The rise of bitcoin and other forms of digital currency is fueling a wealth of questions about tax enforcement: what sort of tax treatment guidelines exist for digital currencies? How are tax reporting agencies responding to the large number of digital currencies that now exist worldwide? To what extent is virtual money being used for tax avoidance purposes?
All of this has sparked fervent conversations among those being paid in bitcoin, those simply investing in it, and many of the anarcho-capitalist bent who view taxation as theft. And given prevailing issues around tax havens, offshore accounts, encryption and the Panama Paper revelations, many would argue that prevailing tax monitoring systems are prime for disruption.
In an interview with Bitcoin Magazine, Certified Public Accountant Daniel Winters, addressed ways to make sense of this increasingly complex U.S. taxation landscape. His boutique firm Global Tax Accountants is one of only a handful worldwide that focuses on the tax ramifications of digital currency and blockchain transactions.
Winter’s journey to this narrowly defined niche is an interesting one. Hearing about bitcoin’s growing popularity in 2013, he ponied up some money and purchased a tiny amount. He became fascinated with Bitcoin’s trustless, peer-to-peer system of exchanging value that exists completely outside of the control of central banks or government. Over time he began to explore how this movement might align with his work as a CPA. Later, after reviewing the the guidance issued by the IRS on the taxation of virtual currencies in March of 2014, he elected to pivot his entire accounting practice last year toward the digital currency/blockchain niche
Today, Daniel has over 30 clients that include investors, contractors and businesses that have bitcoin earnings. He has presented on bitcoin and taxes at the Texas Bitcoin Conference and the New York Bitcoin Center, and was interviewed by Bloomberg regarding New Jersey’s tax treatment of bitcoin transactions.
In the following interview, Winters discusses the road ahead, as U.S. tax authorities and users alike seek to better understand tax policy in the rapidly expanding digital currency landscape.
Is bitcoin considered money for tax purposes?
Per IRS Notice 2014-21, bitcoin is considered a virtual currency and is thus treated as property for federal tax purposes. In other words, the IRS views bitcoin as being similar to stocks and bonds. So under federal tax law, if you purchase bitcoin and later sell it, you will have a gain or loss on the transaction.
Bitcoin’s designation as a virtual currency connotes its use as a medium of exchange. And the fact that it is traded on the market determines its value. However, as we know, it is not backed by any sovereign government and is not legal tender anywhere. So it functions as a currency, but only in the virtual world and electronically.
Where was the definition derived from?
FinCen issued extensive guidance for the defining of digital currency. When the IRS issued their guidance in March 2014, they took the definition of a virtual currency directly from FinCen and then said okay, that is what virtual currency is and how it’s defined for tax purposes. Again the big takeaway from the IRS guidance is that bitcoin for tax purposes is property, not currency.
But given bitcoin’s global nature, why isn’t it considered a foreign currency?
The IRS does not view bitcoin as a foreign currency for tax purposes. Foreign currency has a different classification, and receives very different tax treatment. In other words, bitcoin does not get treated the same way as if you bought some Euros in Germany and then had them converted into U.S. dollars.
And what’s with all of the talk about bitcoin being classified as a commodity?
There is a lot of misinformation out there about this. So for the record: bitcoin is also not treated as a commodity for tax purposes. This confusion likely has ensued from the Commodity Futures Trading Commission (CFTC) that regulates financial derivatives. They have stated that bitcoin is a commodity for purposes of the CFTC. The Commission was created many years ago to regulate financial products, such as futures contracts or derivatives for the price of soybeans, corn or pork bellies. A derivative is basically a contract whose value is dependent on the price of something else, such as the price of soybeans. So the CFTC regulates financial derivatives and futures contracts. What they were trying to convey with regards to bitcoin is that it is also essentially a futures contract or derivative, which they are charged with regulating. But this [the CFTC] has nothing to do with taxation.
So why was it defined as a futures contract to begin with?
Basically, a futures contract allows you to purchase the right to buy or sell a commodity or other asset for a set price at a future point in time. These contracts were originally created for farmers, who wanted to guarantee the price of their crops. These days, you can buy a derivatives contract for a vast array of financial assets, including bitcoin. Therefore, when the CFTC issued their notice concerning bitcoin, this just meant that bitcoin derivatives contracts are being regulated by the CFTC. Again, bitcoin is most definitely not a commodity for tax purposes.
So at the end of the day, is a bitcoin sale viewed in the same way as that of a stock?
Yes. Since Bitcoin sales are treated like stock sales, the resulting gain will be either short-term or long-term and subject to those respective tax rates. Long-term sales, for which bitcoin is held for more than one year, are subject to a 15 percent capital gains tax for most taxpayers. Taxpayers in the top income bracket are subject to a 20 percent capital gains tax, which applies to income above $400,000 for single taxpayers, and $450,000 for married taxpayers filing jointly. Short-term sales are those for which bitcoin was held for up to one year and are subject to ordinary income rates of up to 39.6 percent.
How is all of this accounted for on a tax return?
With respect to bitcoin, there are two things that need to be reported on a tax return: income or revenue and any capital gains on the sale of those assets.
And how are capital gains calculated?
Capital gain/loss is calculated by subtracting the purchase price, or basis, of the virtual currency from the sale price. The basis of a given amount of virtual currency is the fair market value, in US dollars, on the date of payment or receipt.
What that means for the average user is if they purchase $100 of bitcoin today, they own an asset with a cost basis of $100. Now let’s say that a year goes by and bitcoin goes through the moon, doubling in price. So it’s now worth $200. You then sell it and get $200. $200 minus $100 is $100 in capital gains, which must be reported on your tax return.
But there are some that say that bitcoin becomes non-taxable if you convert it before it appreciates.
That’s incorrect. If you receive $1,000 in bitcoin from, let’s say, a mining contract then you have $1,000 in income. And if it’s a business, it should be viewed as $1,000 of revenue. Bottom line, it’s $1,000 of ordinary income or revenue. But also keep in mind that it is also considered a capital asset, with a cost basis of $1,000. So unless you convert that bitcoin into dollars that day, you’re going to have a gain or a loss on the transaction.
How do the tax guidelines apply to bitcoin miners and their earnings?
The IRS says that if you are a miner that receives (bitcoin) revenue from a mining business, this equates to the U.S. dollar value of the virtual currency on the day you receive it. So as an example, say you are solo mining and you go a month and a half without getting paid. Then one day you suddenly become lucky and hit a big block with 12 coins. The complete dollar value of those revenues apply on the date you received them.
How are taxes viewed for a mining business?
Revenue reflects the dollar value of the bitcoin the business receives each day. Businesses can, however, reduce their revenues by any expenses they incur, irrespective of whether those expenses are paid in dollars converted from bitcoin or bitcoin itself. In other words, if you purchase a bunch of, say, power supplies for your mining business with bitcoin, your expenses are deductible.
What about bitcoin received in exchange for goods or services?
It is treated as ordinary income, the same as normal wages paid in fiat currency.
What about a miner or freelance contractor that receives their pay in bitcoin?
IRS stated very clearly that contractors who receive bitcoin or other forms of digital currency are subject to the 1099 reporting rule. That means that if you are a U.S. citizen or permanent resident and someone pays you in bitcoin, that company is obligated to provide a 1099 to you, provided that it was at least $600.
And W-2 employees?
If someone is a W-2 employee and their employer chooses to pay them in bitcoin, the IRS states that the dollar value of those wages gets added into any other dollars they’ve received during the year and that must be included on their end of the year tax document.
The IRS just recently released a new guidance report in September. Can you briefly discuss this?
The IRS’ recent 31 page guidance report takes a broad look at bitcoin and virtual currency taxation, what the IRS has done so far to address it, and what they need to do in the future. The broad goals of this guidance are as follows: (1) determine if virtual currencies are widely being used as a method to hide income and avoid US taxation; (2) share virtual currency knowledge across the IRS; (3) identify audit techniques that can used to determine if taxpayers using virtual currencies in transactions, especially offshore arrangements, are attempting to conceal income and avoid US taxation.
Is this part of a larger enforcement effort?
Let’s just say that the IRS has a team charged with determining whether bitcoin is being used for tax evasion. This knowledge is being shared throughout the IRS and audit techniques are being identified to nail people who are hiding their income. They have given training to over 300 agents, providing a general overview of what virtual currency is and how it works.
The IRS is well aware that most people, many people, don’t properly report their bitcoin transactions and they are well aware of the fact that their enforcement mechanisms are not sufficient.
In your view how pervasive do you believe the use of bitcoin and other forms of digital currency will become as a tax-avoidance tool globally?
It’s very difficult to answer that question. Our firm doesn’t accept clients that are engaged in tax evasion. Bottom line, trying to use bitcoin to avoid paying taxes is not too smart. Since all bitcoin transactions are publicly available on the blockchain, if someone can associate your identity with a particular bitcoin address, your transactions are right there.
Any final advice for those who are actively investing and/or being paid in bitcoin?
Keep good records. This is particularly important given the history of instability among exchanges and the fact that they might go under at any moment. I get asked all the time about how likely it is that the IRS will detect tax avoidance. In my view, it is important to be compliant with the law and avoid any unnecessary complications with the tax authorities. That’s my passion: supporting people in achieving this aim.
Note: Daniel Winters holds a Master’s of Taxation and owns an accounting firm specializing in Bitcoin and virtual currencies. He has written a course for CPAs about Bitcoin Taxes and has an excellent understanding of how the IRS treats Bitcoin transactions. Nonetheless, the information he offers in this post is NOT legal advice, nor does it constitute advice regarding your personal tax situation. Under IRS Circular 230, Winters has no responsibility for any positions you take on your tax return unless he has prepared and signed that tax return. For a detailed analysis of your tax situation, please consult your tax advisor.