IRSBenjamin Franklin once said that in life, nothing was certain save for death and taxes. That certainty has now extended to Bitcoin. In another sign of Bitcoin’s growing use, the US Internal Revenue Service has pronounced itself on how it is going to proceed vis-à-vis Bitcoin.

IRS to Treat Virtual Currency as Property

In a detailed notice posted on its website, the IRS said that it is aware that virtual currency such as Bitcoin may be used to pay for goods or services, or held for investment. The IRS sees virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. In some environments, it operates like “real” currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance — but it does not have legal tender status in any jurisdiction.

As a result of its lack of legal tender in any jurisdiction, the IRS has for the purposes of taxation elected to view bitcoin as property. This approach is likely to become problematic, especially as the volume of bitcoin transactions continues to grow.

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Difficulties with Treating Bitcoin as Property

To illustrate why taxing Bitcoin as property might become problematic, let us consider the example of how the IRS would tax a barter transaction. If you were to work on a project, and are paid with a brand new sports car, the value of the sports car would be regarded as compensation for services rendered. The value of the sports car would be considered as income by the IRS. If say, for example, you went ahead and traded the new sports car for a laptop, the second trade would be a realized taxable transaction. In other words, the basis of the Bitcoin transferred to acquire the sports car is compared to the value of the item to which it is exchanged (the laptop), and any value increase would be viewed as income.

With the IRS’ decision to treat Bitcoin as property, the most problematic element becomes the method that the taxpayer would use to maintain adequate records so as to calculate the correct tax rate. Say, for example, a taxpayer has a cyber-wallet with Bitcoin from numerous transactions. The numerous transactions would in all likelihood have a different basis due to the fluctuations in the value of Bitcoin against fiat currencies such as the US dollar. The question that arises is how to identify the Bitcoin that the taxpayer uses and the method that will be used to reflect the basis.

However, that is not the only problem. There are other tax compliance issues to consider. For example, the IRS stipulates that its general tax principles that apply to property transactions, apply to transactions using virtual currency. Among other things, this means that:

  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by the employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
  • Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules apply. Normally, payers must issue Form 1099.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.

Many employers that are not very keen on withholding and reporting, will likely find it much easier to pay employees in virtual currency so as to fly under the radar. It is likely that this may be happening already.

What do you think of Bitcoin taxation? Comment below!

Images from Internal Revenue Service,Andrew F. Kazmierski and Shutterstock.