Last week, the IRS released IRS Notice 2014-21 (the “Notice”), its first guidance on the income tax treatment of virtual currency, including, bitcoin. A copy of the notice can be obtained at http://www.irs.gov/pub/irs-drop/n-14-21.pdf.
There are three important points to note from the Notice:
1. A Potential Accounting Nightmare For Bitcoin Spenders. According to the Notice, bitcoin is treated as property, not currency, for income tax reporting purposes. This position has far-reaching implications for any taxpayer that invests in, and regularly spends, bitcoin. As property, gains recognized on the disposition of bitcoin investments is subject to tax, similar to the income tax treatment of sales of stock. However, unlike stock, bitcoin is disposed of in everyday, mundane transactions. For example, several coffee shops in the U.S. accept bitcoin as payment. Every time a U.S. taxpayer pays with bitcoin he/she has a taxable transaction that must be reported at the end of the year on the individual’s income tax return. The amount of gain or loss recognized on such a transaction will require taxpayers to keep very detailed records of all bitcoin that is purchased and subsequently disposed of. The Notice does not indicate that there is a de minimis exception to the rule.
2. If Bitcoin is in a Foreign Account, an Even Bigger Nightmare. Whether a bitcoin account is subject to the FBAR reporting rules is an issue that practitioners are struggling with. We do not attempt to tackle this issue in this post (but plan on addressing this at a later time). However, assuming, solely for these purposes, that a bitcoin account is subject to the FBAR reporting rules, paying for a cup of coffee using bitcoin can cause the account to become a non-compliant asset for purposes of the Offshore Voluntary Disclosure Program (“Program”). The Program, pursuant to FAQ 17, permits taxpayers who are tax compliant, but merely failed to file a FBAR, to avoid the strict penalty structure of the Program and simply file back-FBARs without penalty. If bitcoin was used to pay for goods or services, and the transaction was not reported on a taxpayer’s income tax return, then the bitcoin account is not tax compliant, and the taxpayer would not be able to rely on FAQ 17. If the taxpayer decides to clear up past noncompliance through the Program, the taxpayer’s bitcoin account may be subject to the 27.5% penalty.
3. Bitcoin Investors Rejoice. The Notice is not bad news for all taxpayers who invest in bitcoin. By treating bitcoin as property, gains on the sale of bitcoin that are held for longer than one year are eligible for the lower capital-gains rate. Note this rule does not apply to taxpayers who hold bitcoin as inventory or who buy and sell bitcoin as part of a trade or business.