Years after Bitcoin made its way into the world, in March 2014, the IRS has made an attempt to clarify taxation guidelines for convertible virtual currencies (like Bitcoin). The key guideline is to treat bitcoins as property, and not currency. While it is a good move to clarify the government’s stance on Bitcoin taxation to the average tax payer, it has met with mixed feedback, and could still do with further work to streamline it.
Each country seems to have it’s own view on Bitcoin. Germany deems bitcoins as “personal money” to be used akin to cash. Singapore had planned to treat bitcoins as products and levy a goods and services tax. The UK is still unclear.
The IRS circular is retro-active meaning tax payers are expected to have reported bitcoin transactions in a similar fashion even prior to March 25, 2014. Some, like the ever insightful Two Bit Idiot have speculated that the sell-side pressure on the market which led to the decline in price in October 2014 was spurred by the need for some users to pay their tax bills.
Failure to do so may attract penalties. “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” states the IRS circular (Q16).
Bitcoin is property, not currency
For federal tax purposes, bitcoins will be treated as property and not currency. This means that all tax guidelines that apply to buying, selling or holding property or other capital assets, will apply to bitcoins as well. All capital gains and loss calculations, information reporting guidelines and all backup withholding rules will also apply to bitcoin transactions, just like they would to property.
Information reporting requirements
It is now required to comply with the information reporting guidelines applicable to property. This means anyone who makes a payment of more than $600 in bitcoin to a US non-exempt recipient, has to report it to the IRS and the payee. This would include payments to independent contractors or rent, salary, wages and other compensation.
Capital vs Personal income tax rates
What kind of taxation would apply to a bitcoin transaction depends on how the bitcoin was used. If the taxpayer holds bitcoins as a capital asset, then the sale or exchange of bitcoins will fall under the capital gains or loss. In one way this is good news especially for those in the highest income tax bracket. Long term capital gains are taxed between 0-20%; and capital losses can be offset against income up to $3000 each year. Merchants who hold bitcoins as part of some kind of inventory for sale to customers or for business purposes will not fall under the ambit of capital assets.
Most bitcoin holders use bitcoins both as an instrument for long term investment, as well as currency for day to day transactions. This ruling will increases the accounting required along with every Bitcoin transaction, since gains and losses while using bitcoins have to be calculated the same way as buying or selling stock. Pamir Gelenbe, a partner at Hummingbird Ventures, is of the opinion this could reduce the volume of bitcoin transactions. As told to Bloomberg,
“It’s challenging if you have to think about capital gains before you buy a cup of coffee.”
Bitcoin “Income” and taxation
Any bitcoin payments received, including payments for mining, are treated as income. Such payments have to be included as part of the gross income calculated with the fair market value in US dollars on the day of the transaction, as the basis. If a taxpayer earning bitcoin income is self employed, then they have to pay the self-employment tax as defined in the IRS guidelines. Similarly if a firm is paying wages in bitcoin, it is subject to the same rules as normal currency wages and subject to federal income tax withholding and others.
Other tax Implications
Cross border transactions of bitcoins will not be treated as currency exchange and therefore will not be treated as foreign currency gain or loss for taxation purposes.
However, since bitcoin is treated as property, states and cities are free to impose their own sales tax or other measures each time someone does a bitcoin sale.
Impact on Bitcoin Transactions
While the IRS guidelines are welcome, they do create a somewhat sticky situation for the average bitcoin using taxpayer. Let’s consider the case of say Jane, who bought 5 bitcoins to experiment with. That’s just above $3000 at today’s exchange rate. She’s decided to use bitcoin as her primary mode of payment that month. She buys her daily morning coffee at the neighbourhood coffee shop, and pays in bitcoins. Over the weekend, she goes to a pub, and pays for her drinks, again in bitcoins. The following week, she goes shopping and uses her bitcoin wallet again. At the end of the month, her landlord agrees to play along and accepts bitcoins for the $1200 rent.
These are all pretty normal transactions for her, in fact for any bitcoin user. But come tax time, her accountant may not agree. For starters, he would need to track the FMV of the bitcoins the day she bought them, against the FMV each day there was a bitcoin transaction, and calculate the capital gain or loss accordingly – for every single coffee or beer or any other purchase. In addition, since her rent payment exceeds the $600 limit, she will have to file a report for the transaction as well. There’s also an open question about how to determine the FMV. There are many bitcoin exchanges, and even within an exchange, the bitcoin value can fluctuate anywhere from tens to hundreds of dollars in a day.
This is one big gap where accountants can step in to make things easier for the average bitcoin user. It has been nice to see the innovative new approach to this accounting challenge being provided by Libra Tax. This may lead to a new field of accounting specialists – those who deal solely in preparing tax returns for those transacting in bitcoin.
Impact for Bitcoin Investors
The IRS guideline favours bitcoin more as an investment vehicle rather than a currency. It’s much better for those who have invested in bitcoins, but don’t use it for everyday transactions. Since the gain/loss event is triggered only by an actual sale or exchange, just like for stocks, bitcoin investors can breathe a bit easy – at least with respect to the tax guidelines.
Impact on Bitcoin Businesses
For businesses that accept bitcoins, things can get tricky. Many businesses hold on for a while to the bitcoin payments they receive, and convert them to real world currency say at the end of the week or month. For accounting purposes, they would have to maintain the FMV value of bitcoins for each and every sale! In addition, any drop, in the FMV of bitcoins at the time of conversion to real currency could reduce their actual revenue, but they would still be liable to pay sales taxes based on the FMV of the day of the sale.
It’s easy to see the amount of extra accounting the new IRS guidelines bring in. The Tax Foundation thinks the IRS opened up a can of worms. That the rule is retro-active, opens a veritable Pandora ’s Box for bitcoin users, their accountants and legal professionals alike. Everyone needs to go back and examine whether their past reporting of bitcoin income and transactions complies with the new IRS circular. For those who have unwittingly not complied, how do they check whether the lapse falls under “reasonable causes”. After all, the average bitcoin user or accountant can’t be expected to have known the IRS will not treat bitcoins as currency.