under certain conditions, IRS information reporting is required for persons who settle payments made in convertible virtual currency on behalf of merchants that accept it from their customers. Such "third party settlement organizations" must report payments made to a merchant on a Form 1099-K (Payment Card and Third Party Network Transactions) if, for the calendar year, both (1) the number of transactions settled for the merchant exceeds 200, and (2) the gross amount of payments made to the merchant exceeds $20,000. The application of this reporting requirement could have a chilling effect on the use of convertible virtual currency in executing routine retail transactions.
Penalties. The IRS Notice states that taxpayers who fail to comply with the tax laws applicable to virtual currency transactions may be subject to the Internal Revenue Code's existing penalty regime (although relief may be available to taxpayers and persons who can establish that their underpayment of taxes or failure to properly file information returns was due to "reasonable cause").
Comments. The IRS Notice acknowledges that there may be other questions regarding the tax consequences of virtual currency that the Notice has not addressed, and invites comments from the public regarding other types or aspects of virtual currency transactions that should be addressed in future guidance. Comments can be submitted by e-mail to Notice.Comments@irscounsel.treas.gov (include "Notice 2014-21" in the subject line) or by regular mail to Internal Revenue Service, Attn: CC:PA:LPD:PR (Notice 2014-21), Room 5203 , P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044.
If you would like to discuss the tax treatment of virtual currency or the implications of the IRS Notice, or if you need assistance submitting comments to the IRS in response to the IRS Notice, please contact Jeffrey Marks at (212) 826 5536 or firstname.lastname@example.org, Bernard Topper at (212) 826 5547 or email@example.com, Greg Boyd at (212) 826 5581 or firstname.lastname@example.org, or Sean F. Kane at (212) 705 4845 or email@example.com.
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