How Bitcoin and Other Digital Currencies Affect Your Clients’ Taxes

Remember several months back when the whole world was gushing about Bitcoin? The virtual currency made a splash amongst financial beat writers, bankers, black marketeers and a few random law professors, and even served as a ‘shiny object of the month’ for the Technorati. Well, Bitcoin is no longer the cocktail party conversation go-to it once was; but, as often happens when a fashionable new business development takes root quickly, it’s the tax professionals who clean up the mess and make sense of it all.

As your client’s 2015 activity begins to trickle through your office door, a few of you may notice some activity involving Bitcoin or other virtual currency. For those of you seeing these curious entries, some may have gotten early notice, but for others, it may be more than a little surprising to see these transactions pop up. To that end, let’s review a few of the tax principles we have learned in the last few years with regards to Bitcoin and other virtual currency.

Of course, the first thing we learned is that virtual currency isn’t currency at all, at least not in the eyes of the IRS. Actually, Bitcoin is considered a ‘convertible virtual currency:’ Bitcoin has exchange value expressed in other mediums of exchange, including U.S. dollars, but it is not legal tender in any jurisdiction. The nutshell result? Property rules and principles apply to a Bitcoin transaction, not foreign currency rules.

The IRS published a helpful publication in 2014, Notice 2014-21. Here are a few high points, otherwise known as property transactions 101:

• Receipts from Exchanges? Bitcoin is valued at fair market value, as of the date of receipt. In plain English, Bitcoin has FMV Basis.
• The valuation method to determine Bitcoin FMV must be reasonable and consistent, natch.
• Receipts from Mining Bitcoin? Bitcoin acquired via mining is valued at FMV (see above), but that FMV also represents gross income to the miner.
• Unless the miner is an employee of the entity acquiring the Bitcoin, or the mining activity is not a trade or business, Bitcoin acquired via mining also invokes Self Employment tax.
• Purchases Made with Bitcoin? If the exchange of Bitcoin results in the acquisition of assets or currency with a FMV in excess of the Bitcoin FMV, you have a gain. The opposite scenario nets a loss.
• The nature of the gains or losses is determined by the manner in which the Bitcoin is held: as a capital asset or an ordinary asset.
• Pay Employees or Independent Contractors with Bitcoin? Bitcoin is not different from any other medium of compensation: the value of the compensation is reportable income to independent contractors (1099) and employees (W-2).

OK, how about the many states? States have not been as forthcoming with definitive resources regarding their treatment of Bitcoin. New York, Washington, California and Texas have taken stabs at it, but lack consistent determinations. For the sake of this article, sufficed to say that it would be wise to take a look at income tax implications in the states your clients are operating in. Issues like sales taxes or gross receipts tax also come to mind.

The intense interest in Bitcoin has weakened some, but it’s your responsibility as tax pros to get your clients compliant.