By Robert Linch


Recently the IRS addressed taxpayers who trade or accept payment in Bitcoin and other virtual currencies that they not currency for tax purposes, but property and subject to taxation as such. While this may not seem like a large distinction to some people, this could have a large effect on individual taxpayers, the popularity of Bitcoin among vendors, and ultimately the future of virtual currencies.
For those who are not familiar with Bitcoin, it is a digital unit of exchange that is not controlled by a central bank and operates functionally as digital cash for those who are willing to take them as payment. It is a fiat currency (that is, not backed by a commodity) and Bitcoins are created by “mining”. Without getting too complicated, mining basically consists of maintaining block chains (or transaction histories) and processing transactions among merchants and purchasers using Bitcoin in exchange for fees. Bitcoin is a controversial exchange medium, as it was the currency of choice for illicit transactions on The Silk Road before it was shut down last year by the FBI. Security issues are also a concern for holders of Bitcoins. In fact earlier this year, Mt. Gox, one of the largest Bitcoin exchanges was robbed of almost 750,000 Bitcoins. The risk is not limited to just digital thieves. Bitcoin is an extremely volatile commodity due to speculation, with the 52-week High-Low spread fluctuating between $1150 per Bitcoin down to $350.
The IRS, in issuing this guidance on transactions using digital currencies and taxability, emphasized that virtual currencies do not have legal tender status in any jurisdiction, are a substitute for currency and convertible into currency, but not currency. This lack of legal tender status is what makes Bitcoin property as opposed to an actual currency. So what are the tax implications of this decision? Well, it comes down to the way that property is treated for tax purposes.
Generally, those that sell property are subject to the capital gains tax. The period in which the property is held determines whether it is taxed as a long-term capital gain (taxed at 15% for most) or a short-term capital gain (taxed at the rate the taxpayer’s ordinary income). The holding period for assets to qualify as long-term capital gains is one year.  This is generally going to mean that any gains realized on the increased exchange rate for Bitcoins is going to be taxable at the highest rate for that individual taxpayer. This is not the same rule for day traders of foreign currencies (Forex) markets, who are subject to 60/40 percent rule, meaning that a trader’s gains are calculated as being 60% long-term capital gain and 40% short-term capital gain. The tax rate for the Bitcoin trader is more akin to a stock day-trader rather than a Forex, except that Bitcoin has a greater volatility than most stocks traded on national exchanges. This high volatility also incentivizes Bitcoin holders to exchange their Bitcoins more frequently to lock in the value of their exchange with a currency that is more stable and predictable long-term. This also means that a large portion of those participating in Bitcoin commerce are functionally forced to pay the (higher) short-term capital gains rate or risk the locked-in value being eaten up after another (rather frequent) Bitcoin market collapse.
The IRS also advised that wages paid in Bitcoins to employees must be reported on W-2s and are subject to income tax withholding. The same goes for payment to independent contractors paid in Bitcoin, who are on the hook for the self-employment tax. While this is not a shocking position for the IRS to take, there are implications for business owners who pay for services or receive Bitcoin for services. A huge problem is keeping track of the holding periods for each individual Bitcoin, calculating the gain or loss from each Bitcoin or fraction of a Bitcoin, and reporting individual Bitcoin gains and their applicable value at the time they were used by the vendor. None of these are required of businesses that use traditional currency. While it is theoretically possible to keep all of these records, it is difficult to justify the additional cost and work of accepting and using such a volatile exchange medium like Bitcoin.
While it is clear that we are living in an increasingly digital world, it would seem that for the time being digital currencies are getting a chilly reception at the IRS. For the time being, it makes sense. Bitcoin is in its infancy and is extremely volatile due to its vulnerability to speculators. As (and if) Bitcoin sees more widespread use and greater price stabilization, it is interesting to think about how or whether the IRS will change its position on digital currencies as property that are subject to a greater tax rate (generally). Regardless, it seems that Bitcoin is not going to be sweeping international commerce as the new worldwide exchange medium of choice, or even be considered a “real currency”. Apparently, to the IRS, Bitcoin is just real enough to tax — and no more.
Internal Revenue Bulletin: 2014-16, Notice 2014-21