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What Is Bitcoin Digital Currency and Why Does it Matter for Tax Purposes?

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What Is Bitcoin Digital Currency and Why Does it Matter for Tax Purposes?

At its most basic level, Bitcoin is a relatively new technological means to transfer assets pseudo-anonymously over the Internet but some individuals uses bitcoins to commit tax evasion. Bitcoin is a relatively new technology that is sometimes referred to as a digital currency or as a cryptocurrency. While Bitcoin is one type of digital currency competitors include Litecoin, Dogecoin, Peercoin, Quark, NXT, and others.  Users of  Bitcoin and similar digital currencies can send and receive money over a decentralized network that relies on  a public ledger known as a “block chain” to authenticate and verify transactions. For many users of the service, using bitcoin is akin to utilizing a digital wallet, however, additional complexity lurks beneath the surface of user-friendly Bitcoin wallet interfaces.

Users Can Contribute Computing Resources to “Mine” Bitcoins

Traditional forms of hard currency, currency backed by gold or other precious metals are subject to constraints on the supply of money. While this fact is less relevant for fiat currencies, it is highly relevant for Bitcoin due to the artificial scarcity specifically designed into the model. That is, there will never be more than, roughly, 21 million Bitcoins. However, all 21 million coins  have not yet been discovered. Therefore, users can “mine” for Bitcoins which will inject new Bitcoins into the money supply.

Stating that people “mine” for bitcoins somewhat obfuscates the relationship, however. What is actually occurring is that people are choosing to contribute computing power to maintain the public ledger (blockchain) containing all Bitcoin transactions ever conducted.  Thus, for work performed in keeping the Bitcoin network running and functioning as expected, contributors can be awarded compensation in the form of Bitcoin.

Individuals who have been awarded Bitcoin from mining activities have realized income and a taxable gain. Depending on the circumstances, the bitcoin miner may owe self-employment taxes on the bitcoin income. Similarly, individuals and businesses who accept Bitcoin as payment must also generally pay taxes on this income. However, due to 2014 IRS Guidance detailing Bitcoin tax treatment, any individual who holds or uses Bitcoin is required to engage in fastidious record-keeping. A failure to do so can subject one to a number of informational reporting and other tax penalties.

While many Treat Bitcoin as Currency, for Tax Purposes, the IRS Considers it Property

In a 2014 document, Notice 2014-21, the IRS announced that Bitcoin and similar digital currencies should be considered property rather than a form of currency. The IRS based this decision on the basis that virtual currency is not legal currency in any jurisdiction. The IRS’s determination that Bitcoin is property means that users of the virtual currency are subject to capital gains taxes.

That is, consider a shopkeeper who is branching out into the digital world. He sets up a website where he accepts bitcoin as a form of payment. When a customer makes a payment in the form of Bitcoin, the shop owner must keep a record of the Bitcoin’s fair market value at the time of receipt. Then, when he or she sells or uses Bitcoin to engage in a subsequent transfer, the fair market value of the Bitcoin must be recorded to determine the capital gain or capital loss on the transaction. When dealing in Bitcoin, working with a tax professional can help you legally minimize tax impact of such transactions by selecting an appropriate accounting method for market conditions.