Cryptocurrencies (also referred to as “digital currency”) continue to grow in popularity and are becoming mainstream in commerce, perhaps with Bitcoin being the most popular. Naturally, cryptocurrency has not gone unnoticed by the IRS. Cryptocurrencies can be traded, used in commerce, or converted into traditional currency and each of these transactions have tax consequences. As the use of Bitcoin and its comparatives gain traction, taxpayers can expect increased scrutiny from the taxing authorities. This blog will provide an overview of current tax policies regarding digital currency but taxpayers using such assets should always consult with their professional advisor so as to ensure compliance with all relevant tax laws.
Virtual currency: “money” or property
The marketing for digital currencies often portray them as an equivalent to the money that we use every day. However, this is not true as the federal government does not recognize any digital currencies as equivalents to official United States currency. The IRS’ leading guidance (IRS Notice 2014-21) on digital currency defines it as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” The IRS further concludes that virtual currency “does not have legal tender status in any jurisdiction.” In other words, cryptocurrency has no legal status as a substitute for legal currency that is otherwise traditionally backed by an established and recognized national government. Instead, the IRS treats virtual currency as property for U.S. tax purposes and therefore all general tax principles applicable to any other property transaction also apply to cryptocurrency transactions. Also, because cryptocurrencies are property and are not legal tender, the IRS has stated that digital currency cannot result in foreign currency conversion gains or losses.
Tax implications of using virtual currency
A vendor who receives digital currency instead of dollars as payment for goods or services must report the transaction in a manner similar to a barter transaction. The vendor’s reportable revenue for IRS purposes would include the fair market value of the digital currency received. The fair market value is to be measured in U.S. dollars as of the date the digital currency is received by the vendor. The determination of a cryptocurrency’s fair market value can be difficult to ascertain however.
In the Notice cited above, the IRS indicates that the fair market value of digital currency is determined by converting it into U.S. dollars in a reasonable manner that is consistently applied and at the published exchange rate, if the digital currency in question is traded on an exchange that sets prices under an economic theory of supply and demand. In other words, the IRS appears to be looking for a reasonable and impartial determination of the digital currency’s value under an arms-length trade scenario, similar to how stocks might trade. The IRS is essentially looking for values that are determined between reasonable and willing traders under no compulsion to enter into any transaction.
After the transaction(s), the vendor holds an “inventory” of virtual currency and takes basis in each tranche of the cryptocurrency held, also measured as the fair market value in U.S. dollars on the date the underlying business transaction closed. Since the values of cryptocurrency change over time, it is possible for there to be subsequent gains or losses realized when the vendor next utilizes any of his or her inventory of digital currency. The character of these gains and losses (i.e. short-term or long-term) depends on whether the cryptocurrency is a capital asset in the hands of the vendor. These same tax considerations hold true for the vendor’s customer.
If the customer was the initial purchaser of the cryptocurrency used in the transaction, the customer’s basis would equal the cost paid to acquire the currency, measured in U.S. dollars at the date of acquisition. Multiple purchases of cryptocurrency may give rise to the customer owning multiple tranches of the digital asset. At the date of use, the customer is required to determine the gain or loss on the transaction, based on the fluctuation of the digital currency’s fair market value between the time of its acquisition and its disbursement to the vendor, according to the protocol described above.
IRS information reporting requirements
Taxpayers holding digital currency portfolios should be aware that payments made using cryptocurrency are subject to the same information reporting requirements as any other transaction. This means that if payments are made to a contractor by digital currency, an IRS Form 1099-MISC must be issued for the transaction. Likewise, if wages are paid to employees via cryptocurrency, such transactions must be captured on the employee’s Form W-2. Payroll made by cryptocurrency also remains subject to all applicable federal tax withholding requirements and because payroll tax constitutes a trust-fund tax held by the employer on behalf of the federal government, failure to properly withhold on cryptocurrency wage payments subjects any responsible party to personal liability for the unpaid tax. Finally, third-parties settling payments with merchants who accept digital currency from customers are required to report accordingly on Form 1099-K.
A taxpayer’s failure to properly report digital currency transactions may result in the imposition of penalties and interest under audit. Extreme situations of failed compliance may subject taxpayers to criminal prosecution under the theories of tax evasion and filing a false return. Convictions for tax evasion are potentially punishable by a prison term of up to 5 years and a fine as high as $250,000.
Although the use of cryptocurrency is gaining in popularity, taxpayers need to be aware that transactions involving digital currency do not escape taxation. As individuals and enterprises begin making use of cryptocurrencies, they should strategize with a tax attorney to ensure proper compliance. If you would like guidance on cryptocurrency and taxation, contact of the McCarthy Lebit Taxation attorneys.