Taxation of Virtual Currency Transactions
by Soheila Shahidi, Bahar A. Schippel and Matthew P. Chiarello
With the use of virtual currency on the rise, questions emerge as to how virtual currency transactions are taxed. The IRS has issued guidance regarding the tax consequences of such transactions, answering some questions but leaving many unanswered. At a high level, the IRS indicates that virtual currency will be treated as “property” for tax purposes, meaning that the normal tax rules for using property in commerce will apply. Below is a discussion of some of the applicable rules, as well as some issues that await further guidance.
- How Am I Taxed If I Pay for Goods or Services with Virtual Currency?
An expanding group of merchants accept virtual currency as a method of payment (e.g., Expedia, Microsoft, Dish Network, and Overstock). In addition, some government agencies are now accepting (or considering doing so) virtual currency as payment for government services. For example, a committee in the Arizona House of Representatives has recommended the passage of a bill allowing state residents to pay their state tax bills in bitcoin.
Virtual currency owners should be aware that using such currency to make payments is a taxable event. This means that if the value of the virtual currency has appreciated in the hands of the payor, then the payor would owe tax on the amount of that appreciation at the time the virtual currency is used to pay for goods or services. For example, if you purchase a bitcoin for $10,000 and use it to buy a vehicle for $12,000, you would owe taxes on the $2,000 increase in value. In other words, using virtual currency to pay for goods or services is taxed in the same way as selling the virtual currency for cash and then using the cash proceeds to pay for the goods or services.
- Will I Get Capital Gain Treatment?
Since the highest tax rate on ordinary income is 37% as opposed to the highest long-term capital gain tax rate of 20%, taxpayers generally prefer capital gain treatment. The character of gain relating to virtual currency depends on whether such virtual currency is a capital asset in the hands of the taxpayer. If virtual currency is held for investment, similar to how many investors hold their stocks and bonds, it is treated as a capital asset. On the other hand, if virtual currency is held for some other use, it may not be treated as a capital asset. For example, if a business is involved in the sale of virtual currency to its customers, any gain resulting from such sale will result in ordinary income.
Assuming you hold your virtual currency for investment purposes, you may benefit from the reduced tax rate on long-term capital gains only if you hold it for at least a year before using it to pay for goods or services. This is because only capital assets held for more than one year receive long-term capital gain treatment – those held for less than a year are subject to short-term capital gain rates which are the same as ordinary income tax rates.
- Can I Take a Loss If the Value of My Virtual Currency Drops?
Although the holders of virtual currency would prefer that it only increase in value, it is obviously possible that it results in losses. In that case, what is the proper tax treatment of such losses? There are numerous complicated tax rules that impact the timing and character of losses that may prevent a taxpayer from taking a loss resulting from the sale of virtual currency. As a general rule, if virtual currency is held as an investment, then the ability to take losses may be substantially limited.
- Is Mining Bitcoin Subject to Tax?
Mining bitcoin is the process by which new bitcoins are released. Mining involves compiling and verifying transactions in a block and solving a computationally difficult puzzle. A person who successfully verifies transactions and is the first miner to solve the puzzle is rewarded with new bitcoins. The fair market value of bitcoin as of the date of receipt is included in the miner’s income. For example, a miner who is rewarded with 12.5 bitcoins with a fair market value of $10,000 on the day of receiving the reward, will have to include $125,000 in income, as ordinary income (versus capital gains). In addition, if the miner engages in mining as a trade or business, then the gross income derived from this business, minus allowable deductions, will also be subject to self-employment tax. The IRS has not issued any guidance regarding the circumstances under which a miner may be deemed to be engaged in a trade or business of mining.
- How Do I Report My Virtual Currency Gains or Losses?
Gains or losses derived from transactions involving virtual currency held as investment are reportable on Form 8949 as an attachment to Schedule D of Form 1040. The IRS has not issued guidance as to how to report gain or loss derived from virtual currency held as inventory or other non-capital asset property. Until the IRS does so, taxpayers can report such income or gain using the same forms they use to report income derived from other such properties.
- Third-Party Information Reporting of My Virtual Currency
If you mine, purchase, acquire, use, sell, or otherwise dispose of virtual currency, you may wonder if any third party is required to report such transaction to the IRS. Currently, there are not a lot of rules relating to information reporting with respect to virtual currency transactions. There are, however, certain situations in which information reporting may be required.
First, certain companies – known as third party settlement organizations (“TPSO”) – are required to provide the IRS with information reporting with respect to certain transactions. These are companies that contract with unrelated merchants to settle payments between those merchants and their customers. An example of a TPSO is PayPal. A TPSO is generally required to report payments made to a merchant on 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. In computing the total amount reportable on Form 1099-K, transactions where the TPSO settles payments made with virtual currency are aggregated with transactions settled with real currency.
Second, the IRS requires information reporting if a service recipient uses virtual currency to pay for services. This is discussed below.
Finally, even if information reporting is not currently required under the law, the IRS has the ability to obtain information through audits, subpoenas, and other means. For example, the IRS has asked Coinbase, a virtual currency exchange, to provide information regarding its customers that have engaged in any one transaction type (buy, sell, send, or receive) amounting to $20,000 within one year between 2013 and 2015. This reporting requirement affects at least 13,000 Coinbase account holders and was to be provided to the IRS by March 16, 2018.
- Can I Use Virtual Currency to Pay My Employees or Independent Contractors?
Yes, the same reporting, withholding, and income inclusion rules that apply to compensations paid in real money, also apply to virtual currency.
Employers: Since remuneration for services constitutes wages, employers who pay their employees using virtual currency will have to withhold income, FICA, and FUTA taxes and will need to report the fair market value of the virtual currency paid to each employee on the Form W-2. In addition, as discussed above, if the value of virtual currency has appreciated in the hands of the employer, and the employer uses virtual currency to pay for services received, the employer will owe taxes on the gain resulting from such appreciation.
Employees: Taxpayers who receive virtual currency as remuneration for providing services will be required to include in income the fair market value of the virtual currency as of the day of receipt. Presumably, the employer and employee use the same fair market value for reporting purposes, although, as discussed below, there are currently no rules specifically addressing the valuation of virtual currency for reporting purposes.
Independent Contractors: A person who in the course of a trade or business makes a payment in virtual currency in the amount of $600 or more to an independent contractor for performance of services, is required to report that payment to the IRS on a Form 1099-Misc. Please note that similar to employers, if a payor uses virtual currency that has appreciated in value to pay independent contractors, the payor will owe taxes on the gain resulting from such appreciation. Also, independent contractors who receive virtual currency as payment for providing services will be required to include in income the fair market value of the virtual currency as of the date of receipt. Additionally, as with other types of income, virtual currency income received by independent contractors is subject to self-employment tax.
- Determining the Fair Market Value of Virtual Currency
The value of virtual currency that is listed on an exchange is established by market supply and demand. Given virtual currency’s highly volatile value, an area of uncertainty is how to determine the fair market value of virtual currency on a given day when the value could vary at different times within a day. Generally, valuation of traditional stock traded on a public exchange accounts for intraday volatility by taking the average of the highest and lowest selling prices for a given trading session. Given the tendency for exceptional volatility and the lack of defined (or any) trading hours, it is unclear whether a similar approach will apply in the context of determining the fair market value of virtual currency.