Six Important Tax Considerations for Cryptocurrency Transactions
Although the use of Bitcoin and other cryptocurrency (For simplicity, we use the term “Bitcoin” to refer to all cryptocurrencies, recognizing there may be some differences that could impact certain tax considerations) has exploded in recent years, their treatment for US tax purposes remains a bit of a mystery to many. The IRS has issued some high-level guidance, but many questions remain. Here, we address six issues that holders and users of Bitcoin should be aware of.
#1 — Persons engaged in Bitcoin transactions should assume the IRS may examine their Bitcoin transactions, and therefore understand how the IRS treats those transactions, and the consequences and reporting obligations.
In 2014, the Internal Revenue Service announced its awareness about the use of “virtual currency” to pay for goods or services, or to be held for investment. The IRS provided high-level guidance as to how existing tax principles apply to virtual currency transactions (IRS Notice 2014–21, 2014–16 IRB 938 (Mar. 25, 2014)). Obviously, transactions in Bitcoin and other cryptocurrency transactions no longer can “fly under the radar” of the IRS. That results in the first (and perhaps most important) tax point you need to know about Bitcoin transactions: assume the IRS will examine them.
#2 — To comply with US tax reporting requirements, persons acquiring, holding and disposing of Bitcoins need to a) maintain detailed records to track their transactions, b) document how and when they acquired the Bitcoin including its value at the time acquired and any gains or losses they may have.
The IRS view is that Bitcoin should not be treated as “currency” for tax purposes, but rather should be viewed as “property”. Therefore, recipients of Bitcoin should track each transaction, including its initial tax “basis” (based on its value when received), and its disposition (based on its value when transferred). Specific rules applicable to Bitcoin still are scarce, so in many cases taxpayers will have to look to analogies in other scenarios for guidance on appropriate tax treatment. Cogent law group can help, and provide you guidance on appropriate tax treatment and reporting positions.
#3 — A person subject to US taxes who receives Bitcoin for payment for goods or services must include in taxable income the fair market value (FMV) of the Bitcoin received.
Persons receiving Bitcoin as a payment should view the transaction in the same way as they would if they had received cash instead of property. For taxpayers using the cash method accounting (For IRS guidance on requirements for using the cash vs. accrual method of accounting, see IRS Publication Publication 538 (12/2016), Accounting Periods and Methods.), the FMV of the Bitcoin received should be measured at the time it is actually transferred. For businesses using the accrual method of accounting, however, the value of the Bitcoin might be measured when the obligation and the amount to be received becomes fixed, and not when the Bitcoin is actually delivered.
#4 — The IRS requires that for US tax reporting purposes, transactions involving Bitcoin be reported in US dollars.
For Bitcoin and other virtual currency listed on an exchange, the FMV is based on the exchange rate for converting it into US dollars at the time of the acquisition or disposition transaction.
#5 — Persons selling Bitcoins should be careful to document specifically which Bitcoins were disposed of in order to calculate the seller’s gain or loss.
Although there are no rules specifically addressing the basis of Bitcoins upon their disposition, there are rules applicable to the basis of stocks and bonds. Because the IRS position announced in Notice 2014–21 states that it views Bitcoins transactions as property transactions, not currency transactions, the rules that apply to stock and bonds arguably should apply. Under those rules, there are three methods to determine the basis of property disposed of, which can produce very different results:
(i) The “adequate identification method” — the seller can use the specific tax basis of particular stock disposed of if he adequately identifies the specific stock transferred by (i) the settlement date, or (ii) the time for settlement under SEC rules (Treas. Reg. § 1.1012–1(c)). Because the nature of Bitcoin is such that each one is unique, and the holder/transferor will have specifically identified the one being transferred, this method should be available in most cases.
(ii) The “average basis method” — in some cases, a taxpayer may elect to use the average cost basis of stock or mutual funds shares that are acquired at different times and held by a custodian or broker. Given the nature of Bitcoin, it is not clear that this method would be permissible — or even advantageous — for sellers of Bitcoins.
(iii) The “first-in, first out” method is the default for taxpayers who do not use the average basis method, and cannot adequately identify the particular stock to be able to use the adequate identification method.
This illustrates the need to adhere to Rule #4 from above — persons subject to (or potentially subject to) US tax reporting obligations must maintain detailed records regarding their bitcoin transactions to properly report the transactions. Note that this would include any purchases of Bitcoin for cash (with the purchase price establishing the tax basis of the purchased Bitcoin), as well as transfers of Bitcoin as a gift, bequest, or charitable contribution.
#6-Because persons engaged in a US trade or business generally are subject to tax reporting requirements (e.g., Forms 1099) for many transactions, they should be cognizant of their tax reporting obligations in Bitcoin transactions, and the information they must obtain from a payee — including a taxpayer identification number (TIN).
The IRS made clear in Notice 2014–21 that payments made using virtual currency are subject to backup withholding to the same extent as payments made in cash or other property. Therefore, payors making reportable payments using Bitcoin must solicit a TIN from the payee, and must backup withhold if a TIN is not obtained. Other withholding and tax information reporting also may apply.
Here is an Example of how several of these points can come into play in a simple transaction:
Jones (as US resident) receives 1 Bitcoin as payment for professional services rendered to Smith (also a US resident). Smith acquired the Bitcoin years before as a speculative investment, and paid $1,000 for it. At the time Jones rendered services to Smith, and Smith paid the Bitcoin to Jones, the value of the Bitcoin was US$6,000.
- In this case, Jones should have gross income of $6,000, the value of the Bitcoin received for the services he rendered to Smith, which Jones should report as taxable income.
- Smith should report his transfer of the Bitcoin to Jones as a taxable disposition of property (i.e., as if he had sold it for its FMV). Smith likely would have gain of $5,000 (because he received services worth $6,000, less his $1,000 original cost basis). Because Smith acquired the Bitcoin for cash several years before, his $5,000 gain on the disposition might qualify for capital gain treatment (and thus be taxed at a lower tax rate).
- If the services to Smith were for business purpose, Smith may be entitled to deduct the amount he paid (based on the FMV of the Bitcoin he used to pay for them).
- As noted in #6, Smith may have US tax reporting obligations (e.g., Form 1099), and may be required to obtain the TIN of Jones in connection with this payment to Jones made in connection with Smith’s business, or withhold from the payment made to Jones.
SUMMARY: Although the IRS has made provided some initial guidance regarding Bitcoin transactions, there undoubtedly will be many more US tax issues coming down the pike as Bitcoin transactions become more common, and the IRS increases its scrutiny of them.
