In perhaps a historic action, the IRS announced that by the end of this month it will contact more than 10,000 taxpayers with reminders of the federal income tax consequences of transactions involving virtual currencies. Taxpayers who the IRS believes have engaged in virtual currency transactions that may have given rise to unreported or improperly reported income tax liabilities are urged to review past tax filings, file amended, or delinquent returns if necessary, and pay any required back taxes, interest, and penalties due to prior failures to fully or accurately report income from transactions involving virtual currency. The IRS also advised that virtual currency is an ongoing area of focus for the agency’s Criminal Investigation division.
Described by the IRS in a July 26 news release as an “educational letter” for individual taxpayers, Letters 6173, 6174, and 6174-A are warning thousands of targeted individuals that the IRS has obtained “information” that the recipients may own or may have owned virtual currency that was not properly reported to the IRS as taxable income in connection with a transaction involving a virtual currency. The IRS advises that such virtual currencies may include either cryptocurrencies (i.e., virtual currencies used in conjunction with digital cryptography on a blockchain platform, including Bitcoin and Ether), or non-crypto virtual currencies. In the release, the IRS noted that it obtained the names of recipients of these letters through “various ongoing . . . compliance efforts,” and also referenced the agency’s increased use of data analytics in its enforcement efforts relating to virtual currency transactions. The IRS also noted that the IRS anticipates issuing additional legal guidance soon.
The IRS issued its position on the tax treatment of virtual currency more than five years ago, in the form of “Frequently Asked Questions” in Notice 2014-21 (“Notice”), where it stated that “convertible” virtual currency, while not recognized as legal tender, is considered property for federal tax purposes. Virtual currency is considered “convertible” when it has an equivalent value in real currency (i.e., can be readily purchased with or exchanged for U.S. dollars), or when the virtual currency acts as a substitute for real currency. The IRS concluded in 2014 that under existing general tax principles, transactions involving convertible virtual currency are generally taxable transactions of property resulting in income that must be reported to the IRS and is potentially subject to tax. Examples of taxable virtual currency transactions may include: (i) an employee’s receipt of wages or salary in Bitcoin (or any other convertible virtual currency) rather than U.S. dollars; (ii) a contractor’s receipt of virtual currency in exchange for goods or services; or (iii) the sale of a cryptocurrency held for investment.
The FAQs in the Notice also addressed certain fundamental tax rules relating to property transactions as specifically applied to convertible virtual currency. For example:
- Inclusion of Value of Virtual Currency in Gross Income. In the Notice, the IRS stated that a taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency (measured in U.S. dollars), on the date that the virtual currency was received.
- Fair Market Value of Virtual Currency. Following general federal tax principles and as provided in the Notice, the fair market value of virtual currency is the value in U.S. dollars on the date of payment or receipt. This is where the ready convertibility of virtual currency into U.S. dollars on an exchange (e.g., Bitcoin) comes in handy for both taxpayers and the IRS to value virtual currency on any given date.
- Gain or Loss Recognition. In the Notice, the IRS stated that, as with exchanges of other property, a taxpayer has a taxable gain upon an exchange of virtual currency if the fair market value of property received in exchange for the virtual currency (including money) exceeds the taxpayer’s adjusted basis of the virtual currency. Conversely, a taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency exchanged.
- Computing a Taxpayer’s Basis of Virtual Currency. According to the IRS, a taxpayer’s basis in virtual currency that is received as payment for goods or services is the fair market value of the virtual currency in U.S. dollars on the date of receipt.
- Potential Capital Gain Treatment on Sale or Exchange. According to the IRS, if virtual currency qualifies as a capital asset while in the hands of a taxpayer (capital assets commonly being stocks, bonds, and other investment property), the subsequent sale or exchange of the virtual currency will be a capital gain and may qualify for the current preferential tax treatment of long term capital gains. If not qualified as a capital asset, the gain will represent ordinary income to the taxpayer transferring the virtual currency.