Dealing with Virtual Currency? Taxation, Reporting FBARs, and FATCA Worries

By:
Keith Miller, Richard Peterson and Joseph Cutler
Published Date:
Jan 1, 2015

You or your client decide to jump into the exciting but volatile world of Bitcoin and virtual currencies. What are some of the most important tax-related implications of dealing in virtual currency, and what are the hidden reporting requirements associated with such transactions?

Virtual currency is a term used to describe several different mediums of exchange, from “convertible” virtual currencies like Bitcoin and prepaid digital credits that have equivalent values in regular currency and can be converted into real currency to non-convertible currencies like airline miles or in-game tokens and credits used to “pay” for goods or services. This article focuses on convertible virtual currencies, and in particular “decentralized” convertible virtual currencies, like Bitcoin, which are tracked using a decentralized ledger. On March 18, 2013, in FIN-2013-G001, the U.S. Department of the Treasury’s enforcement body, the Financial Crimes Enforcement Network (“FinCEN”), released guidance defining virtual currency as: “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency.” While virtual currency does not have legal tender status in any jurisdiction, it is nevertheless used both for investment purposes and to pay for goods and services. In the aftermath of FinCen’s guidance, many wondered how the IRS would treat virtual currency for tax purposes.

On March 25, 2014, the IRS issued Notice 2014-21 to provide tax guidance regarding transactions involving virtual currency. In this notice, the most significant tax relevant determination is the classification of Bitcoin and similar virtual currencies as property. Prior to the IRS notice, it was not clear whether transactions or holdings of virtual currency were to be treated as property or foreign currency for tax purposes. Somewhat paradoxically, despite characterizing virtual currency as property for tax purposes, the IRS adopted the definition of virtual currency in FIN-2013-G001, which equated virtual currency to real currency without any indication that it should be characterized or treated as property.

A close reading of the notice, however, suggests the IRS’ rationale for treating virtual currency as property is that unlike “real currency,” it is not “the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance.” Because of this distinction, virtual currency is not the same as legal tender, and hence is property for tax purposes.Thus, similar to any transaction involving property, income generated by convertible virtual currency transactions should be treated as either ordinary income or capital gain, as applicable. Conversely, if virtual currency was treated like foreign currency, foreign currency gains attributable to fluctuating currency values would be taxed as ordinary income.

For those who participate in the virtual currency ecosystem, there are a number of significant issues raised in the IRS notice. However, in spite of the guidance, there remain many unanswered questions, even to the regulators themselves. In any event, the IRS asserts that the notice “describes how general tax principles apply to transactions using virtual currency” and is a clarification, not a new interpretation. However, as developments and advances in the virtual currency technology and ecosystem continue to occur so will new issues evolve. Therefore, taxpayers should consult tax advisers or counsel who have a solid understanding of the present regulatory standing of virtual currency regulation in both taxation and any other area applicable to their particular business or situation. It is important to note that the IRS will apply the rules and principles discussed in its notice to past transactions as well as future transactions. Although for any audit with respect to a virtual currency transaction that occurred prior to the March 25, 2014, release date of the notice, taxpayers may be able to avoid penalties due to the lack of prior guidance by the IRS, such a waiver of penalties is not guaranteed.

Despite the uncertainty surrounding virtual currency issues, the IRS notice did provide some helpful answers to questions it posed. Through a series of questions and answers, the IRS covered certain issues by focusing on the context in which the taxpayer was tendering or receiving virtual currency:

Investors

Because virtual currency is characterized as property, the IRS notice is generally good news for taxpayers who hold virtual currency as investments, because lower capital gain tax rates may be applicable to sales or exchanges of their virtual currency held for more than one year.

So, an investor who purchased an investment with bitcoins would recognize gain in an amount equal to the difference between the purchase price and the investor’s basis in the bitcoins. If the bitcoins were held for more than a year, long-term capital gains tax would apply (maximum of 20%) and possibly net investment income (subject to a 3.8% surtax if the taxpayer has adjusted gross income in excess of $200,000).

Miners

In decentralized virtual currency ecosystems, like Bitcoin, the virtual currency is “mined” by either solving complex mathematical algorithms or verifying “blocks” of transactions on the decentralized ledger to verify the ledger’s accuracy. In either circumstance, a taxpayer who successfully mines virtual currency is taxable on the mined bitcoins. Obviously, a taxpayer who mines virtual currency is not engaged in a sale or exchange (that could potentially trigger capital gain). Instead, the IRS considers the income from mining as ordinary (maximum rate of 39.6%) as well as self-employment income (subject to Social Security and Medicare taxes) with respect to a taxpayer who is self-employed and actively mines virtual currency.

On the other hand, some advisors disagree with the IRS position, arguing that that if mining Bitcoins is similar to producing or mining an asset, rather than realizing income upon the receipt of the virtual currency, there should be no taxable event until the virtual currency is sold or exchanged for money or other property.

Exchanges

There are a number of commercial services that enable consumers to either buy or exchange virtual currency. Some services directly sell virtual currency either online or at kiosks that function like vending machines (sometimes called “Bitcoin ATMs”), while other services function more like a stock exchange, matching consumers who want to sell virtual currency with consumers who want to buy virtual currency, and then handling the exchange between the consumers through an open order book and hosted deposits of the virtual and real currencies.

Clearly, virtual currency held mainly as inventory for sale to customers will likely be treated as noncapital assets. For example, an exchange that sells virtual currency in the course of its trade or business to customers must recognize ordinary income to the extent the amount received exceeds the basis (the amount paid for the virtual currency).

As to registration and information-reporting requirements (unrelated to tax issues), none of the federal agencies have decided whether virtual currency constitutes a security or a commodity, such that brokers in virtual currency would be subject to the same rules as are applied to brokers in securities and commodities.

Persons Who Use Virtual Currency as a Method of Payment

Because the IRS notice characterizes virtual currency as property, any exchange or payment of virtual property for other property is a taxable event, triggering potential gain or loss for the payor. Although in the notice, an answer to a question regarding the payment of virtual currency as wages focuses only on the tax consequences of the employee, the payment would also trigger gain or loss to the employer to the extent that the fair market value of the virtual currency exceeded the employer’s basis in the virtual currency. The same concept would apply to a buyer in a retail transaction if the value of the merchandise purchased exceeds the buyer’s basis in the virtual currency tendered.

Reporting and Withholding Requirements

Payments made using virtual currency are subject to IRS tax reporting to the same extent as other payments made in money or property. For example, a person in a trade or business making a payment in excess of $600 (or its equivalent fair market value in virtual currency) to a nonexempt recipient would have to report such payment to the IRS on a Form 1099.

Backup withholding rules also apply if the person reporting the transaction (i.e., the payor) does not know the recipient’s taxpayer identification number. Similarly, although not directly addressed in the IRS notice, a payment of U.S. source income to a foreign person generally would be subject to 30% tax withholding as well as reporting the transaction to the IRS. Moreover, all withholding of U.S. taxes must be in U.S. dollars even if the payment was made in virtual currency. Significantly, the failure of a payor to report the transaction to the IRS does not excuse the recipient from the obligation to pay U.S. income taxes in U.S. dollars on such income.

Employees and Independent Contractors

Any taxpayer paid in virtual currency for the performance of services as an employee or an independent contractor is taxed in the same manner as if the amounts paid were U.S. dollars. Employees are subject to wage withholding and Social Security and Medicare taxes, and independent contractors are liable for income and self-employment tax. The tax with respect to compensation paid in virtual currency must nonetheless be paid in U.S. dollars.

Payment Processors

The IRS information reporting rules applicable to third-party settlement organizations (“TPSOs”) also apply to payment processors that settle transactions in virtual currency. If a virtual currency payment processor is a TPSO, it must report payments made to a merchant if, for the calendar year, the number of transactions settled for the merchant exceeds 200 and the gross amount of payments to the merchant exceeds $20,000. The dollar value of payments denominated in virtual currency is based on the fair market value of the currency on the date of payment.

FinCEN recently published an opinion concluding that a payment processor who assisted online merchants convert payments by consumers in virtual currency to payments of real currency (so that the merchants could advertise that they accepted virtual currency as a form of payment) was considered a “money transmitter” required to register with FinCEN as a “money service business” under FinCEN’s anti-money laundering regulations. Any taxpayer who offers payment processor services dealing with virtual currency should seek not only tax advice but also regulatory advice related to its status as a potential money service business, subject to other federal anti-money laundering regulations.

One consequence of the IRS characterization of virtual currency as property will be to prevent it from becoming an independent benchmark for pricing goods and services without reference to U.S. dollars or other real currency. In other words, in any transaction or exchange involving virtual currency, the amount realized would by necessity be expressed in U.S. dollars either directly or by reference to an exchange price.

Another consequence of the IRS notice is to likely increase the need for virtual currency exchanges. The immediate tax cost of mining activities and the tax cost incurred upon the purchase of goods, among others, will create an even greater need for U.S. taxpayers to convert virtual currency into U.S. dollars.

At this point, it is an open question as to whether the IRS position on virtual currency will reduce the number of people using virtual currency in retail transactions, especially for numerous small transactions. These taxpayers may opt to exchange virtual currency directly for U.S. dollars in fewer, larger transactions. Moreover, retailers will need to increase their record keeping to keep track of the basis they have in the virtual currency received for purchased goods.

Additionally, the New York State Department of Taxation and Finance recently issued guidance, Technical Memorandum TSB-M-14(5)C, (7)I, (17)S, indicating the same treatment of virtual currency set forth in IRS Notice 2014-21 will apply for New York State tax purposes. The Technical Memorandum also indicates that for sales purposes, the use of virtual currency is treated as a barter transaction. In other words, the buyer is purchasing the goods or services from the seller in exchange for the goods and services, whereas, the seller is treated as purchasing the virtual currency in exchange for the goods or services it is providing to the buyer. Thus, even though the buyer pays for the goods or services in virtual currency, this part of the transaction is subject to sales tax payable by the buyer. On the other hand, because the seller is viewed as buying virtual currency, an intangible asset, exempt from sales tax, no sales tax is imposed on this part of the transaction.

Practitioners who assist individual clients should consider providing record-keeping logs or software to help their clients keep track of virtual mining transaction (including mining or spending) in addition to exchanges of virtual currency for U.S. dollars or other assets.

Look for part two of this article to address FBAR and FATCA implications of virtual currency in the February TaxStringer.


The authors work for the law firm Perkins Coie LLP. This article should not be construed as providing legal advice, but rather as an attempt to identify certain tax issues associated with virtual currency.

Keith MillerKeith Miller is a partner with Perkins Coie’s Litigation practice and firmwide Chair of the White Collar & Investigations practice. Mr. Miller is a former SEC enforcement attorney whose practice focuses on investigations and white collar crime matters, as well as complex civil litigation. His clients have included some of the world's leading financial institutions, including investment banks, and broker-dealers. He frequently represents these clients in civil litigation and in connection with investigations being conducted by various federal and state agencies, including the SEC, Department of Justice, Financial Industry Regulatory Authority, and Commodity Futures Trading Commission. Mr. Miller has recently represented clients in several high-profile litigations and investigations involving virtual currencies and decentralized crypto-currencies. He can be reached at: KeithMiller@perkinscoie.com. 

Richard PetersonRichard Peterson, a partner with Perkins Coie’s and firmwide Chair of the Federal Tax practice, has experience in a wide variety of matters including taxation of mergers, acquisitions and divestitures, partnership taxation and international taxation. He is experienced in partnership tax planning, including structuring venture capital funds (both U.S. and international) and advising potential investors. Mr. Peterson has worked on mergers, acquisitions and divestitures including taxable and tax-free transactions with both asset and stock acquisitions. He also has significant tax litigation experience covering all aspects of IRS controversy work from audits and appeals work through litigation before the U.S. Tax Court. He can be reached at: RPeterson@perkinscoie.com.

Joseph CutlerJoseph Cutler is counsel in Perkins Coie’s Privacy & Security practice, providing advice related to data privacy and security, consumer protection, and Internet law. His litigation practice focuses on combating cybercrime and enforcing website terms of use where he manages a rapid response enforcement team to defend clients, such as Facebook, against illegal spamming, phishing, pretexting, and other forms of malicious Internet behavior. In addition to his litigation work, Mr. Cutler represents a range of companies in the emerging financial technology and virtual currency industry, designing their anti-money laundering programs, representing them before regulators, and providing compliance advice. He can be reached at: JCutler@perkinscoie.com.

 
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