The United States Taxation of Bitcoins and Transactions Denominated in Bitcoins

Introduction
On March 25, 2014 the Internal Revenue Service published Notice 2014-21 which described the United States taxation of Bitcoins[1] and the United States taxation of transactions denominated in Bitcoins. This Notice generally treats Bitcoins as “property.”[2] The IRS guidance tracked a Financial Crimes Enforcement Network “Guidance” dated March 18, 2013 (FIN-2013-G001). The FinCEN Guidance noted that Bitcoins have many, but not all of the characteristics of currency. In particular, IRS noted that Bitcoins do not have “legal tender status” in any jurisdiction. The purpose of this article is to summarize some of the more important United States income tax consequences arising from the use of Bitcoins in transactions. Since the FAQs of Notice 2014-21[3] are readily available, this article is lightly footnoted.

Recognition of Income Derived from “Mining” Bitcoins
The fair market value of the Bitcoins is includable in the gross income of “miners” who are on the cash receipts and disbursements method of accounting. Fair market value is determined as of the date of receipt by the Bitcoins “miner.” See Notice 2014-21, FAQ A-8. This represents a departure from normal “mining” rules where miners of gold ore, for example, reports income when they sell the mined ore to the refiner.[4]  Perhaps this difference in tax treatment is due to the nature of the property acquired. When taxpayers mine gold ore, they obtain property that must be sold to obtain money.  Bitcoins, in contrast, although not “legal tender” is already a form of money. Since the normal rules of tax realization require the recognition of income when money is received, it follows that the reporting of income arising from the receipt of Bitcoins follows normal tax recognition rules. Thus, IRS recognizes that Bitcoins are money for some purposes, but not for all purposes.

The United States Taxation of Transactions Denominated in Bitcoins
Since Bitcoins are not presently considered to be a currency, the normal barter rules apply – just as if the taxpayer was exchanging goods and services for property, such as gold bullion. Thus, if a taxpayer received Bitcoins in exchange for services, the taxpayer must report service income up to the fair market value of the Bitcoins received. For example, a person paying for the services is required to report the income on Forms W-2 or 1099-MISC or, as appropriate. Similarly, the recipient of the services income must report services income and, if appropriate, self-employment income.

Similarly, when a taxpayer purchases property with Bitcoins, he or she receives a basis (tax cost) in the newly acquired property equal to its fair market value at the date of acquisition. When the taxpayer sells property for Bitcoins or other money, he or she reports gain or loss based on the difference between the fair value of the property received and the amount of money received over the tax basis of the property sold.

Deduction of Losses on the Theft of Bitcoins
In 2014, the news featured the bankruptcy of Mt. Gox, one of the largest Bitcoin exchanges. We later learned that Mt. Gox had been hacked and its Bitcoins stolen. These losses are presumably theft losses which are deductible as ordinary losses up to the tax basis of the Bitcoins stolen, if the losses are incurred by individuals in a trade or business. If losses are not incurred in a trade or business, individuals are subject to the normal limitations of $100 per casualty and 10 percent of adjusted gross income.[5]

The Possible Deferral of Gain Under Section 1031 on the Sale of Bitcoins for U.S. Dollars
The sale of a functional currency – such as the Euro or the Canadian dollar – and the acquisition of United States dollars can result in capital gains and losses. The recognition of gains from these foreign currency transactions may be deferred where a taxpayer exchanges one functional currency for another if (1) both currencies are held for in a trade or business or for the production of income; and (2) both currencies are considered to be of a “like kind.” See Section 1031 of the Code. It is unlikely, however, that Bitcoins will be treated as “like-kind” property compared to other currencies. Currencies such as the Euro are “legal tender;” but Bitcoins are not “legal tender” in any jurisdiction. Therefore, as a practical matter, the recognition of gain cannot be deferred under Section 1031 unless Bitcoins are exchanged for a similar virtual currency that might be treated as “like kind.”[6]

If Bitcoins Becomes Recognized As a Currency

            If Bitcoins is treated by IRS as a “full” currency at some time in the future, the following rules might apply.

  1. Are Bitcoins a “Functional Currency?”

Are Bitcoins a “functional currency?” Section 985(b) of the Internal Revenue Code (“Code”) defines a “function currency” as “the currency of the economic environment in which a significant part of such [taxpayer’s income producing] activities are conducted and which is used by such [taxpayer] in keeping its books and records.” For the moment, Bitcoins cannot be a functional currency because neither of these criteria appears to be met. It is very possible, however, that this may change as taxpayers begin to keep their books and records in Bitcoins and the Bitcoins becomes part of the economic environment where the taxpayer’s income producing activities are conducted. At that point, IRS may well conclude that the fact that Bitcoins are not legal tender is not a relevant consideration. For the present, however, Bitcoins is not a “functional currency.” This has two consequences, discussed below.

  1. Tax Reporting Issues

Section 987 provides that the income of taxpayers using a “functional currency” is determined:

  • By computing the taxable income or loss separately for each business activity in its

functional currency; and

  • By translating the income or loss separately computed under paragraph (1) at the appropriate exchange rate.

If Bitcoins are not a “functional currency,” however, the above rules do not apply and income arising from transactions denominated in Bitcoins is measured under the barter rules, discussed above.

  1. Characterization of Gain or Loss Issues

If Bitcoins become fully recognized as a currency, gain or loss on the purchase and sale of Bitcoins may sometimes be characterized as capital gain or loss and sometimes as ordinary income or loss, depending on whether or not the transaction involves a functional currency or a nonfunctional currency.[7] In situations where Bitcoins are used as a functional currency, the gain or loss is capital gain or loss.[8] But where Bitcoins are a nonfunctional currency, the gain or loss is ordinary gain or loss.[9] Currently, since the IRS does not consider Bitcoins to be a currency, all gains and losses are currently treated as capital gains and losses. Thus, currently the gains and losses are long-term if the Bitcoins were held for over one year. Gains and losses are short-term (ordinary) if the Bitcoins were held for one year or less.

Conclusions

The United States government has taken notice of Bitcoins. The Financial Crimes Enforcement Network has considered regulatory treatment under the United States Bank Secrecy Act (FIN-2013-G001). Now the IRS has considered the taxation of Bitcoins and transactions denominated in Bitcoins under the Internal Revenue Code. (IRS Notice 2014-21). Hopefully, this white paper will assist Bitcoin owners to better understand the United States income tax consequences arising from the use of Bitcoins in transactions.

 

The material in this publication does not constitute legal advice. It is intended for general information purposes only. If legal issues arise, the reader should consult legal counsel.

If you have questions or need assistance with regard to international tax planning, the attorneys at M. Robinson & Company may be able to assist you. Please feel free to contact us at 617-428-6900.

End of Article

[1] Bitcoins are a highly volatile asset that has been used in criminal enterprises. The author therefore urges caution when investing in Bitcoins or using them in Bitcoins-denominated transactions.

[2] The recognition of Bitcoins as a currency would challenge to the present dominance of “legal-tender” currencies, which are controlled by national governments. Therefore, it is unlikely that the United States government will recognize Bitcoins as a “full” currency at any time in the foreseeable future.

[3] Notice 2014-21 may be accessed at http://www.irs.gov/irb/2014-16_IRB/ar12.html last visited on August 4, 2015.

[4] See Market Segment Specialization Program: Placer Mining Industry. “Major operators produce the bulk of gold recovered and refined, but small-scale, independent miners make up the majority of the returns filed. Mining has historically been a cash-based activity.” Page 1-1, First Paragraph.  “Raw gold is usually delivered to the refiner where it is purchased from the miner, processed, and refined. At the point of sale, funds received are considered income to the miner.” Page 2-1, First Paragraph. This document can be accessed at: http://www.irs.gov/pub/irs-mssp/placer.pdf last visited August 4, 2015.

[5] See, generally, Section 165 of the Internal Revenue Code.

[6] It is well within the realm of possibility that people will invent other virtual currencies that are similar enough to Bitcoins to be considered property of a “like kind.”

[7] See above for the definition of a “functional currency.”

[8] This follows the normal tax rules.

[9] Transactions in nonfunctional currencies normally are treated as Section 988 transactions that give rise to ordinary income. See, generally, Section 988(a)(1)(A) and Section 988(c)(1)(A) of the Internal Revenue Code.

 

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