Bitcoin is not a fiat currency with legal tender status in any jurisdiction, but often tax liability accrues regardless of the medium used. There is a wide variety of legislation in many different jurisdictions which could cause income, sales, payroll, capital gains, or some other form of tax liability to arise with Bitcoin.

According to the IRS:

  • Digital currency payments made to independent contractors and service providers must be reported via Form 1099.
  • Profits and losses from the sale of digital currencies are subject to capital gains when being used as capital assets.
  • Wages paid to employees in digital currencies are taxable and must be reported.

 

SECTION 4. FREQUENTLY ASKED QUESTIONS

Q-1: How is virtual currency treated for federal tax purposes?
A-1: For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.

Q-2: Is virtual currency treated as currency for purposes of determining whether a transaction results in foreign currency gain or loss under U.S. federal tax laws?
A-2: No. Under currently applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.

Q-3: Must a taxpayer who receives virtual currency as payment for goods or services include in computing gross income the fair market value of the virtual currency?
A-3: Yes. A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. See Publication 525, Taxable and Nontaxable Income, for more information on miscellaneous income from exchanges involving property or services.

Q-4: What is the basis of virtual currency received as payment for goods or services in Q&A-3?
A-4: The basis of virtual currency that a taxpayer receives as payment for goods or servicesin Q&A-3 is the fair market value of the virtual currency in U.S. dollars as of the date of receipt. See Publication 551, Basis of Assets, for more information on the computation of basis when property is received for goods or services.

Q-5: How is the fair market value of virtual currency determined?
A-5: For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt.

If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency 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.

Q-6: Does a taxpayer have gain or loss upon an exchange of virtual currency for other property?
A-6: Yes. If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain.

The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency. See Publication 544, Sales and Other Dispositions of Assets, for information about the tax treatment of sales and exchanges, such as whether a loss is deductible.

Q-7: What type of gain or loss does a taxpayer realize on the sale or exchange of virtual currency?
A-7: The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer. For example, stocks, bonds, and other investment property are generally capital assets.

A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer. 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. See Publication 544 for more information about capital assets and the character of gain or loss.

Q-8: Does a taxpayer who “mines” virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) realize gross income upon receipt of the virtual currency resulting from those activities?

A-8: Yes, when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. See Publication 525, Taxable and Nontaxable Income, for more information on taxable income.

Q-9: Is an individual who “mines” virtual currency as a trade or business subject to self-employment tax on the income derived from those activities?

A-9: If a taxpayer’s “mining” of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute self-employment income and are subject to the self-employment tax. See Chapter 10 of Publication 334, Tax Guide for Small Business, for more information on self-employment tax and Publication 535, Business Expenses, for more information on determining whether expenses are from a business activity carried on to make a profit.

Q-10: Does virtual currency received by an independent contractor for performing services constitute self‑employment income?
A-10: Yes. Generally, self‑employment income includes all gross income derived by an individual from any trade or business carried on by the individual as other than an employee. Consequently, the fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self‑employment income and is subject to the self-employment tax. See FS-2007-18, April 2007, Business or Hobby? Answer Has Implications for Deductions, for information on determining whether an activity is a business or a hobby.

Q-11: Does virtual currency paid by an employer as remuneration for services constitute wages for employment tax purposes?

A-11: Yes. Generally, the medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes. Consequently, the fair market value of virtual currency paid as wages is subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement. See Publication 15 (Circular E), Employer’s Tax Guide, for information on the withholding, depositing, reporting, and paying of employment taxes.

Q-12: Is a payment made using virtual currency subject to information reporting?
A-12: A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.

For example, a person who in the course of a trade or business makes a payment of fixed and determinable income using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee. Examples of payments of fixed and determinable income include rent, salaries, wages, premiums, annuities, and compensation.

Q-13: Is a person who in the course of a trade or business makes a payment using virtual currency worth $600 or more to an independent contractor for performing services required to file an information return with the IRS?

A-13: Generally, a person who in the course of a trade or business makes a payment of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment to the IRS and to the payee on Form 1099-MISC, Miscellaneous Income. Payments of virtual currency required to be reported on Form 1099-MISC should be reported using the fair market value of the virtual currency in U.S. dollars as of the date of payment.

The payment recipient may have income even if the recipient does not receive a Form 1099-MISC. See the Instructions to Form 1099-MISC and the General Instructions for Certain Information Returns for more information. For payments to non-U.S. persons, see Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.

Q-14: Are payments made using virtual currency subject to backup withholding?
A-14: Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. Therefore, payors making reportable payments using virtual currency must solicit a taxpayer identification number (TIN) from the payee.

The payor must backup withhold from the payment if a TIN is not obtained prior to payment or if the payor receives notification from the IRS that backup withholding is required. See Publication 1281, Backup Withholding for Missing and Incorrect Name/TINs, for more information.

Q-15: Are there IRS information reporting requirements for a person who settles payments made in virtual currency on behalf of merchants that accept virtual currency from their customers?

A-15: Yes, if certain requirements are met. In general, a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third party settlement organization (TPSO).

A TPSO is required to 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.

When completing Boxes 1, 3, and 5a-1 on the Form 1099-K, transactions where the TPSO settles payments made with virtual currency are aggregated with transactions where the TPSO settles payments made with real currency to determine the total amounts to be reported in those boxes. When determining whether the transactions are reportable, the value of the virtual currency is the fair market value of the virtual currency in U.S. dollars on the date of payment.

See The Third Party Information Reporting Center, http://www.irs.gov/Tax-Professionals/Third-Party-Reporting-Information-Center, for more information on reporting transactions on Form 1099-K.

Q-16: Will taxpayers be subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with this notice prior to March 25, 2014?
A-16: Taxpayers may be subject to penalties for failure to comply with tax laws. For example, underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties under section 6662.

The IRS’ treatment of digital currency as property is a boon to taxpayers holding it as a long-term investment – that is, holding it for more than a year. This is so because when investing in or undergoing transactions in foreign currency, the gains are taxed at the ordinary income tax rate; whereas with digital currency treated as property, the taxpayer can benefit from the lower capital gains tax rate.

Moreover, like any other commodity, if the digital currency loses value instead of making gains then the taxpayer can claim a capital loss, which would help lessen the tax bill. The character of gain or loss generally depends on whether the digital currency is a capital asset in the hands of the taxpayer.

According to the IRS, if the taxpayer holds digital currency as capital – such as stocks or bonds or other investment property – gains or losses are realized as capital gains or losses. But where such currency is held as inventory or other property mainly for sale in a trade or business, then ordinary gains or losses are generally incurred.

Taxpayers who obtain digital currency through mining must include the fair market value of the digital currency, as of the date of receipt, when reporting their gross income on tax returns.

This creates an enormous task for frequent miners who have to go back and see what the values of the bitcoins were on the dates they were mined. If the mining activities make up a trade or business, and the miner is not an employee, then the net earnings resulting from the activities constitute self-employment income that’s subject to self-employment tax.

Paying employee wages in digital currency are subject to federal and state income tax withholding, and by law should be reflected on both employers’ and employees’ tax returns. Such payments are required to be reported to the IRS on your business and payroll tax returns and must further be reflected on IRS Forms W-2 issued to each employee and filed with the IRS. In turn, the employee must report to the IRS and state tax authorities the wages he or she receives in digital currency on his or her personal tax returns.

For each, the reported amounts – the wages reported paid or received and the payroll taxes withheld – will be calculated using the fair market value of the digital currency in US dollars on the date paid or received.

Businesses paying independent contractors with digital currency must report amounts on Form 1099 – the document used to report other forms of income than wages or salaries – and supply the forms to tax authorities and their independent contractors.

Like employees, independent contractors are taxed in the same manner as if the amounts were received in US dollars. They must report amounts received as income on their tax returns and pay self-employment tax.

In regards to estate planning, experienced holders of bitcoin are aware of IRS Notice 2014-21. This notice states that for US tax purposes, bitcoin is to be treated as property rather than currency. The notice was, in all probability, issued with intent to slow down bitcoin adoption, and until bitcoin becomes mainstream to the point where the IRS recognizes it as a currency, these obvious consequences should be followed.

  • Whenever bitcoin is spent on goods or services, the spender must recognize taxable income or loss on the difference between tax basis (usually the price at which he acquired the bitcoin) and the fair market value of the bitcoin at the time spent.
  • Bitcoin miners must recognize ordinary income equal to the fair market value of the bitcoin mined at the time of mining.
  • If an employer pays you in bitcoin, such payments must be reported on your W2 and are subject to tax withholding in US dollars.

In regards to estate planning.  Since bitcoin is deemed to be property, when a bitcoin holder dies, beneficiaries of a will or living trust receive the bitcoin with tax basis at the fair market value on the date of death. For example, should you inherit 100 BTC from a relative, and on the date of death 1 BTC is worth $250 – if 1 BTC increases to $260 at the time it is later spent, the taxable gain would be $10 on the bitcoin use. If the relative paid only $150 for that bitcoin when it was acquired, that purchase price is irrelevant for tax purposes once the relative is deceased.

If the initial price paid was much higher, this could be beneficial. For bitcoin that has increased in value since purchase, this could be a disaster. In the above scenario, if the relative had paid $1,000 for 1 BTC, upon spending a taxable gain of $10 would still be the case, because the only relevant factor is the fair market value on the relative’s date of death.

An older individual holding bitcoin bought at a much higher rate than it is now worth, would be wise to hold onto it as long as you can so that your heirs might take advantage, and possibly eliminate all taxation of the gains on your investment.

However, if you own bitcoin bought at a much lower rate than it is now worth, you might consider spending it and preserving your cash. Upon spending, you’ll recognize taxable losses (which may possibly result in a reduced overall tax bill) and you’ll avoid your tax basis being stepped down upon death.

It is also important to ensure your heirs are aware that you have bitcoin, either by informing them or putting in place a service, person, attorney, etc. that would inform them upon your death.  The anonymous nature of bitcoin means that if your heirs are not aware – your bitcoin will die with you.  Without your private key (or in the case of a hosted walled like Coinbase or Circle, your username/password), your executor will be totally powerless to distribute your bitcoin under the terms of your will.  It might be wise to keep this information in your safety deposit box, or safe.  Also, any power of attorney document must explicitly allow your agent to access either your bitcoin specifically, or your digital assets broadly. Same as your executor, your agent under your power of attorney is going to need access to your private key or login info.

Furthermore, be aware of the Prudent Investor Act enacted on some level by most states, which requires that executors and trustees diversify investments. Should you hold a large amount of bitcoin, upon your death there is a argument that under the Act the bitcoin would be considered an “investment” rather than cash, and a volatile one at that. Such a classification could mean that an executor or trustee may be required under the Act to sell your bitcoin and diversify into traditional securities. This may not be what you wish to happen, and the Prudent Investor Act generally allows itself to be explicitly overridden. If you want your executor or trustee to have the power to hold your bitcoin long-term, including a specific provision in your will or trust absolving him from any liability for failure to diversify bitcoin should be considered.

Any disposition of digital currency is a taxable event, including the use of digital currency such as Bitcoin to acquire an asset, pay for services, use for retail transactions and investments where the goods are received or investment has a higher value than the payor’s basis in the digital currency. Payments made using digital currency are subject to the same tax reporting and backup withholding as other payments made in property.

What happens if a person or business receives more than $10K in one or a series of transactions to an individual?  For example, does an antique dealer have to report an antique dining set purchased with bitcoins?  According to the IRS, any person or business that receives more than $10K in one or a series of transactions must identify the person involved via Form 8300, but digital currencies such as Bitcoin are not recognized as currencies by the IRS – so does this rule apply?  Every individual or business should consult with their tax advisors regarding the implications of their specific Bitcoin or other digital currency transactions – and you should track your digital currency purchases appropriately.