The guidance issued by the Internal Revenue Service this week treating virtual currencies such as Bitcoin as property rather than currency for federal tax purposes may end up helping Bitcoin investors, even though it means Bitcoin users will need to be extra careful to report their transactions from now on.
The IRS released Notice 2014-21 on Tuesday containing guidance in the form of frequently asked questions on how virtual currency should be treated for tax purposes (see IRS Says Bitcoin Counts as Property for Tax Purposes). The guidance came in response to requests from tax practitioners as well as the IRS’s own National Taxpayer Advocate.
“People have been pressing the government to come out with a notice,” said Steve Brecher, a senior adviser at the accounting firm WeiserMazars, who has been closely following Bitcoin developments. “The National Taxpayer Advocate in her report about three months ago clearly recommended that the Service provide guidance here because it was needed.”
The guidance may not satisfy everybody who may have been hoping the technology would be able to escape the scrutiny of regulators and the tax authorities, but it will also provide reassurance to those investors who were burned by the collapse of Bitcoin markets like Mt. Gox, which reportedly lost $460 million after it came under attack from hackers.
“It certainly will provide an additional way for the government to go after illegal or noncompliant behavior,” said Brecher. “A lot of times, the government has a hard time prosecuting people for illegal activity, but they still get them on tax fraud.”
Still, the government will need to rely on users and the nascent Bitcoin markets to provide information reports, which they may not be prepared to do.
Dan Thrailkill, CPA, a manager in the tax department at the accounting firm Ellin & Tucker, sees a flaw in that approach.
“It is encouraging to read that the IRS has prescribed guidance regarding the taxation of virtual currencies, such as Bitcoin,” he said. “The recent IRS notice suggests that the use of virtual currency be taxed as property. However, without a formal regulatory agency in the US, there will be no form of checks and balances. The IRS will have to rely solely on the users of virtual currency to provide them with the taxing information. If there is, indeed, a viable future for virtual currency, then we as tax professionals are obligated to educate our clients accordingly.”
Accountants will need to help their clients deal with the information reporting requirements if they have started to use Bitcoin. Such requirements could put a damper on Bitcoin’s popularity, although the various scandals involving the collapse of Mt. Gox and other Bitcoin exchanges, along with the arrest of the founder of Silk Road, whose users employed Bitcoin for transactions such as money laundering, drug deals and prostitution, hasn’t helped its reputation either.
“There’s nothing surprising to me, but what I think has been made clear and may discourage some use is you’re now going to be subject to the information reporting requirements that you would have for any payments made,” said Brecher. “You’ve got 1099s, you’ve got W-2 payments, and you’ve got a whole tax regime that they’re saying is clearly subject to this. Up to now, my guess is that would have been the case, but there certainly was a question. The IRS has now made it very clear this is what we’re going to have to do.”
The IRS also said the foreign currency exchange rules did not apply to Bitcoin, Brecher noted, but that too could cause some problems. “You’re going to have to measure it against the dollar,” he said. “Now there could be some technical issues there because the assumption here is that the functional currency of the person is the U.S. dollar. Maybe you’ve got a U.S. citizen abroad whose functional currency is not the dollar and that could create some other issues, but for the most part, for U.S. people, they’ve defined that. The conversion has to be into U.S. dollars. I think they’ve given a lot of guidance. It doesn’t take into account all the issues, but it certainly clarifies a lot of things that one might have anticipated. Maybe it’s not what one would have liked, but I don’t think tax experts should be surprised.”
Brecher anticipates the IRS may be lenient on some of the previous Bitcoin activity prior to the issuance of the guidance, but virtual currency users and their accountants will know what to expect going forward.
“It’s certainly up to the individual taxpayer to determine if they’re going to comply or not, and if they’re not going to comply, they may be subject to penalties,” he said.