Originally published on Forbes.com Mar 26th, 2014
The IRS has just issued Notice 2014-21 which is a Q&A on how “existing general tax principles” apply to virtual currencies. The thrust of the Q&A is fairly simple and not at all surprising. Bitcoins are not tax fairy dust. I credit Joe Kristan with coming up with the concept of the Tax Fairy:
The Tax Fairy, in the imagination of believers, appears in the form of magical legal maneuvers that make your taxes all go away. Your drinking buddies may even claim to have seen it, or that their tax guy knows her.
There are sixteen questions. Nine of the questions (Questions 3,8,9,10,11,12,13,14,15) are there to drive home the point that when you are paying or receiving virtual currency, you have the same obligations and tax consequences as if you would if you were paying or receiving dollars. Wages are still wages. Self-employment income is still self-employment income. Question 16 really lets you know that none of this should be surprising.
Q-16: Will taxpayers be subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with this notice prior to March 25, 2014?
A-16: Taxpayers may be subject to penalties for failure to comply with tax laws. For example, underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties under section 6662. In addition, failure to timely or correctly report virtual currency transactions when required to do so may be subject to information reporting penalties under section 6721 and 6722. However, penalty relief may be available to taxpayers and persons required to file an information return who are able to establish that the underpayment or failure to properly file information returns is due to reasonable cause.
Living In Bitcoin Land
The import of the other rest of the Q&A is that if you want to run your life on bitcoins, it will be fiendishly complicated to be perfectly compliant. It actually is not that easy for a US person to run their life on anything other than dollars and be perfectly compliant, but, based on this notice, bitcoins will be harder. If you decided to run on British Pounds, what makes life simpler is that foreign currency gains and losses are ordinary.
The statute of limitations has run on that year, so it is probably safe for me to confess that when I traded my leftover Euros for dollars after returning from vacation in Ireland, I did not report any gain or loss. In principle, I should have. You can really get a headache trying to think through all the implications of recognizing gain and loss as you move from your functional currency (that would be the dollar for most US persons) to other currencies, but the fact that the gains and losses are ordinary makes it a lot easier.
So the bad news from a practical point, if you wanted to use bitcoins on a day to day basis comes in the answer to Question 2, where we learn that virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes. The answer to Question 6 is very good news for someone who bought a boatload of bitcoins before late 2013 if this chart is accurate. Virtual currency is a capital asset. Gains from its disposition will be taxed at capital gain rates. Of course, that is not such good news for those who bought at the peak.
If you are interested in having a virtual currency sub-economy though, the answer to question 6 skates on a very important issue. Suppose I hire you to help me work on my blog. I pay you in Petedollars, which are worth $0.50. When you spend your Petedollars, sometimes they are worth $0.75 and sometimes they are worth $0.25, other times $0.50. Two bits, four bits, six bits. Who knows? Maybe a dollar.
You have a gain or a loss on most of those transactions. The gain is clearly taxable as a capital gain. If you have a loss, though, they refer you to Publication 544. On page 22, you learn that assets held for personal use generate non-deductible losses. Since you are using your Petedollars to pay your personal expenses, it may well be that the losses are non-deductible. That would create significant tax inefficiency for someone trying to operate in a virtual currency environment.
Is The IRS Wrong On The Currency Question?
There is a concept called “functional currency”. A business operation can, in the right circumstances, have a functional currency other than the US dollar. This is a great simplification. It allows you to just translate the bottom line into dollars rather than each transaction. (That is probably a bit of an oversimplification) “Functional currency” is defined in Code Section 985 as:
in the case of a qualified business unit, the currency of the economic environment in which a significant part of such unit’s activities are conducted and which is used by such unit in keeping its books and records.
It seems to me that, in principle, enough people adopting a virtual currency could create an “economic environment” that a business unit could operate in.
Good News For Gold Farmers And The Linden Economy?
My very first blog post ever was about virtual currency. It was inspired by a thought journey I had started on around eight years ago, when my son asked me if he could use my credit card to buy gold. As I started wrapping my head around the concept, I sarcastically speculated that there were a bunch of kids in China playing World of Warcraft to earn gold to sell to the likes of slackers like him. Silly me. It is a major industry. Google “Wow gold” and you will see what I mean.
I started thinking about the tax implications of WOW gold. Buying and selling WOW gold is a violation of the game’s terms of service. Second Life is a different story, the in-game currency (Linden dollars) is freely traded on the LindeX. So should in-game transactions be taxed? There does not seem to be much in the way of guidance on that issue, and the most reasonable answer seems to be that there is no taxable income until you translate into dollars or something equivalent.
Notice 2014-21 seems to leave the Linden economy unmolested. In the introduction, we read
In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.
If you would like some idea as to the potential that virtual worlds might have for money laundering, pick up Reamde by Neal Stephenson. It is a great read. Maybe it will help you get over mourning another tax fairy choking on her dust.
Did The IRS Contradict Itself?
In its answer to Question 8, the notice states that someone who “mines” virtual currency has income when they receive the virtual currency. I have to admit that I have read about mining as it relates to bitcoins and still do not grasp it. In principle, though, if the “mining” is creating virtual currency that did not previously exist and the virtual currency is property, there should not be gross income until the currency is exchanged for something. It will be interesting if that issue ever gets litigated.
You can follow me on twitter @peterreillycpa.
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