IRS RELEASES BITCOIN GUIDANCE; MAY HAVE A CHILLING EFFECT ON VIRTUAL CURRENCY

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.

IRS Reverses Decision; Readmits Bank Leumi Customers Into OVDP

When making a voluntary disclosure pursuant to the IRS Offshore Voluntary Disclosure Program (OVDP), the first step involves sending a letter requesting pre-clearance to make a voluntary disclosure.  The letter includes a taxpayer’s identifying information, including the taxpayer’s name and social security number.  The IRS then runs the taxpayer’s information through an IRS database to ensure that the IRS has not already received offshore account information with respect to the taxpayer or that the taxpayer is not already under audit or investigation.  If the taxpayer’s information is not in the IRS database, the taxpayer is ordinarily preliminarily accepted into the OVDP.  The taxpayer then must complete a questionnaire, and absent extenuating circumstances (e.g., non-compliance with the terms of the program, such as the funds in the offshore accounts being derived from criminal activity), the taxpayer’s matter is transferred from the IRS Criminal Investigation Division to the IRS Civil Division for processing.

Several dozen taxpayers who were prior customers of Bank Leumi in Israel completed this process and, in many cases, were both pre-cleared to make a voluntary disclosure and transferred from the IRS Criminal Investigation Division to the IRS Civil Division.  These taxpayers were apparently fully compliant with the terms of the OVDP.

Last March, however, the IRS abruptly kicked out these taxpayers from the OVDP.  Practitioners believe that the IRS had received information from Bank Leumi with respect to the taxpayers but had yet to update its database.  As a result, the IRS preliminarily accepted the taxpayers into the OVDP, despite the fact that the IRS was already in receipt of their offshore account information.

The IRS actions caused an uproar among (1) practitioners, who were advising their clients that they had cleared a huge hurdle in being preliminarily accepted into the OVDP, and (2) taxpayers, who were faced with the possibility of the severe civil (and perhaps criminal) penalties that the taxpayers originally sought to avoid by entering into the OVDP. 

Perhaps as a response to this uproar, the IRS last week reversed its decision, and readmitted the taxpayers into the OVDP.  The OVDP has been a huge success for the IRS, with the IRS collecting approximately $5.5 billion through the program.  However, abruptly kicking taxpayers out of the program likely jeopardized the continued success of the OVDP because taxpayers were more hesitant to enter the program knowing that the IRS may remove taxpayers from the program at any time.  The IRS actions last week should provide taxpayers with some measure of comfort that they will be treated fairly within the OVDP.