I recently had an opportunity to be involved in tax planning with “virtual currency”, or “cryptocurrency”, for the first time. My client ended up making a gift of bitcoin (one of several forms of cryptocurrency, also including Ethereum, Ethereum Classic, Litecoin and Bitcoin Cash) to a charitable remainder trust to avoid income tax on a sale of a portion of a highly appreciated Bitcoin holding to diversity the investment portfolio. Investments in cryptocurrency by our clients (and perhaps you) is increasing at a rapid rate and the purpose of this Tax Tip is to provide a summary of the income tax rules and principles applicable to virtual currency. IRS Notice 2014-21 (IRS Virtual Currency Guidance) is the starting point and most important tax guidance on this topic. For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency. Under current applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss for US federal tax purposes.
A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in US dollars, as of the date that the virtual currency was received. For US tax purposes, transactions using virtual currency must be reported in US dollars. Therefore, taxpayers will be required to determine the fair market value of virtual currency in US dollars as of the date of payment or receipt. The character of the gain or loss (i.e., capital gain or ordinary income) depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A taxpayer who “mines” virtual currency (for example, uses computer resources to validate bitcoin transactions and maintain the public bitcoin transaction ledger) realizes gross income on receipt of the virtual currency resulting from those activities. An individual who “mines” virtual currency as a trade or business is subject to self-employment tax unless undertaken by the taxpayer as an employee.
Virtual currency received by an independent contractor for performance of services constitutes self-employment income, and virtual currency received by an employee for remuneration for services constitutes wages for employment tax purposes. Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. Payers making reportable payments using virtual currency must solicit a taxpayer identification number from the payee.