Anyone craving emerging technology has surely seen the enormous interest generated by and surrounding Bitcoins. In just five years the little-known virtual currency has gone from being worth pennies to thousands of dollars apiece. And many speculators have been cashing in on them.
Bitcoins are an online digital currency created at a predetermined rate by an open-source computer program. Bitcoins are not a paper currency. Each Bitcoin consists of a coded Internet address that can be stored in an online “wallet” that is created by the digital currency’s owner. Bitcoins are created through a process called “mining” in which computers are used to solve complex mathematical problems. Only a finite number of Bitcoins can be created which leads to their value.
Unlike conventional money, Bitcoins are independent of a controlling or government-backed bank. These appeal to proponents because of the non existence of currency exchange rates or banking fees associated with other currencies. Also, Bitcoins are transferred anonymously peer to peer across the Internet, thus limiting the regulatory oversight of transactions and eliminating the need for clearance by payment facilitators such as Visa or PayPal.
Until recently, the use of Bitcoins was primarily by crypto-anarchists, libertarians and criminals. However, now Bitcoins have gone mainstream with many retailers, including CVS, Target, Amazon, and Home Depot accepting them as payment. Bitcoin demand is very real. In fact, the digital currency is so popular the Internal Revenue Service (IRS) decided to get involved.
In March 2014, the IRS released Notice 2014-21 instructing that Bitcoins, which do not have the status of legal tender, be treated as property and not as currency. Therefore, gain from the sale of Bitcoins is taxed as ordinary income or as capital gain depending on the owner’s circumstances. If a taxpayer holds Bitcoins as capital or a commodity, like a stock or bond, gain from the sale of the Bitcoins is treated as capital gain. However, a person who qualifies as a dealer in Bitcoins, meaning he is in the business of trading them, treats any gain as ordinary business income. It all depends on whether the Bitcoins are capital or ordinary assets in the hands of the taxpayer.
The IRS guidance clarifies the tax treatment and hopefully encourages taxpayer compliance in recognizing income associated with the digital currency. Yet, a looming issue that remains is determining how to assign a dollar value to a Bitcoin. Establishing the value of a Bitcoin is far more subjective than determining the value of a foreign currency that is traded on public exchanges and subject to regulatory oversight. According to the IRS guidance, taxpayers are supposed to convert the value of Bitcoins into dollars at the time of their transactions. The problem is the Bitcoin market is not as stable or efficient as hard currencies. Virtual currency is extremely volatile. Furthermore, there is no control over how Bitcoins are valued against other currencies, thereby subjecting them to price manipulation and speculation. Currently, many of the online exchanges differ vastly in their Bitcoin price listings, ranging anywhere between $300 to $7,000, which may allow some taxpayers to exploit the issue by using exchange values in their favor.
Aside from the tax treatment of Bitcoins, from a business prospective the IRS guidance sheds light on other aspects as well. For example, payments using Bitcoins clearly are subject to the same information and backup withholding requirements as are other property transactions. Additionally, there is a possibility of increased IRS auditing of Bitcoin transactions, because even though such transactions are anonymous, all Bitcoin transactions are stored on the “block chain,” a universal public ledger.
In the wake of the IRS guidance, state revenue departments are slowly beginning to offer insight into their income tax treatment of the virtual currency. For example, Washington has not yet announced the state’s position, but it has hinted that it will depart from the IRS and treat Bitcoins as currency. In contrast, New York and Texas conform to the IRS, calling digital currency an investment.
A handful of states have issued bulletins on various sales and use tax considerations presented by transactions involving Bitcoins. Four states, California, New York, Wisconsin and Kentucky have pronounced that purchases of taxable goods or services made with Bitcoins are subject to state sales tax, just like any other purchase. The sales price in dollars is the proper measure of the tax.
Interestingly, although the IRS treats Bitcoins as property, guidance from New York, Wisconsin and Missouri indicates that the sale or exchange of Bitcoins themselves is not subject to sales tax. New York, for example, treats the use of virtual currency to pay for goods or services as bartering. Typically, New York views bartering transactions as two separate transactions and applies sales tax to each item transferred between parties. However, when Bitcoins are exchanged for taxable tangible personal property or services, sales tax is only applicable with respect to one side of the transaction. The party paying with Bitcoins is not responsible for remitting any sales tax since it is viewed as the exchange of nontaxable intangible property.
While the IRS and a handful of states have begun addressing digital currency issues, many questions still remain. For example, the IRS was noticeably silent regarding Bitcoin exchanges. One has to believe that the IRS will likely subject the exchanges to the same requirements as other financial asset exchanges, which would include the reporting of Bitcoin transactions on Form 1099-B. Only time will tell how the IRS and states will react to this growing phenomenon. Until then, we can only speculate on the tax realities of virtual reality.
If you have any questions regarding the taxability of virtual currencies, please contact Alan Goldenberg, Manager of Tax Controversy and State and Local Taxation, at firstname.lastname@example.org or 212-897-6421, or your Friedman LLP tax professional.