It’s virtual, but not tax free

Virtual currency is something that can be difficult to wrap your brain around, but if you are using it, make sure that you understand how the IRS views virtual currency.

Jeffrey S. Freeman, J.D., LL.M

SONY DSCEnough people are using virtual currency, such as bitcoin, that the IRS has taken note and want to make sure that individuals understand how to treat it for taxation purposes. Bitcoin is the largest digital currency and was recently addressed specifically in Notice 2014-21 from the IRS. Bitcoin is a decentralized currency, meaning it is not backed by a government or central bank. Its origins are rather difficult to verify, but since appearing in 2008 it has made serious waves in the financial community. Is this the future of banking? Is it a gamble and way to get rich quick? The IRS doesn’t know the answers to those questions, but they do want you to know that it is taxable just as property for U.S. Federal tax purposes.

What is virtual currency?

The IRS considers a convertible currency that is used to pay for real-world goods and services to be a virtual currency. Bitcoin users have a digital wallet to receive payments and store Bitcoins to pay for goods and services.

How is virtual currency taxed?

For federal tax purposes, virtual currency is treated as property. When property transactions occur the same general tax principles are applicable to virtual currency as “paper and coin” currency.

How is fair market value of virtual currency determined?

Looking at the value of a Bitcoin since 2008 it has fluctuated from a few cents to $260 per Bitcoin. Even within a single year there were swings from $30 to $2, similar to that of the stock market. To determine the fair market value of virtual currency all transactions must be reported to the IRS in U.S. dollars based on the exchange rate of the virtual currency as of the date of payment or receipt.

Are you subject to self-employment tax if you are paid in virtual currency?

Income derived from any trade or business contributes to gross income, which would then be subject to self-employment tax. As described above, the equivalent U.S. dollars at the date of receipt should be recorded for all virtual currency received.

Will there be penalties for previously not treating virtual currency as property outline in the March 25, 2014 IRS notice?

Taxpayers are subject to penalties when they do not comply with tax laws and virtual currency is not exempt from this rule. If there were underpayments due to virtual currency transactions or a failure to correctly report virtual currency transactions there may be penalties. But, penalty relief available for tax payers that establish that the underpayment or failure to properly file their return is due to reasonable cause.

If you are concerned about your previous or current tax responsibilities in relation to virtual currency contact a tax professional today to get yourself in compliance with the IRS.

About Freeman Tax Law

Freeman Tax Law is a boutique tax law firm with national exposure equipped to handle all domestic and international tax law matters. At Freeman Tax Law, the attorneys and professional staff have vast experience with foreign tax compliance, international tax planning, and resolving tax controversies involving offshore banking matters. Freeman Tax Law helps taxpayers and foreign entities become in compliance with laws such as Foreign Account Tax Compliance Act (FATCA) and Offshore Voluntary Disclosure Program (OVDP). In addition to handling complex tax controversies, the Freeman Tax Law team has extensive expertise in assisting clients with wealth management and estate planning.

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