There is a pervasive myth that virtual currency exists in a regulatory vacuum – but the Internal Revenue Service (the “IRS”), the U.S. Securities and Exchange Commission (the “SEC”), the U.S. Financial Crimes Enforcement Network (“FinCEN”), the Commodity Futures Trading Commission, and multiple state legislatures and regulators (e.g., blue sky laws, money services business regulations) would beg to differ. For example, (i) certain persons or business entities characterized under applicable law as virtual currency “money transmitters” may be required by the Bank Secrecy Act, FinCEN regulations, and state money services business regulations to develop, implement, and maintain an effective anti-money laundering program that, among other things, includes a process for verifying customer identification, (ii) the SEC has recently published a Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934 concluding that a virtual currency venture called the DAO was in fact the issuance of unregistered securities, and (iii) the IRS has issued published guidance which describes how the IRS will apply fundamental U.S. federal income tax principles to transactions involving convertible virtual currency. This blog focuses on the manner in which the IRS will apply fundamental U.S. federal income tax principles and information reporting requirements to convertible virtual currency transactions.
There are numerous convertible virtual currencies in existence today, the most prominent of those being Bitcoin. Bitcoin can be obtained in a number of different ways. Bitcoin users can trade bitcoins for other types of currency, i.e., purchase and sell bitcoin, on an internet exchange website. Bitcoin users can also accept Bitcoin from other people in exchange for goods or for the performance of services, such as designing websites. Lastly, Bitcoin can be earned through a process known as “mining.” Each virtual currency transaction is verified using open-source software across a network of individual computers all over the world, connected via the Internet. Some of those computers, called “miners,” are tasked with adding “blocks” of verified transactions to the “blockchain”. The term “blockchain” refers to the shared, encrypted accounting ledger stored on the decentralized global computer network of all Bitcoin users. Each new “block” added by the “miners” contains a group of virtual currency transactions that have been submitted for verification since the previous “block” of transactions were verified. The mining system ensures that new transactions are valid in light of prior transactions, i.e., that a sender has enough bitcoin to fund a later submitted transaction. The “mining” process repeats time and time again, resulting in the creation of a continuous, ever-growing chain of blocks, or “blockchain,” that continually updates to represent at any given moment a snapshot of the entire history of Bitcoin transactions. A “blockchain” thus maintains a permanent record of transactions of bitcoin between Bitcoin users.
The “mining” process is competitive, and requires the use of specialized computer hardware optimized for the mining task, which hardware consumes a large amount of electricity and generates an exceptional amount of heat, to the point that any computer not optimized for the mining task (e.g., any computer without a powerful graphics card and processor) would likely take a period of years to mine any bitcoins. Miners use this sophisticated computer hardware to compete with other miners in solving complicated mathematical problems that incorporate information about prior transfers to validate new transfers. The miner or group of miners that win the race to complete the next “block” of the shared transaction log by generating a valid answer to the complex mathematical problem are paid by the Bitcoin system in newly generated Bitcoins for their work.
In March of 2014, the IRS issued Notice 2014-21 (the “IRS Virtual Currency Notice”), which describes how the IRS applies fundamental U.S. federal income tax principles to transactions involving convertible virtual currency. In the IRS Virtual Currency Notice, the IRS stated its position based on fundamental federal income tax principles: virtual currencies that can be converted into traditional currency are property for tax purposes, and a taxpayer can have a gain or loss on the sale or exchange of a virtual currency, depending on the taxpayer’s cost to purchase the virtual currency, i.e., the taxpayer’s tax basis. The main thrust of the IRS Virtual Currency Notice is that convertible virtual currency users will be subjected to fundamental income tax principles applicable to property transactions analogous to those applicable to the sale, exchange, or other disposition of real property, stocks, and bonds.
Pursuant to the fundamental income tax principles applicable to property transactions articulated in the IRS Virtual Currency Notice, the following virtual currency transactions are reportable in the manner indicated:
- If an employee receives wages, salary, or other income from an employer in the form of virtual currency, then any such payments so received are reportable by the employee as ordinary income, and will be subject to employment taxes paid by the employer.
- If a self-employed individual receives virtual currency from a service recipient in exchange for providing goods or services, then any such payments so received are reportable as ordinary income, and will be subject to self-employment tax. This rule would apply to a person engaged in the trade or business of “mining” virtual currency.
- If virtual currency is received by a business in exchange for goods or services, then any such payments received are reportable as ordinary income.
- If virtual currency is exchanged for other property, then any taxable gain attributable to such exchange is generally reportable as a capital gain if the virtual currency so exchanged was held by the taxpayer as a capital asset, and reportable as ordinary income if the virtual currency is property held mainly for sale to customers in a trade or business.
- If property held as a capital asset is exchanged for virtual currency, then any taxable gain attributable to such exchange is generally reportable as a capital gain.
- Any payments made in virtual currency are subject to the same information reporting requirements as payments made in property, real currency or instruments denominated in real currency. For example, (i) gains and losses attributable to virtual currency transactions may need to be reported on Form 8949 (Sales and Other Dispositions of Capital Assets), which is attached to Schedule D of a Form 1040; (ii) payments made by a person engaged in a trade or business to an independent contractor using virtual currency for the performance of services may require reporting of such payments to the IRS and to the payee on Form 1099 MISC, Miscellaneous Income; and (iii) payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property, so payors making reportable payments using virtual currency must solicit a taxpayer identification number (TIN) from the payee, and the payor must backup withhold from the payment if a TIN is not obtained prior to payment or if the payor receives notification from the IRS that backup withholding is required. Note that a bitcoin is not a “covered security” for Form 1099-B issuance purposes, so bitcoin investors and the IRS don’t receive a Form 1099-B from Bitcoin exchanges.
In the view of the IRS, taxpayers who have engaged in such virtual currency transactions and have not properly reported them may be subject to penalties for failure to comply with tax laws. For example, the IRS Virtual Currency Notice provides that (i) underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties under IRC Section 6662; and (ii) failure to timely or correctly report virtual currency transactions when required to do so may subject taxpayers to information reporting penalties under IRC Section 6721 and IRC Section 6722. However, penalty relief may be available to taxpayers and persons required to file an information return who are able to establish that the underpayment or failure to properly file information returns is due to reasonable cause.
Due to an increasing public perception that virtual currency can be used to evade taxes, including at least one instance of open acknowledgement by Bitcoin users that tax evasion is a sought-after feature of using bitcoins, and reports issued in 2013 and 2014 by the Government Accountability Office at the request of the Senate Finance Committee regarding tax compliance issues relating to virtual currencies, the IRS has recently stepped up enforcement efforts to identify U.S. persons who conducted transactions in a convertible virtual currency, and to correct the federal income tax liability of U.S. persons who failed to report and pay applicable federal income taxes attributable to such transactions.
In fact, on November 17, 2016, the United States filed a lawsuit in federal district court requesting an order permitting the United States to serve a “John Doe” administrative summons (“IRS Summons”) on Coinbase, Inc., an exchange that deals in convertible virtual currency, operating a bitcoin wallet and exchange business headquartered in San Francisco, CA. The IRS Summons “seeks information regarding United States persons who, at any time during the period January 1, 2013, through December 31, 2015, conducted transactions in a convertible virtual currency as defined in the IRS Virtual Currency Notice.”
The takeaway from this blog is U.S. taxpayers that invested in and/or spent convertible virtual currency have likely realized and recognized some form of income (or incurred a loss) that should be reported on an appropriate U.S. tax and/or information return. Although the scope of the IRS Summons has narrowed considerably since inception of the litigation, the Coinbase, Inc. case continues to demonstrate the need for taxpayers engaged in virtual currency transactions to be proactive about correcting prior tax returns, if necessary, and in ensuring compliance with the U.S. internal revenue laws on a going forward basis.
Consideration should be given to engaging appropriate tax advisors to assist with these matters.