Bitcoin, the virtual currency that tech savvy consumers can use to purchase anything from the latest music on iTunes to a Lamborghini off a showroom floor, has been around since 2009 but just recently hit the radar of U.S. regulators. Recently, the IRS issued Notice 2014-21, which provides clarification on the taxation of convertible virtual currency, such as bitcoin.
Virtual currencies are treated as property and not currency for tax purposes. Gains and losses from the exchange of virtual currency will be treated under Internal Revenue Code Section 1001 and not as foreign currency gains or losses under Section 988.
A taxpayer who receives virtual currency as a payment for goods or services must include the fair market value of the virtual currency in gross income.
A taxpayer who uses virtual currency to make a purchase is treated as if the virtual currency was sold on the date of the transaction and the taxpayer has a taxable gain (or loss) equal to the value of the currency sold, minus the adjusted basis of the virtual currency.
The exchange of virtual currency will generally produce capital gain or loss, provided the taxpayer holds the virtual currency as a capital asset, which will normally be the case. Thus, a virtual currency transaction would produce ordinary gain only if the taxpayer held virtual currency mainly as inventory or other property for sale to customers in a trade or business.
Taxpayers who successfully “mine” virtual currency must include the fair market value of the “mined” virtual currency in gross income on the date of receipt. If the “mining” activities rise to the levels of a trade or business and the activities are not undertaken as an employee, the net income is subject to self-employment tax. Issues of sourcing (e.g., foreign vs. domestic income) mined virtual currency were not addressed.
This notice is not new law, but instead is a clarification of existing law. Taxpayers who acted in a manner inconsistent with this notice prior to its issuance may be subject to accuracy related penalties and failure to file penalties.
Proponents of bitcoin and other virtual currencies had a generally positive response to this notice. Had the IRS treated virtual currency as foreign currency under Section 988, gain would be taxed at ordinary income rates. Some practitioners had hoped that the IRS would treat virtual currency as currency and apply the section 988(e) exception to virtual currency. Section 988(e) provides that when an individual realizes a foreign currency gain on a personal transaction, the individual need not recognize a gain that does not exceed $200. A personal transaction is one which is neither related to a trade or business or an investment activity. As economists such as Paul Krugman have noted, virtual currency’s function as a means of investment far outweighs its function as a means of exchange. Because virtual currency has strong investment potential, if it were treated as a currency it would most likely not qualify for the section 988(e) exception.
The compliance burden for virtual currency users should be minimal. It is essential that taxpayers who engage in virtual currency transactions choose a virtual currency exchange that will maintain proper record keeping and track basis, sales, and transaction dates. Additionally, taxpayers should choose an exchange that will issue annual tax reporting documents, such as Forms 1099-B and 1099-K.
While this guidance was anticipated, the tax treatment of bitcoin and other virtual currencies is now certain. Taxpayers who transact in virtual currency should discuss these issues with their tax advisors, particularly if they had treated previous virtual currency transactions in a manner inconsistent with the notice.
If you have any questions regarding the taxation of Bitcoin or any other similar tax issues please contact your normal WithumSmith+Brown partner.
 Krugman, Paul, “Golden Cyberfetters,” 9/7/2011, available at http://krugman.blogs.nytimes.com/2011/09/07/golden-cyberfetters/