By: Wayne Buckwalter
Bitcoin is an open-source, peer-to-peer payment network and digital currency that has been around since 2009. It is the most well known of the cryptocurrencies, which include Litecoin, Namecoin and Peercoin. Commercial use of Bitcoin is small compared to its use by investors and speculators, which has resulted in value spikes. Bitcoin is also used to pay for products and services, because transaction fees are lower than the 2 to 3 percent charged by credit card companies.
What happens when a speculator cashes out or payment is made by appreciated Bitcoin? Of course the Internal Revenue Service wants its fair share, but what is that? There is presently no U.S. law or regulation regarding this. Senate hearings are underway. Several European countries have determined that since Bitcoin is not legal currency, taxable events from use or sale are treated as capital gains. Where is this issue going here in the United States?
Whenever a taxable event occurs, Bitcoin is taxable. A taxable event is whenever you trade Bitcoin for anything (bartering) or sell Bitcoin for currency (dollars, euros, etc.). Bitcoin is an asset. Treasury Regulation §1.61 specifies that gross income may be realized in any form, including currency, property or services. Whether Bitcoin is more like cash, stock or a claim check is not relevant for the purposes of determining if it is taxable. It’s probably taxable.
In Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955), the U.S. Supreme Court examined Section 22 of the Internal Revenue Code. That section is the predecessor of Section 61, which defines gross income. In this case, money damages were recovered as part of a settlement in an antitrust suit, a portion of which was classified as punitive damages, and the taxpayer did not report these punitive damages as income. The court stated, “The mere fact that the payments were extracted from the wrongdoers as punishment for unlawful conduct cannot detract from their character as taxable income of the recipients.” The court found that the language used by Congress in Section 61 indicated that it intended to exert “the full measure of its taxing power.”
To determine whether a taxpayer has received gross income, courts look at whether the taxpayer has (1) undeniable acquisition of wealth, (2) which is clearly realized, and (3) over which the taxpayer has complete dominion. Realization is important when examining Bitcoin and other cryptocurrencies. It is a matter of timing and founded on administrative convenience.
Unrealized gain may fluctuate over time as value changes, and will be treated as income only upon realization. This is when cryptocurrencies must be classified. The simplest solution is to call them property, which basically means that cryptocurrencies are something that can be owned. Cash is a government-issued note, and is the property of the government.
In Cottage Savings Association v. Commissioner, 499 U.S. 554 (1991), the Supreme Court held that “an exchange of property gives rise to a realization event so long as the exchanged properties are materially different—that is, so long as they embody legally distinct entitlements.” So, if you purchase an asset using a unit of cryptocurrency, the person who sold you the asset has experienced a realization event upon receipt of the cryptocurrency. The same is true for transfers of cash and services. Challenges arise, however, when the value of the items or services being exchanged are unclear.
Cryptocurrencies are constantly changing in value. The price you pay for cryptocurrency is your “basis.” Internal Revenue Code § 1001(a) states, “The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in Section 1011 for determining gain.” Section 1001(b) states, “The amount realized from the sale or other disposition of property shall be the sum of any money received plus the fair market value of the property (other than money) received.” Pursuant to Section 1001 of the code, a taxpayer must adjust his or her basis in property to reflect any recovery of his or her investment or any additional investment made in the property. And, a taxpayer can recover tax-free his or her investment (capital) in property before being charged with income from a disposition of the property.
A common Bitcoin transaction occurs when Bitcoin is exchanged for other property. For purposes of Section 1012, “the cost basis of the property received in a taxable exchange is the fair market value of the property received in the exchange,” as in Philadelphia Park Amusement v. United States, 126 F. Supp. 184 (1954). If the value of the property received is unascertainable, then the value is assumed to be the same as the fair market value of the property relinquished.
Exchanging Bitcoin for services may make calculating tax liability more challenging. In Revenue Ruling 79-24, the IRS found that Treasury Regulation “Section 1.61-2(d)(1) provides that if services are paid for other than in money, the fair market value of the property or services taken in payment must be included in income. If the services were rendered at a stipulated price, such price will be presumed to be the fair market value of the compensation received in the absence of evidence to the contrary.”
Once the taxpayer has determined the dollar amount of gain he or she has received, the next step is to determine the tax consequences. The tax rate generally depends on total income.
To be treated as a capital asset, and thus subject to a favorable 15 percent tax rate for capital gains, the property must be an asset. Items such as interest, salary and accounts receivable from compensation for services are not capital assets. Also, to use the 15 percent rate, the asset must be long-term. To be long-term, the asset must be held for at least a year and a day.
So far, the world’s governments and central banks have put more energy into advising the public that Bitcoin is risky and not a currency, or restricting its use, than formulating rules to tax its transactions. Slovenia (the home of Bitstamp) has said Bitcoin is a virtual currency but not a “monetary asset,” and Bitcoin income would be taxable. Germany has said it regards Bitcoin as “private money” or a “financial instrument,” and the Swiss parliament is considering a move to have Bitcoin officially recognized as a currency.
The Canada Revenue Agency (CRA) issued an official release on how to treat Bitcoin and other virtual currencies for taxation in early November 2013. The guidance gives tax advisers working with Canadian Bitcoin companies something to go on when working within the Bitcoin space. Although it contains no new information, it does reinforce the CRA’s previous statement on the subject. The fact sheet, titled “What You Should Know About Digital Currency,” is a brief outline that states that tax rules apply when it is used to pay for goods and services in the same way the rules for barter transactions apply; it links to the CRA’s rules on barter transactions after defining barter transaction and giving an example of buying movie tickets.
The Australian Taxation Office (ATO) took an almost identical stance to the IRS in June 2013, warning that although no specific rules have been passed relating to Bitcoin, it is aware of the cryptocurrency, and that people should be keeping detailed records of their transactions, in case it decides to levy taxes on Bitcoin-based profits. The ATO said it was able to track transactions in Bitcoin.
The IRS hasn’t offered guidance on Bitcoin, beyond saying that it is working on the issue and that it has been monitoring digital currencies and transactions since 2007. “The IRS is aware of the potential tax compliance risks posed by virtual currencies,” it said in the statement. “The IRS continues to study virtual currencies and intends to provide some guidance on the tax consequences of virtual currency transactions.”
Clients should be advised to keep accurate records regarding the creation, ?purchase, sale and use of Bitcoin for acquiring goods and services. It is extremely likely that all of these transactions are subject to tax reporting and payment where applicable. Tax advisers should include Bitcoin and other cryptocurrency in lists of information required of clients for accurate tax reporting.
Obviously, there will be more to come on this topic. Buckle your seatbelt when purchasing a Jaguar using Bitcoin. You may also get tax issues as part of the deal.
“Reprinted with permission from the February 4, 2014, issue of the Legal Intelligencer© 2014 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.”
“Circular 230 Disclosure: To ensure compliance with IRS Circular 230, we inform you that any tax advice contained in this message is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding Federal tax penalties, or (ii) promoting or marketing any transaction or matter discussed herein.”