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Bitcoin and Virtual Currency: What CPAs Need to Know Heading into Tax Season

by Jason M. Tyra, CPA, MBA, CFE | Jan 19, 2016

With tax season rapidly approaching, many practitioners are likely to encounter clients for the first time with virtual currency activity to report. Bitcoin, the best known virtual currency, peaked in value in early 2014 before all but disappearing from public view shortly thereafter. Nearly two years later, virtual currencies are still out there: an impressive run in the fall of 2015 (possibly due to an alleged Chinese pump and dump scheme) attracted fresh attention and new converts. While industry and venture capitalist focus currently appears to be shifting from bitcoin as a currency to Bitcoin as a technology, virtual currencies are likely to be an enduring (if niche) asset class.

What is Bitcoin?

If you’ve somehow missed out on the virtual currency revolution, you probably aren’t alone. A Business Insider poll[1] at the height of bitcoin’s popularity in March of 2014 revealed that only 55% of Americans and Europeans had heard of it. Most of the publicity was bad--thefts, hacks, Ponzi schemes, and frauds kept bitcoin and other lesser-known virtual currencies in the news on an almost continuous basis during late 2013 and early 2014. Though easily dismissed as a tool of criminals, virtual currencies offer a few compelling use cases that, while not driving mass adoption, are at least keeping them from disappearing altogether.

Bitcoin is a trustless, decentralized means of exchange and store of wealth. It is decentralized because its network consists of thousands of individual nodes running open source software on privately-owned computers. It is trustless because it does not rely on a single intermediary to guarantee transactions conducted over its network in the same way as conventional payment methods. Instead, transactions and balances are verified by consensus, meaning that the network at large is the intermediary between sender and recipient.

Bitcoins are created by a complex computational process known as “mining.” Once created, they are held in cryptographically-protected accounts known as “wallets.” A single bitcoin (or fraction thereof) is prevented from appearing in multiple wallets by the confirmation process carried out by individual nodes on the network. In short, only when a user has a valid key for an existing wallet with a sufficient balance can that user send some or all of the bitcoins held in that wallet to another address. Every node on the network carries a complete copy not only of the current status of all accounts on the network, but also of the complete history of every account, ensuring that no bitcoin can be spent twice. This set of transaction records is known as the “blockchain.” It is this distributed ledger technology that has attracted the interest of large banks in the United States and elsewhere.

Tax Treatment of Bitcoin and Other Virtual Currencies

In the spring of 2014, the IRS released guidance to the public (Notice 2014-21) that explicitly classified virtual currencies as property, removing much of the uncertainty surrounding appropriate handling of tax filings. Notice 2014-21 includes the caveat: “General tax principles applicable to property transactions apply to transactions using virtual currency." Classification as property, or more accurately as something other than a currency, means that virtual currencies are subject to tax treatment in the United States that is similar to other asset types under similar circumstances.

Virtual currencies offer a wider range of use cases than ordinary cash. Thus, tax treatment varies based on the context of their acquisition and use. The normal property classification rules under Section 1221 apply to virtual currencies. Clients may classify holdings either as capital or non-capital assets depending on the nature of the client’s activities. For example, bitcoins in the hands of a casual investor might be a capital asset, whereas a money service business that holds bitcoin for resale to others might view bitcoins as inventory (explicitly excepted from the definition of a capital asset under Section 1221).  

Virtual Currency Mining

Mining is the computational process by which bitcoins are created. Many virtual currencies use variants of Bitcoin’s mining algorithm to regulate the rate at which they can be created and/or spent.  

The doctrine of constructive receipt suggests that virtual currency miners generally realize ordinary income when mining activity results in the receipt of virtual currency. Income is not deferred until mining receipts are converted or sold, but must be declared in the tax year the coins are actually created.

The market value of the virtual currency received on the date of receipt is typically used to calculate income and basis. At the time of publication of this article, there are a variety of reliable sources of pricing information for virtual currencies, most of which would likely be considered acceptable in this context.

Some clients may participate in pools that combine computing power for more consistent payouts to their members. If a taxpayer participates in a mining pool, then he or she may be required to use the date that the virtual currency was mined by the pool, rather than the date received by the miner (there may be a time lag between these two events), depending on the tax structure of the pool and its operating rules.

Many bitcoin enthusiasts operate mining hardware with little expectation of turning a profit. Miners may be considered either hobbyists or business owners depending on the scope of their activities. Material participation and active participation rules apply here, as do the hobby loss rules.

Virtual Currency Trading

Virtual currencies are usually considered capital assets in the hands of individuals, subject to most of the same rules and tax treatment as more common capital assets, such as securities. Most rules applicable to securities trading are also thought to be applicable to virtual currency trading. The notable exception here is wash sale rules. Since virtual currencies are not, by definition, securities, IRS wash sale rules do not apply to virtual currency transactions. This means that some clients may be able to take advantage of unrealized losses in virtual currency holdings at year’s end to offset gains in other areas without having to materially change the composition of their portfolios.

A word of caution to practitioners considering whether to take on virtual currencies: virtual currency exchanges and trading platforms are not currently required to report basis or trade information to US taxpayers or to the IRS on Form 1099-B. This means that it is incumbent upon individual taxpayers to maintain adequate, consistent records for tax reporting purposes. My experience in this area has shown that many fail to do so.

Purchases and Sales Using Virtual Currencies

The ability to seamlessly employ virtual currencies to pay for everyday purchases (the proverbial “cup of coffee”) is the holy grail of the virtual currency movement. Unfortunately, current IRS rules make daily transaction tracking a difficult and time consuming affair for clients who hold bitcoins as a capital asset.

Under IRS barter exchange rules, when a virtual currency is used to make a purchase, the event is treated the same as a disposal due to sale, triggering recognition of (usually capital) gain or loss.

Businesses that accept virtual currencies in settlement of sales recognize ordinary income equal to the US dollar value of the sale. Also, clients should be aware that receipts denominated in virtual currencies do not cancel out local sales, use or excise tax rules or otherwise relieve merchants of the responsibility to accurately record and report revenue in any way.

Many virtual currency trading platforms offer the option of immediate settlement to US dollars or another currency. If virtual currencies are not immediately disposed of, then they are ultimately taxable in two ways--ordinary income on receipt to establish basis and capital gain or loss at time of disposal. This means that practitioners who handle businesses using virtual currencies to pay vendors or employee salaries will face additional record keeping requirements beyond merely booking the expenses.

Gifts and Donations of Virtual Currencies

Gifts are a major part of the virtual currency community. It is not uncommon to see a digital “tip jar” at the bottom of a blog post or other piece of original content or to find enthusiasts seeking gifts of virtual currencies to fund projects that are of interest to the general community. Virtual currencies make it possible to send payments as small as a fraction of a cent without the expense of credit card interchange fees.

Gifts of virtual currencies are subject to IRS Gift Tax rules in the United States in the same manner as other forms of personal property. Gifts of virtual currencies are not exempt from reporting and count toward annual and lifetime exempt gift limits for US taxpayers.

Charitable donations of virtual currencies are subject to IRS rules governing donated non-cash property, including deductibility limits and value substantiation requirements. Donors should carefully maintain records of the date and amount of all charitable donations and be sure to obtain a receipt or other acknowledgement from the recipient of the donation. Due to the ready availability of pricing information online, an appraisal of donated virtual currencies would usually not be required.  

Use caution: donation-seeking for open source software and other community oriented projects is very common among virtual currency users. Clients may donate funds to non-exempt or otherwise ineligible entities without realizing that they have done so. Donations to non-qualifying entities would be considered non-deductible gifts under IRS tax rules. 

These are the most common federal tax situations likely to be encountered by practitioners with clients who are casual users of or investors in virtual currencies. Be sure to check if your state has issued additional guidance on income, sales or other types of taxes and virtual currencies.

Jason Tyra, CPA, MBA, CFE, is principal of Jason M. Tyra, CPA, PLLC, in Killeen, Texas. A CPA licensed to practice in Texas, Jason provides tax and consulting services to the Bitcoin user community, including some of the leading figures and companies in Bitcoin. Contact him at jason@tyracpa.com.


[1]Source: http://www.businessinsider.com/bitcoin-awareness-survey-2014-3

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