The Internal Revenue Service (IRS) issued much-needed tax guidance on March 25 to provide clarification for users of Bitcoin and other digital currencies. It has decided that cryptocurrencies should be treated as property, not currency, for US federal tax purposes.
As was noted by National Taxpayer Advocate Nina E. Olson in her 2013 annual report to Congress in January this year, Bitcoin usage increased by over 75 percent in the four months between July and December 2013 – from about 1,700 transactions per hour to over 3,000 – and, over the same period, the market value of Bitcoins in circulation rose more than ten-fold from about USD1.1bn to USD12.6bn.
With taxpayers being unsure previously of the tax rules to which they should comply, it is now hoped the provision of IRS guidance will promote tax compliance, particularly among those who want to report digital currency transactions properly, and provide tax certainty.
The IRS guidance has been issued in the form of answers to frequently asked questions, so as to provide clear and basic information on the US federal tax implications of transactions in, or transactions that use, virtual currency.
While, in some environments, virtual currencies operates like fiat currency, the IRS points out that they do not have legal tender status in any jurisdiction, and that, consequently, it should be treated as property for US federal tax purposes.
It is therefore confirmed that the general tax principles that apply to property transactions apply to transactions using virtual currency. This means, for example, that wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2 (Wage and Tax Statement) , and are subject to federal income tax withholding and payroll taxes.
In addition, payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply, with payers normally required to complete Form 1099-MISC (Miscellaneous Income).
Meanwhile, the treatment of the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
Next, the IRS has clarified that a payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
Although the fact that virtual currency will not be treated as currency by the IRS will mean that no foreign currency gain or loss is generated for US federal tax purposes, payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. Therefore, payers making reportable payments using virtual currency may need to solicit a taxpayer identification number from the payee, the IRS said.
Given that Bitcoin investors may be subject to an income tax liability that has not been previously specified, they may also be subject to penalties for failure to comply with tax laws, even for transactions or investments concluded before March 25, the IRS guidance says. In addition, failure to report virtual currency transactions when required to do so may be subject to information reporting penalties. However, it is stressed that penalty relief may be available to taxpayers who are able to establish that the underpayment or failure to file information returns is due to reasonable cause.