Bitcoin and other cryptocurrencies are squarely in IRS crosshairs

On behalf of Lawrence Brown

The IRS is serious about taxing actual increases in value or income realized through transactions, employment and investment involving virtual currencies.

The IRS treats Bitcoin and similar cryptocurrencies like real currency when used and valued in ways equivalent to traditional money. For example, if a cryptocurrency is used as a financial investment or to pay someone for services, resulting gain is normally taxable – and failure to properly report and pay tax on the transaction is subject to the same federal tax liabilities and associated penalties.

In extreme cases, even potential criminal liability can arise.

What is cryptocurrency?

Most people have heard of Bitcoin, but have only a murky understanding of its nature. Bitcoin is the most well known cryptocurrency, a unit of value that only exists digitally on the Internet, but that can often be used like cash and sold for cash. It is that cash-equivalent attribute that distinguishes it from other digital currencies like those used within elaborate online games like World of Warcraft, according to Bitcoin Magazine, which says, “[c]ryptocurrencies are designed to be capable of replacing cash …”

Bitcoin Magazine explains further that cryptocurrencies have no central control mechanism like traditional currency has a central government bank. FinCEN, the Financial Crimes Enforcement Network of the U.S. Department of the Treasury, however, explains that some cryptocurrencies have centralized nongovernmental repositories that administer currency transfers between parties.

Still, cryptocurrencies tend to be decentralized and subject to “free market demand.” Increased supply of Bitcoin, for example, is done through an online process called “mining,” a complex phenomena in which anyone with the proper technology can participate online by solving computational puzzles and claiming rewards, describes Investopedia.

What is the IRS position?

The IRS made public its positions on “virtual currency” in its Notice 2014-21, defining it as “digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” The government is concerned at this point in time about virtual currency that is “convertible” like Bitcoin to real currency like dollars.

Once virtual currency transactions result in the transfer of real value that can convert to cash, the IRS will tax those transactions if they fall within traditional taxable events. For these purposes, the IRS treats virtual currency as “property” and associated transactions as “property transactions.” For valuation and basis, the IRS uses the “fair market value of the virtual currency, measured in U.S. dollars, as of the date the virtual currency was received.”

The IRS explains some of the potentially taxable events and other tax issues concerning virtual currency:

• When virtual currency is used to buy goods or pay for services, its fair market value must be included in gross income, if appropriate.
• When virtual currency is exchanged for other property, it can result in taxable gain or loss, depending on the taxpayer’s adjusted basis in the virtual currency
• Tax rates from the sale or exchange of virtual currency is based on whether it was held as a capital asset, which generates capital gain or loss. Otherwise, it would be taxed as ordinary gain or loss.
• Gain from mining virtual currency is taxable as income.
• Mining activity carried on as a trade or business would be taxable as self-employment.
• An employer that pays wages in virtual currency would still be subject to federal tax withholding requirements and related responsibilities on those payments.
• And many more

Why is legal advice important?

The IRS is serious about scrutinizing Bitcoin and similar transactions for taxable activity. For example, at IRS request, a John Doe summons was granted to Coinbase, a large cryptocurrency exchange, which requires it to disclose Bitcoin transactions worth at least $20,000 from 2013 through 2015.

Any individual or business that deals in virtual currency should seek advice and guidance about its related tax responsibilities, especially if subject to the summons or if the IRS has already made contact of any sort about the matter. An experienced tax lawyer can vigorously represent the taxpayer’s interests and provide guidance for future use of virtual currency as it concerns taxable activity.