In an earlier post, we discussed the basics behind how Bitcoin operates and how it might create unique issues for employers. In the span of just a little over a month, the Bitcoin community has had its share of stories in the news cycle. One of the largest exchanges, Mt. Gox, has filed for bankruptcy following an apparent security breach costing customers and the exchange nearly $500 million. Within a couple weeks of Mt. Gox’s demise, Newsweek then claims to have identified the creator of the virtual currency, known only as Satoshi Nakamoto (the pseudonym used in the white paper that laid out the cryptography framework for bitcoin operations). Whether the person identified really is Nakamoto is still debated, but stories like this and the fall of Mt. Gox continue to add to the mystery that is bitcoin.

Yesterday, the IRS removed some of that mystery when it released guidance on the tax treatment of bitcoin and other virtual currencies (which just happened to be day one of a virtual currency industry summit in San Francisco). One of the appealing factors for users of the virtual currency is that it was an unregulated peer-to-peer network, meaning it is not tied to any central monetary authority. The IRS’s guidance was expected, but many in the Bitcoin community believed that it would be treated like any other foreign currency. Apparently relying on the premise that bitcoin does not have legal tender status in any jurisdiction, the IRS has determined that bitcoin should be treated as property for tax purposes.

IRS Notice 2014-21 is somewhat of a blow to bitcoin users because the exchange of property, even to buy a cup of coffee, is now a reportable event. The notice provides that virtual currency is treated as property for U.S. federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency. Among other things, this means that:

  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
  • Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply. Normally, payers must issue Form 1099.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.

This may sound like an insurmountable hurdle of onerous recordkeeping for virtual currencies, but automated accounting solutions are already in the works with more likely on the way. With a request for public comments included in its guidance, the IRS has signaled that these rules are not set in stone and changes may be ahead to the tax treatment of virtual currencies.

What seems unlikely to change is the continuing momentum bitcoin and other virtual currencies appear to be gaining. The failure of Mt. Gox may have been bad for Bitcoin’s public image, but supporters of the virtual currency seem undeterred. Despite security concerns, Bitcoin ATMs continue to pop up in the United States and abroad. The number of e-commerce retailers accepting bitcoin has outpaced those accepting in-store purchases, but that is starting to change. And even if your store of choice does not let you spend bitcoins, other companies have begun to find innovative ways around that problem too.

But perhaps the most intriguing item on the horizon is the race to open regulated investment funds and exchanges in the United States. Bitcoin might soon see an enormous influx of capital if investors are comfortable with the regulatory safeguards. The hope amongst the Bitcoin community is that this will lead to new innovations, making the use virtual currencies more prevalent and practical for everyday use.

New technologies almost always trend to the ‘more’ side of the spectrum. Whether Mr. Nakamoto’s (who(m)ever he or she is) vision of a global economy utilizing peer-to-peer transactions will come to pass is anyone’s guess, but you may not want to bet too much bitcoin against it.