Most of your clients deal in dollars and cents, but you may have a few who have entered the virtual realm. They should be advised that their transactions in virtual currency have real tax consequences.
What is Virtual Currency?
Virtual currency is a digital representation of value that can function as a medium of exchange. Where it is accepted, virtual currency operates like “real” currency and can be used to pay for goods and services or held for investment. However, it does not have legal tender status in any jurisdictions.
Some virtual currency, such as Bitcoin, is “convertible.” That is, it has an equivalent value in real money and can be purchased for or exchanged into U.S. dollars, Euros, or other real or virtual currencies. Other virtual currencies are “closed” and have no connection to the real economy, such as currencies used in online games.
IRS Ground Rules
The IRS has issued guidance on the tax treatment of transactions in virtual currency that is convertible into “real” money. For federal tax purposes, the IRS considers virtual currency to be property. Therefore, the general principles applicable to property transactions apply to transactions using virtual currency.
For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars. Therefore, it is necessary to determine the fair market value of the virtual currency in U.S. dollars. If the virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency that can be converted into U.S. dollars) at the exchange rate, in a reasonable manner than is consistently applied.
A taxpayer’s basis in virtual currency is generally the fair market value of the virtual currency in U.S. dollars as of the date of receipt.
Virtual currency can be acquired through a rather arcane process called “mining.” Miners receive new virtual currency by using computers to solve complex, encrypted mathematical equations. The IRS says that when a taxpayer successfully mines virtual currency, the fair market value of the virtual currency, as of the date of receipt, is includable in gross income. If a client’s mining activity rises to the level of a trade or business, the net income from the mining business will be treated as self-employment income and subject to self-employment tax.
Selling or Spending Virtual Currency
Selling virtual currency or spending it is treated as property exchange. Clients who exchange virtual currency for other property or money must figure gain or loss on the exchange. If the fair market value of the other property exceeds the taxpayer’s adjusted basis in the virtual currency, the taxpayer has a taxable gain. The taxpayer has a loss if the fair market value of the other property is less than the adjusted basis of the virtual currency.
The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the client. For example, virtual currency that is held for investment like stocks or bonds will be treated as capital asset and the client will have capital gain or loss.
Payments for Services
A client who receives virtual currency as payment for services performed as an independent contractor must report the fair market value of the virtual currency (measured in U.S. dollars) as self-employment income that is subject to self-employment tax. Similarly, payments to an independent contractor using virtual currency totaling $600 or more are subject to information reporting in the same manner as payment in U.S. dollars. Payments must be reported to the IRS and the payee on Form 1099-MISC, Miscellaneous Income, using the fair market value of the virtual currency on the date of payment.
In the case of payments to employees, the IRS says that the medium used to pay for services is generally immaterial to the determination of whether the compensation counts as wages for employment tax purposes. Consequently, the fair market value of virtual currency paid as wages is subject to federal income tax withholding and employment taxes. Virtual currency payments, like other wage payments, must be reported on an employee’s Form W-2, Wage and Tax Statement. But, here again, the value of the virtual currency must be calculated in U.S. dollars for tax purposes.