IRS Warns Taxpayers with Cryptocurrency Gains of Reporting Obligations
Updated: Aug 1, 2019
In effort to increase to enforce the laws related to virtual currency or cryptocurrency (like Bitcoin), the Internal Revenue Service is sending letters to taxpayers with virtual currency transactions who failed or potentially failed to report income and pay tax from virtual currency transactions. Letters will also be sent to taxpayers who did not report their virtual currency transactions properly. Taxpayers who receive letters should review their virtual currency transactions and amend their tax returns as required, which may include additional taxes, penalties and interest.
The IRS noted in its press release that it is increasing enforcement efforts in this area due to the popularity of cryptocurrency like Bitcoin or Euthereum, and the rapid expansion of the currency as a trading medium, in addition to using the currency to buy and sell goods. The IRS expects to send approximately 10,000 letters by the end of August. For taxpayers receiving a letter, there are three variations: Letter 6173, Letter 6174 or Letter 6174-A. The goal, according to the IRS, is, to help taxpayers understand their tax and filing obligations and how to correct past errors. Of course, the IRS also expects taxes, penalties and interest to be paid as well. Going forward, the IRS will continue to enforce this area of the law with audits and criminal investigations on the table to keep taxpayers in compliance.
For taxpayers who did not receive a letter, but have a general interest in virtual currency, IRS Notice 2014-21 is the latest and current guidance from the IRS regarding how convertible virtual currency transactions are taxed for federal income tax purposes. Convertible cryptocurrencies, like Bitcoin, may be converted into real currencies like US dollars, Euro, Yen, etc. Notice 2014-21 covers convertible cryptocurrencies, but not other cryptocurrencies. Taxpayers should apply general income tax principles to those transactions.
This tax notice made various assumptions that may not be applicable for all taxpayers. These assumptions relate to the ability of the currency to be valued in US dollars on the date of a relevant transaction. This is important because taxpayers report income in US dollars and income is measured in US dollars. Typically only US taxpayers with foreign businesses are aware of this US dollar requirement due to their requirement to convert various sources of foreign income to US dollars using various US income tax reporting methods. Keeping it simple, virtual currency transactions must be converted to US dollars on the day of the relevant transaction.
Taxpayers who are using virtual currency to pay for goods or services, the virtual currency is measured on the date of the transaction to report the amount paid as a deductible expense or the amount received as revenue. virtual currency is treated as property and generally measured or valued at fair market value using an appropriate standard on the date of the transaction. One area where taxpayers may not realize a reportable amount arises is when a taxpayer uses a virtual currency to pay for a transaction, but the taxpayer purchased that virtual currency for an amount that was different than the value on the date of use. For example, if a taxpayer purchases virtual currency in exchange for $100 dollars, but then uses that same amount of virtual currency to buy an asset for $150, there is a taxable gain of $50. The virtual currency appreciated $50 from $100 to $150, and the gain was recognized when the currency was used to purchase a different asset. Here, there would be a reportable gain of $50 on a US income tax return.
This gain of $50 raises another common US income tax question - what is the character of the gain. For some taxpayers, the gain may be a capital gain and subject to lower capital gains tax rates. Other taxpayers may recognize ordinary income if the virtual currency is used in the ordinary course of a trade or business or received as salary or payment for services performed. Other common areas of tax law apply to virtual currency transactions under Notice 2014-21 as well. For example, if an employee of a business receives virtual currency as payment for services, the virtual currency would be reportable to the employee on the employee's W-2 and taxed as ordinary income. FICA taxes would apply and the employer would be required to pay unemployment taxes as necessary. For independent contractors who receive virtual currency, the payor should also issue the independent contractor a Form 1099 for the payment.
The common theme here is the IRS has recognized the popularity of virtual or virtual currency, and has responded by treating virtual currency similar to US dollars or foreign currencies for purposes of using the currency to make payments and recognizing both the amount of income and the character of income as either capital or ordinary. Gain or loss must be reported as required under the US tax laws, and the IRS is making a strong effort to enforce these laws and let taxpayers know that while the identity of the currency holder may go under the radar, the transaction itself won't go unnoticed, or unreported.