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The Internal Revenue Service (“IRS”) last year issued a notice addressing the tax treatment of Bitcoin. It chose to treat bitcoin as “property” rather than “currency” for tax purposes. In this backgrounder we will look at the classification options the IRS considered, what it chose to do in its notice of March 2014, and why.
The IRS had several options to consider in providing a framework for the taxation of bitcoin and bitcoin transactions. It is clear that bitcoin is an intangible property. The specific type of property, however, is elusive. Possible tax categories for bitcoin include taxing it as personal property, a commodity, a currency, a security or a debt instrument. Bitcoin has qualities resembling all of these property forms, yet it does not neatly fit any of them. Irrespective of the difficulty of finding a good match, bitcoin’s classification has had and will continue to have significant tax consequences.
For example, had the IRS treated bitcoin as a currency, special tax rules would have applied to its use and ownership. Unlike most assets, the gain or loss from a sale of bitcoin, or its use in an exchange, would generally be taxed as ordinary income, and be ineligible for capital gain treatment. This would mirror our normal interaction with dollars or other fiat currencies; if you get paid in dollars it doesn’t matter that the price of dollars against rubles or euros changes before you spend it. The value of the dollar may be rising internationally, but you are not taxed on that return like a normal investment.
Treatment as currency would have also qualified personal bitcoin use for an exclusion from the recognition of gain or loss in ‘small’ transactions. To illustrate, say you bought one bitcoin when the price was at $100 and then used a fraction of that bitcoin to buy a cup of coffee months later when the price was at $200. Treatment as currency would excuse you from calculating the profit you made by buying the bitcoin low and selling some of it at a high (for your coffee). This exclusion could make the currency option attractive to many bitcoin users because reducing the transaction cost inherent in calculating every gain or loss may facilitate the use of bitcoin as a viable medium of exchange for commerce.
Other property-type categories each present idiosyncratic tax treatments that emerged over the years as the use of the targeted asset type (e.g. stocks, commodities, or debt instruments) matured. For example, the concept of a stock as a share of ownership in a company is relatively easy to grasp and early tax rules were also easy to grasp and apply. But as the securities market matured, and stocks became complex, complex tax rules grew to meet the challenge. Today, differing tax treatment is applied to equity options, calls and puts, derivatives, LEAPS, index futures and other forms of stock and stock-based transactions. Again, fitting bitcoin into this multi-faceted structure, similar to its treatment as a currency, is difficult.
The IRS has been curiously silent on the taxation of virtual currencies for decades. This is so, despite the IRS Taxpayer Advocate, and more recently, the Government Accountability Office, calling upon the IRS to issue administrative guidance to taxpayers who desire a degree of certainty for tax reporting of their virtual currency transactions. Virtual currencies are not a new phenomenon. However, the emergence of bitcoin presented potential broad economic impact, and the IRS responded by the issuance of IRS Notice 2014-21 in March of 2014.
What the Notice Specified
The Notice provides three basic principles. First, it globally classifies bitcoin as property for U.S. federal tax purposes. Second, it states bitcoin is not ‘currency’ that generates foreign currency gain or loss for U.S. federal tax purposes. Finally, it declares that ‘mining’ income is to be recognized for tax purposes when the miner receives the bitcoin at its then fair market value.
In effect, the IRS left many options on the table by releasing guidance to the taxpayer that provided a broad and generic classification of bitcoin (“property”) and excluded but a single subcategory, currency. Moreover, only a single unique activity in the virtual currency arena, that of bitcoin mining, is specifically addressed.
Notice 2014-21 does offer some concrete specifics, however. It expressly applies to only “virtual currencies” which have an “equivalent value in real currency, or acts as a substitute for real currency.” Sixteen questions are posed and answered by the IRS, most of which flow from the answer to the first question posed which states, in part, that “[f]or federal tax purposes, [convertible] virtual currency is treated as property,” reportable in its equivalent value in U.S. dollars.
As mentioned, the Notice does not classify what kind of “property” bitcoin is, other than specifically stating that it is not “currency.” It requires that bitcoin used in an exchange for goods and services be valued at fair market value when received. This value thereafter constitutes the basis of the bitcoin received. Taxable gains and losses from that basis are recognized in the exchange and the type of gain or loss, capital or ordinary, depends upon whether the bitcoin was held for investment, as inventory, used in a trade or business or held for personal reasons.
Bitcoin received for services by employees are wages for both U.S. income and employment tax purposes, reportable as such by both employer and employee at fair market value. Likewise, bitcoin received by independent contractors constitutes self-employment income to be reported and taxed as such.
Traditional U.S. tax reporting requirements apply to bitcoin payments as are applicable to any other transaction involving property. As well, “backup withholding” and reporting by third party settlement organizations are mandatory as if the bitcoin were U.S. currency.
In addition to treating bitcoin as property, two other principals were addressed in Notice 2014-21. Both areas were unique to virtual currencies. The first states that virtual currencies are notcurrency as might give rise to foreign currency gain or loss.  Among other things, this means that bitcoin is not eligible for the personal use exemptions to capital gains taxes on small transactions, as described earlier in the coffee example. The notice also specified that income from virtual currency mining for tax purposes is to be recognized when the miner receives the reward from the mining efforts and not upon a later sale of the currency.  In other words, you owe income taxes on the bitcoins you mine for the tax year in which you mined them, not for any future year when choose to sell or spend them.
The Challenges of Building a Tax Framework for Bitcoin
The U.S. federal tax framework for bitcoin and other virtual currencies remains confusing and largely undefined. As frustrating as this may be, it is not hard to understand why this is so. The IRS, like those holding bitcoins themselves, are participants in the emergence of one of the most novel and potentially far-reaching technologies of the 21st century.
Historically, a cautious approach to the taxation of new intangible assets by the IRS is typical. Software technologies are dynamic, and their development, categorization, use and transfer permit only “best guess” tax treatment until a level of technological maturity is reached. For example, the tax principles initially applied to mainframe software were challenged by the emergence of the personal computer. They were challenged once again as the internet emerged.
Difficulties also arise as U.S. income taxes are assessed annually. Yearly cut-off dates are difficult to apply to developing technologies. The IRS, and taxpayers, often cannot report technology-based assets and transactions with certainty. Indeed, what the asset is may itself be elusive.
Bitcoin is an excellent example. It has already morphed from the transactional medium of exchange envisioned by its inventor into a variety of uses: a system of stored value, an asset identification and management tool, a tokenized instrument of title, a key for the encryption, authentication or escrow of other assets, and more. Bitcoin as only a currency is no longer reality. And the technology is still in its infancy. No wonder the IRS is taking a cautious approach.
A cautious regulatory approach is prudent for reasons other than how dynamic the technology is. Hastily drafted rules may stifle innovation or, even worse, chase technological development from U.S. shores to thrive in unfriendly jurisdictions. The wait-and-see tax attitude is indeed confusing to taxpayers, but not without foundation.
Finally, as virtual currencies need not respect political boundaries, the harmonization of a regulatory environment with other jurisdictions is a necessary consideration. Tax and other policies must consider global impact and circumstance, and the efforts by multiple jurisdictions must be harmonized, a process that involves significant time and effort.
The tax treatment of bitcoin will likely follow a cautious approach for some time. This will be frustrating to taxpayers at best, but that caution is warranted.
Bob Derber is a corporate tax attorney at Summit Legal Group, previously he was general counsel at the gaming software pioneer Maxis.
 The taxation of currency transactions is, generally, governed by Subpart I, IRC §§ 982, et. seq. ‘Dealers’ in foreign currency may also find themselves subject to complex “marked to market provisions” which may permit capital gain and loss treatment. See, IRC § 1256.
 See, IRC § 988(e).
 U.S. Internal Revenue Service’s National Taxpayer Advocate 2008 Annual Report to Congress, p. 213, recommended the IRS issue tax guidance for the transfer of “virtual” items and currency. More recently, a call for guidance came from the Government Accountability Office (GAO), Report to the Committee on Finance, U.S. Senate, Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks, GAO-13-516 (May 2013), followed by the identification of a lack of tax guidance as a top 25 “Most Serious Problem” in 2013 by the IRS Taxpayer Advocate. MSP #24 DIGITAL CURRENCY: The IRS Should Issue Guidance to Assist Users of Digital Currency, http://www.taxpayeradvocate.irs.gov/userfiles/file/2013FullReport/DIGITAL-CURRENCY-The-IRS-Should-Issue-Guidance-to-Assist-Users-of-Digital-Currency.pdf.
 Virtual currencies called Lindon Dollars were the ‘currency’ for the popular virtual world, Second Life, for over a decade. Computer games such as World of Warcraft have also employed in-game currencies with a U.S. dollar equivalent value.
 Notices are mid-level IRS administrative interpretations considered authoritative as substantial authority under IRC § 6662(d)(2)(B)(i). Notably, no private letter ruling or chief counsel advice from the IRS Office of Chief Counsel has been issued with respect to bitcoin.
 The Notice defines virtual currency as “…a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Notice Section 3, SCOPE, further limits the application of the guidance given to convertible virtual currency, defined as virtual currency which has an “equivalent value in real currency, or acts as a substitute for real currency.”
 Many taxpayers and tax practitioners called upon the Service to treat bitcoin as ‘currency’ instead of property. What was not understood, however, was that ‘currency’ is ‘property’ under the U.S. federal tax law. It was only afforded special treatment for tax purposes as of the 1981 Economic Recovery Tax Act. It was this special treatment that many bitcoin advocates sought, not necessarily the classification of bitcoin as property.
 Notice, Section 4, Answer 5.
 Notice, Section 4, Answer 3. The Notice, Section 3, SCOPE, limits its application to cash basis taxpayers.
 Id., Answer 4. What constitutes ‘receipt’ and the reference point for determining value and the accounting method to apply to identify the bitcoin involved in the transaction (i.e. FIFO, LIFO or some other method) are left unstated. Deferred receipts are not addressed nor are transactions where the receipt is subject to a substantial risk of forfeiture.
 Id., Answer 6.
 Id., Answer 11.
 Id., Answer 10.
 Id., Answer 12. The Notice specifically references the need for 1099-MISC reporting for payments to independent contractors exceeding $600 in a year (Notice, Section 4, Answer 13).
 Id., Answer 14.
 Id., Answer 15.
 Id., Answer 2. The exclusion of virtual currency from being a ‘currency’ was not broadly stated. Rather, the Notice states that under “currently applicable law,” virtual currency would not be treated as a currency “that could generate foreign currency gain or loss.” This, of course, begs the question of when a virtual currency will be treated as a currency. Might the ‘marked to market’ rules still apply? Does the status of a virtual currency impact the treatment and characterization of hedging transactions, swaps or the treatment of derivatives?
 Id., Answers 8, 9.
 Consider the development of other technologies that have emerged in the ‘pay space.’ Gift cards, point- and air-mile rewards and other ‘stored value’ alternatives are finding integration into the Federal tax system.