TaxProf Blog op-ed: IRS Makes Sense of Bitcoin Taxation: Initial Reaction to Notice 2014-21, by Omri Marian (Florida):
Over the past few months, the IRS has been under tremendous pressure to issue guidance on the taxation of Bitcoin transactions. The National Taxpayer Advocate, the Government Accountability Office, elected officials and taxpayers have all pressed the IRS to explain the tax consequences of transactions involving the increasingly popular virtual currency. The IRS delivered yesterday – just in time for tax season – by issuing Notice 2014-21 (the “Notice”).
The Notice “describes how existing general tax principles apply to transactions using virtual currency.” Indeed, the IRS should not be expected to do more than interpreting existing law as applicable to the new technology. It is useful to separate the notice into two main components: substantive part (i.e., how Bitcoin transactions should be taxed), and information reporting part (i.e., how income on Bitcoin transactions should be reported and how tax can be collected). In terms of substance, the Notice does an excellent job explaining how transactions involving Bitcoin are taxed. I also believe that IRS got all of the substantive issues right. In the context of information reporting, however, the Notice exposes the limitations of current tax law when it comes to collecting tax on Bitcoin transactions. While the IRS got the information reporting part right as well, the practical ability of the IRS to enforce such requirements may be limited in certain contexts. Below I separately address substance, information reporting, and some issues that are left unaddressed.
The substance. For people who have been following the discourse on the taxation of Bitcoin, the substantive part of the Notice provides very few surprises. Here are some (not all!) of the most important anticlimactic conclusions:
- As most commentators have already concluded, Bitcoin is NOT a currency for tax purposes. It is a property. As such, gain and losses on the disposition of Bitcoins can never be “exchange gain or loss”. This may come as a disappointment to taxpayers who lost money in Bitcoin investments and may have hoped to have the losses classified as exchange-losses, and as such as ordinary losses. Taxpayers who have disposed of appreciated investment positions in Bitcoins may enjoy capital gains treatment. Taxpayers who hold Bitcoin as inventory will be subject to ordinary gains and losses upon disposition.
- Receipt of Bitcoin for goods and services is taxable at the time of receipt. The amount realized is the U.S. dollar value of the Bitcoin received. Also, disposition of Bitcoin in exchange for goods and services is taxable to the extent the value of Bitcoin had changed since the time it was acquired. Thus, if a taxpayer bought 1 Bitcoin for $500, and later used 1 Bitcoin to purchase a TV when Bitcoin was trading at $600, the taxpayer has a taxable gain of $100. This part of the Notice attracted some criticism from several commentators. A New York Times article from yesterday summarized this critique, noting that characterizing Bitcoin as property “could discourage the use of Bitcoin as a payment method. If a user buys a product or service with Bitcoin, for example, the I.R.S. will expect the individual to calculate the change in value from the date the user acquired Bitcoin to the date it was spent. That would give the person a basis to calculate the gains — or losses — on what the I.R.S. is now calling property.” This, according to critics, would encourage users “to hoard rather than spend, because as soon as they spend they would be liable to incur capital gains taxes.”
This criticism is partially justified. The reason is that the result would have generally been the same had the IRS decided to classify Bitcoin as a foreign currency. Under current law, U.S. taxpayers whose functional currency is the US dollar (practically all U.S. taxpayers), must track their basis in any foreign currency they hold, and recognize exchange gain or loss as soon as they dispose of the currency, to the extent their exchange gain or loss exceeds $200. The critic does have some merit, as capital gains or losses are taxed from the first dollar, while exchange gain or losses are subject to the $200 threshold. This could be corrected if a de-minims threshold would be made applicable to Bitcoin transactions as well (though it is not clear what would be the legal basis for the IRS to do so).
The only way to avoid completely taxation upon disposition of Bitcoin is to characterize it as a functional currency, which could only conceivably happen if the U.S. adopts Bitcoin as a legal tender. This is much to ask for, and certainly not within the power of the IRS to decide.
- Since taxes are paid in US Dollars and not in Bitcoins, the Bitcoin value must be converted to US dollars for purposes of determining gains and losses. Fair market value is determined by reference to the BTC/USD price quoted in an online exchange if “the exchange rate is established by market supply and demand”. The problem with this determination is that there are multiple such exchanges, and the BTC/USD spot price may vary significantly among such exchanges. At the time of drafting this post, price difference between various exchanges varied by as much as $100, for an average trading price across exchanges of about $575. Taxpayers could cherry-pick their BTC/USD exchange rate and reduce tax gains or increase tax losses. The Notice prescribes that BTC to USD conversion must be made “in a reasonable manner that is consistently applied.” It is not clear what does “consistency” mean in this context and more guidance on this issue is needed.
- Mining income is taxable upon receipt. Bitcoins come into existence by a mining process. “Miners” use their computing resources to validate Bitcoin transactions, and in return are compensated with newly created Bitcoin. Unsurprisingly, the IRS concluded that such income is taxable upon receipt. The IRS did not explicitly rule on the character of mining income, but it is most likely ordinary, under several possible theories:
a. It is income from services – Miners are paid in newly generated Bitcoin for handling the bookkeeping of the Bitcoin public ledger. The IRS describes mining income as income received from using “computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger”. This may imply that the IRS views mining income as income from the provision of services.
b. It is wagering income – from a technical point of view mining is guessing the correct answer to a complex cryptographing problem.
c. Mining pools – most miners mine through mining pools, where multiple individual miners pool together their computing resources in order to generate Bitcoins. Mining pools might be classified as partnerships for tax purposes. If the mining pool is a partnership – the mining pool itself is clearly in the business of mining Bitcoins. Any income from trade or business of the partnership (the pool) passes through as ordinary income to the partners (the miners). If the mining pool is not a partnership – miners essentially rent out their computing capacity to the mining pool’s operator. Rental income is ordinary income.
Information reporting and backup withholding. The Notice, as expected, also concludes that payments in Bitcoins are subject to information reporting and backup withholding. Thus, a person who in the course of trade or business makes Bitcoin payments in excess of $600 to a non-exempt U.S. person, must report such payments to the IRS and to the recipient on the applicable Form 1099. The payments are also subject to backup withholding to the extent the payor is unable to solicit the requisite tax information form the payee.
This interpretation is perfectly reasonable, but its practical significance left to be seen. Our information reporting system is built, among others, on the assumption that parties to a taxable transaction know each other (or can reasonably obtain information about one another and send information to each other). As such, for example, taxpayers can send 1099s to each other. The operation of Bitcoin defeats this assumption. Bitcoin is specifically designed to allow for exchange of value without having the parties to a transaction ever know each other. In fact, a Bitcoin payor is not always in a position to know whether payments he or she makes are made to the same person, or to different people. Payors may have hard time to even decide whether the $600 threshold is met. The default is backup withholding. It is not clear, however, how the IRS can enforce reporting and withholding requirements when both parties to a transaction are anonymous both to the IRS and to each other.
The ramifications may be significant. Consider for example mining pools. In order to be in compliance, U.S. based mining pools would have to identify their participants by name (rather than by anonymous address) a result that the Bitcoin community is all but certain to dislike. The alternative – backup withholding by the pool operator in respect of the Bitcoin mined – would probably drive Bitcoin miners to mining pools operated by non-U.S. taxpayers. It will be interesting to see how these requirements pan out.
Unaddressed issues. The Notice is well aware of its limited breadth and solicits comments from taxpayers. I would like to note some specific issues not addressed by the Notice that may be of significance:
- Whether Bitcoin and Bitcoin-wallets are financial assets and financial accounts, respectively, for purposes of FATCA and FBAR reporting requirements. This may not be of immediate relevance to most taxpayers due to the dollar amount thresholds applicable in such contexts, but as Bitcoin grows in popularity, such issues may become relevant.
- Whether Bitcoin service providers (such as wallet service providers, Bitcoin exchanges, Bitcoin mining pools and so on) are financial institutions for reporting, withholding, and FATCA purposes.
- Whether Bitcoin mining pools are entities for tax purposes. Some Bitcoin mining pools may conceivably be classified as entities separate form their owners for tax purposes, and as such may qualify as partnerships. This may carry with it significant tax consequences to Bitcoin miners.
- Can Bitcoin be classified as a commodity for purposes of section 475(e), allowing dealers to elect mark-to-market accounting?
To summarize, the IRS guidance is an effective one. It is clear, concise, and correct on the law. While some obscurities remain, most major interpretative issues are addressed. The main challenge remains in the area of collection. Time will tell whether the arsenal at the disposal of the IRS is enough to deal with tax evasion through Bitcoin, or whether Congress will have to supply the IRS with additional ammo.
- ABA Journal, IRS Answers Bitcoin Tax Questions, Says Virtual Currency Is Property, Not Money
- Bloomberg, Bitcoin Currency Use Impeded by IRS Property Treatment
- Bloomberg, Bitcoin Is Property, Not Currency, in Tax System: IRS
- Forbes, IRS Issues Bitcoin Guidance -- It's Property, Not Currency, And 1099s Are Required
- Los Angeles Times, IRS to Treat Bitcoin as Property, Not Currency, for Tax Purposes
- New York Times, IRS Says Bitcoin Should Be Considered Property, Not Currency, by Rachel Adams
- Reuters, Bitcoins Are Property, Not Currency, IRS Says Regarding Taxes
- USA Today, IRS: Answers to Tax Questions About Bitcoin
- USA Today, IRS: Bitcoin Is Not Currency
- Wall Street Journal, IRS Says Bitcoin Is Property, Not Currency; IRS Notice Means Investors Could Benefit but Transactions Subject to Taxes
- Wall Street Journal, Q&A: The New IRS Rules on Bitcoin