It seems like every day brings new questions about the digital currency
called bitcoin, which first appeared in 2009. Who is the shadowy
"Satoshi Nakamoto" who created the currency's protocol and software? Who
stole $450 million worth of bitcoin from the Tokyo-based Mt. Gox
exchange? Who was the mystery buyer who used bitcoin to snag a $500,000
house on the Indonesian island of Bali?
Last week, the IRS solved a mystery by ruling on how bitcoin
would be taxed, at least here in the United States. And their answer to
that question may shoot a hole in bitcoin's hope to become more widely
accepted. Notice 2014-21 holds that virtual currencies like bitcoin will be treated as property — not
currency — for U.S. tax purposes. That means, among other things, that
if you take payment in bitcoin at your business, those payments will be
taxable (at the fair market value of the currency at the time you earn
it), subject to the same rules as if you had accepted cash. If you earn
wages in bitcoin, they'll also be taxable, must be reported on a Form
W-2, and will be subject to income and payroll tax withholding as if you
had earned those wages in cash.
But those rules come as no surprise. The real headache comes when you
use bitcoin to buy or sell something. Let's say you acquire two bitcoins
for $500 each. A week later, they're worth $520, and you use them to
pay an independent contractor across the country or even in the
Phillipines. You'll have to report that $40 gain on your taxes. "That's
not such a big deal," you might think. "My bitcoin is worth more; I'm ok
with paying tax on my gain." But now imagine having to report gains or
losses on every bitcoin transaction you make!
If bitcoin is going to succeed as an actual currency, it has to pass
three strict tests. (Getting an "A" for effort won't work here.) First,
it has to be a medium of exchange,
meaning it has to be widely accepted as payment for goods and services.
(Everyone takes U.S. dollars, but most people have never used bitcoin —
at least, not yet. Although, Virgin Atlantic has announced that
you can use bitcoin for their $250,000 flights into space.) Second, it
has to be a store of value, meaning users feel safe holding it
without worrying that its value will fall. (You can take payment in cash
knowing that it will be worth the same amount tomorrow.) And third, it
has to serve as a unit of account, meaning it has a standard
value and every bitcoin is the same as every other bitcoin. (If you have
a wallet full of $20 bills, it doesn't matter which one you use to pay
for your morning latte.)
The IRS's ruling that bitcoin is property means bitcoin fails that last
test. Let's say you have three bitcoins: one that you acquired when it
was trading at $280, one that you acquired at $480, and one that you
acquired at $880. It makes a real difference which one you spend! It's
no wonder the New York Times headlined one story on the IRS notice: "Taxes Won't Kill Bitcoin, But Tax Reporting Might."
There's a "bit" of good news in the ruling. If you hold bitcoins for
investment, you benefit from lower rates on long-term capital gains. But
that's going to be scant comfort for most users who really want to see
bitcoin succeed as a true currency.
We've got a long time to go before most clients have to worry about
bitcoin in anything but the most theoretical sense. But keeping an eye
out on the future is what separates us from the vast majority of tax
professionals who just settle for recording history. Your job is to go
out and make money, in dollars, bitcoin, or whatever else works best for you. Let us worry about helping you keep it!