Virtual Currency

Taxation of Convertible Virtual Currency, Part III: Reporting and Penalties for Noncompliance

When it comes to Bitcoins and other convertible virtual assets, anonymity may not be all it’s cracked up to be.  For one thing, an underlying assumption is that individuals who keep their financial transactions hidden have something illegal to hide.

Earlier this month in Brisbane, Australia, a Bitcoin ATM owned by a local cafe was seized by the authorities as part of a drug investigation--apparently the "Bandidos Bikie Gang" was using the cafe in a multimillion dollar methamphetamine trafficking network.

IRS Notice 2014-21 now makes it a requirement to report all convertible virtual currency payments.

Reporting Virtual Currency

Payment received in the form of convertible virtual currency is now subject to federal income tax withholding, payroll taxes, and information reporting to the same extent as payment earned in any other manner.

  • Payments made to an independent contractor in convertible virtual currency worth $600 or more must be reported on Form 1099-MISC.
  • If a taxpayer identification number has not been obtained from the taxpayer, the payor must withhold 'backup withholding.'
  • Third party settlement organizations (TPSOs) are required to report payments to a merchant on Form 1099-K if the payments to that merchant exceed 200 in a calendar year and the gross amount of payments exceeds $20,000.

The amount reported should be the fair market value of the virtual currency (in U.S. dollars) on the date of payment.

Penalties for Noncompliance

Taxpayers who have failed to pay tax or file an information return regarding their convertible virtual currency transactions prior to the date of the IRS guidelines (March 25, 2014) may be subject to penalties under Internal Revenue Code section 6662.  Relief, however, is available to taxpayers who can show “reasonable cause” for their underpayment or failure to properly file their returns.
The intent appears to be a warning to traders and virtual currency businesses to heed their income tax responsibilities

Things to watch out for

There is no such thing as the anonymity of convertible virtual currency transactions since your virtual currency holdings are not FDIC-insured, you should at least know and trust the people you work with.  As with any business, those that deal in virtual currency need a certain level of professional recognition to build their reputation, something that client anonymity cannot provide.

Further, online exchanges may be forced at some point to report their clients’ accounts, as do banks and brokerage firms, and may even classify these exchanges as financial institutions for purposes of FATCA reporting. In addition, by classifying convertible virtual currency as property, IRS Notice 2014-21 may lead to a situation where cities and states demand that sales tax be applied to virtual currency transactions. All we know at this point is that the IRS has finally taken notice of virtual currencies and you should as well.

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Taxation of Convertible Virtual Currency, Part II: Taxation of Virtual Currency Income

In Part I of this series, we discussed the IRS guidelines on the taxation of gains and losses associated with convertible virtual currency.  In this post, we will focus on the taxation of income--wages, self-employment income and income from the “mining” of virtual currency.

Virtual currency income

James Howells of the UK began “mining” Bitcoins in 2009, when the pastime of creating virtual currency by having your computer solve mathematic problems was done exclusively by tech geeks and the value was minimal.  A few years later, Howells cleaned house and threw away an old computer with a digital store of 7,500 Bitcoins. In November of 2013, he realized that those Bitcoins were worth $7.5 million.  With no backup, the only way of retrieving the Bitcoins was to go through 25,000 cubic meters of waste and earth at the nearby landfill-an obviously hopeless task.

A growing number of taxpayers are now earning in Bitcoins and other convertible virtual currency, and IRS Notice 2014-21 provides guidelines on how this income is treated for income tax purposes.  In sum, income in the form of convertible virtual currency is treated no differently than income received in more traditional ways:

  • Wages.  Employees paid in virtual currency must pay taxes on their earnings, at the fair market value on the date of payment. This income is subject to federal income tax withholding and payroll taxes. The wages must be reported by the taxpayer’s employer on Form W-2.
  • Self-Employment Income. Virtual currency received for services performed as an independent contractor are subject to the self-employment tax.  This self-employment tax is imposed on the fair market value of the income as of the date of receipt (measured in U.S. dollars). Payers must issue a Form 1099 to the taxpayer for the annual payment of more than six hundred dollars when the payment is incurred as an ordinary and necessary expense of the payor's business.
  • "Mining" Virtual Currency. If a taxpayer generates new Bitcoins or other convertible virtual currency, the fair market value of that virtual currency on the date of receipt is includible in the taxpayer’s gross income. If the taxpayer mines virtual currency as their trade or business, and the taxpayer is not mining as an employee, the taxpayer’s gross income from mining (less allowable deductions) is considered self-employment income and is subject to self-employment tax.

Look to the not so distant future:

San Francisco’s first Bitcoin Teller Machine (BTM) was just installed this past September at the Workshop Cafe on Montgomery Street.  Right in our office building!   The BTM allows users to convert their Bitcoins to cash (and get a great cup of coffee in the process).  We will be keeping a close eye on how the new tax guidance affects the Bitcoin and other convertible virtual currency markets, and whether Bitcoin will proceed to develop as a form of “currency” for ordinary transactions. In the meantime, keep track of your virtual currency--and please don’t throw it out.

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Part III of this series will address reporting requirements for employees, employers, independent contractors, and third party settlement organizations, as well as penalties for noncompliance.