Virtual currencies, like Bitcoin, are gaining popularity. However, many individuals, investors, and businesses are unclear about how they actually work and if there is reporting they must do on their federal tax returns. To clear up any misinterpretation, the IRS recently announced that it is targeting virtual currency users in a new “educational letter” campaign.
The basics
Most small businesses still generally accept only cash and credit cards and have not yet endorsed virtual payments for routine transactions. This is changing, however, as many larger online businesses and retailers now accept this payment type. You can even pay employees or independent contractors with virtual currency.
Virtual currencies, such as Bitcoin, has an equivalent value in real currency. It can be digitally traded between users. You can also purchase and exchange Bitcoin with real currencies (such as U.S. dollars). The most common ways to obtain Bitcoin are through virtual currency ATMs or online exchanges, which typically charge nominal transaction fees.
Once you (or your customers) obtain Bitcoin, it can be used to pay for goods or services using “Bitcoin wallet” software installed on your computer or mobile device. Some merchants use and accept Bitcoin to avoid high transaction fees charged by credit card companies and online payment providers (such as PayPal).
Tax reporting
Virtual currency has triggered many tax-related questions since its initial ledger start approximately 10 years ago. The IRS has been slow to advise and issued limited guidance to address them. In 2014, the IRS established that virtual currency should be treated as property, not currency, for federal tax purposes.
Consequently, businesses that accept Bitcoin and other virtual currency payments for goods and services must report gross income based on the fair market value of the virtual currency when it was received. This is measured in equivalent U.S. dollars.
From the buyer’s perspective, purchases made using virtual currency results in a taxable gain if the fair market value of the property received exceeds the buyer’s adjusted basis in the currency exchanged. Conversely, a tax loss is incurred if the fair market value of the property received is less than its adjusted tax basis.
Wages paid using virtual currency are taxable to employees and must be reported by employers on W-2 forms. Payroll by virtual currency is still subject to federal income tax withholding and payroll taxes and it is based on the fair market value of the virtual currency on the date of receipt.
Virtual currency payments made to independent contractors and other service providers are not exempt, they are also taxable. In general, the rules for self-employment tax apply and payers must issue 1099-MISC forms.
IRS letters
The IRS is sending a letter to taxpayers who potentially failed to report income and pay tax on virtual currency transactions or didn’t report them properly. The letters urge taxpayers to review their tax filings and, if appropriate, amend past returns to pay back taxes, interest and penalties.
By the end of August, more than 10,000 taxpayers will receive these letters. The names of the taxpayers were obtained through compliance efforts undertaken by the IRS. The IRS Commissioner warned, “The IRS is expanding our efforts involving virtual currency, including increased use of data analytics.”
Last year, the tax agency also began an audit initiative to address virtual currency noncompliance and has stated that it’s an ongoing focus area for criminal cases.
Implications of going virtual
Make sure you talk with your accountant about the tax implications of using virtual currencies. As they become more readily used and accepted, it’s important to stay up to date on the constantly changing tax laws.
Here’s more on this subject from our blog archives:
Businesses and the Tax Consequences of Accepting Bitcoin
