Tax Issues Relating to Bitcoins

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Sec. 1221 as "Property held by the taxpayer"(whether or not connected with trade or business).4 Thus, the default classification for property is a capital asset. The IRS does not recognize following assets as capital assets: inventory, real or depreciable property held for held for use in trade or business, intellectual property created by the taxpayer’s personal efforts, accounts receivable, government documents, and certain dealer held derivative financial instruments, heading transactions and non-inventory supplies regularly used or consumed by the taxpayer in his trade or business. Therefore, the definition of a capital asset makes clear that the determination of whether an asset is capital depends on how it is held by a particular taxpayer.

Further to the above tax treatment the bitcoin activities giving rise to consider ordinary income rather than capital gain. For example, engaged in mining of bitcoin, income generates by bitcoin mining activities can be considered as ordinary income under the IRS notice 2014-21 at Q-8.3 However, later these bitcoins earned used to buy goods or services will be recognized as ordinary income rather than capital gain. The argument among bitcoin experts is important to discuss. In this case, the bitcoin is extracted from within a large source similar to mining ore or extracting oil from the earth. Therefore, bitcoin income from mining is normal ordinary income rather than capital gain income.

Bitcoin holders have another problem in using exchange rate where there is more than one is available? Is averaging allowed? Bitcoin is also has established exchange rate. Therefore, fair market value of bitcoin is easy to calculate. But when spending to acquire bitcoins the basis for tracking the exchange rate is unclear in order to IRS notice 2014-21. For example, assume taxpayer ‘A” buys 10 bitcoins on January 01st. when bitcoin is worth $100 each, 20 bitcoins on January 10th when bitcoin is worth $120 each, and 30 bitcoins on January 20th when exchange rate dropped $110 each. Then the "A" spent 10 bitcoins on January 25th. Then what is his basis for the spent 10 bitcoins? The daily exchange rate permits taxpayer “A” to keep track of dates he purchased or acquire bitcoins. But bitcoin holder can use more than one virtual wallet to keep and segregate bitcoins purchases. This act avoids mixing of bitcoin with different bases. However, the related problem is if the taxpayer “A” has a different virtual wallet for each bitcoin transaction. This allows bitcoin holder to segregate bitcoins and could purposely pick and choose the highest basis to reduce his gain or creating a loss to gain tax benefit.

Another complex tax issue in bitcoin is no proper tracking and tracing method when a person engages in bitcoin mining. If a person engaged in bitcoin mining using his computer connecting to server or network of computers physically located in outside the United States. An issue related to this case is whether this income from mining process is properly calculated where the miner resides or where the computer is physically located. There is no proper tracking solution for this problem in the current IRS guidance.

Another problematic tax issue is in employer – employee compensation system in bitcoin. Bitcoin payments to employees are treated as wages and subject to employment withholding tax (IRS Notice 2014-21 at Q 11).3 Since the IRS does not accept bitcoin in a line of cash to meet employment tax withholdings. Therefore, the employer needs to liquidate bitcoins in order to generate dollars to pay required withholding tax. In this transaction, capital gain/loss realized to the employer due to exchange different of bitcoin to dollars. The transaction tracking exchange rate basis is a problem faced by IRS when calculating the employment tax. The other problem when employee converts bitcoin into dollars. The gain or loss on realization at the time of the exchange the bitcoin is taxable under the IRS regulations. However, these problems are real tax issues in the bitcoin system to fix by the IRS.

Another bitcoin tax issue is that bitcoin transactions are not necessarily required to report like credit card transactions. In order to the IRS Sec.6050 W, Payment settlements entity must report the amount paid to those who receive more than 200 payments (more than $20000 in total).6 The credit card entity has a contractual obligation to report these transactions. But bitcoin transactions use a peer to peer network and there is no such operating establishment. Therefore, in the bitcoin transactions there is no such regulating requirement enforced by the IRS. Therefore, IRS loses a lot of money on these kinds of transactions.

5. Conclusion

In this article discussed a few number of tax issues relating to bitcoins though there are many questions raised in the marketplace. Since the decentralized peer- to –peer currency does not control by any institution, the use of bitcoin is increasing rapidly day by day. Therefore, it is important to IRS and other legal entities need to prepare to face virtual currency system challenges how to regulate and taxed. The modern cyber technology provides great opportunities to deal with bitcoins and that enables to find loopholes to mislead and evade tax easily since there is no proper regulatory system.

Though the IRS notice 2014-21 in operation on bitcoins but my idea is that there is no acceptable and transparent guideline to bitcoin customers to record and report their income. The IRS primary purpose is to regulate the tax system while maximizing the tax revenue. But all rules applicable to bitcoin should not be too burdensome for taxpayers.

Notes

1. Satoshi Nakamoto, Bitcoin: “A Peer-to-Peer Electronic Cash System”, Bitcoin.org, available at: http://Bitcoin.org/Bitcoin.pdf

2. Pete Rizzo, “IRS to Tax Digital Currencies as Property, not Currency”, accessed March 29, 2015,http://www.coindesk.com/internal-revenue-service-treat-digital-currencies-property/

3. Internal Revenue Bulletin: 2014-16 April 14, Notice 2014–21 IRS Virtual Currency Guidance accessed April 01, 2015, http://www.irs.gov/irb/2014-16_IRB/ar12.html

4. Sasha Klein, Andrew Comiter: Are You Ready for This Change for a Dollar? Probate & Property Magazine: Volume 29 No. 02

5. FinCen (2013), “Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies”.

6. “General FAQs on Payment Card and Third Party Network Transactions”. Accessed on April 01, 2015, http://www.irs.gov/uac/General-FAQs-on-New-Payment-Card-Reporting-Requirements.