Tax Issues Relating to Bitcoins

Wipula Kurudugahamada

Research in Taxation
Professor Richard L. Russell
April 9, 2015

Tax issues relating to Bitcoins
1. Introduction
What are the flat currencies? The currencies created by a government. Then there is a central regulatory agency responsible for the issue. The accepted characteristics of present day use money are included a store of value, a unit of account, and a medium of exchange. However, the supplies of currencies are governed and authorized by the central bank on behalf of the government. However, after the mortgage crisis in 2008 the money supply increased sharply therefore the confidence in the government issued currency declined among the people.
At this point, the paper by Satoshi Nakamoto was published online describing the “Bitcoin” for the first time. In the opinion of Nakamoto, the major problem with conventional currency today and discussed the easiness of bitcoins.1
In a nutshell, Bitcoin is an electronic cash system started in 2009. Therefore, it is new to the market. Still most of the countries have been studying the system and how it operates. But it is not fully accepted in a lot of countries as a legal tender. There are more than hundred thousand vendors in the market today who accepts bitcoins as a currency. There are more than sixty thousand in the USA.2 However, until March, 2014 IRS notice 2014-21 came into operation; the bitcoin was treated as currency in the USA for tax purposes. But thereafter, bitcoin is considered as a property, and gain and losses generate from bitcoins are considered as a capital gain or loss.3 However, existing tax laws provide a measure of guidance as to reporting and tax treatment for bitcoin transactions but still there are doubts among the users of bitcoin for proper treatment for tax purposes. Thus, the basic objective of this paper is to study a few selected tax issues relating to Bitcoins.
2. What is Bitcoins?
Bitcoin is cryptocurrency electricity converted into lines of code with monetary value.1 in the simplest of forms, cryptocurrency is digital currency. A form of payment that uses cryptography to control its creation and management, rather than relying on central authorities. According to Nakamoto, Bitcoin is a software-based online payment system and introduced as open-source software in 2009. Bitcoin is considered as a peer-to-peer digital system of payment.2 therefore, no physically seen proof records as seen in the manual system. When the bitcoin founder Nakamoto created the mathematical algorithm, he fixed the total number of bitcoins that would ever exist to 21 million units. However, currently; over 14 million are in circulation. According to bitcoin market information, since 2009 the bitcoin mined has increased rapidly. As per the Nakamoto the final bitcoin will be mined in the year 2140, 1 at the current rate.
3. Why people use virtual currencies
The application of financial rules and regulations on bitcoins are least compared to money and banking system. Using the virtual currency can lower the transaction fee in order to credit card and other money transfers. Credit card fees run anywhere from 2-5% plus $.30 per swipe. Bitcoin transaction fees using the Coin of Sale POS are only 0.59% 7. Transactions are easily done Using bitcoins compared to check or credit card. Since the bitcoin uses the public key, therefore, personal information is not transferred from one person to another. This prevents the risk of identity theft. In brief, we examined how well the overall Bitcoin network has enabled bitcoin to fulfill the functions of a fiat money.
4. The related tax issues in bitcoins
In March 2014 IRS issued a special notice 2014-21 which describes how existing tax principles apply to transactions using Virtual Currency.3 Before this notice issued the taxpayers were free to declare their bitcoin income for tax purposes. But thereafter, taxpayers should review notice 2014-21 and use it in inform their decisions when reporting bitcoin transactions and income. And also be aware that the notice is neither to the sole nor final authority regarding the taxation of bitcoin.
Even there is an IRS notice in operation for bitcoins but tax issues relating to bitcoin are remaining. Prior to the notice 2014-21, the main question was the bitcoin income considered either currency or property but after the notice mainly bitcoin income treats as capital gain (property).
The selected tax issues of bitcoins are discussed here. Bitcoin transactions are taken place in between one computer to another. But IRS tax purposes bitcoin customers must be honest in disclosing their income and expenses. However, the biggest problem is how the IRS rely on the disclosed transactions are purely correct.
One another problem IRS notice 2014-21 does not include very clear information about Foreign Bank Account Reporting Obligations (FBAR). If US person's bitcoin is maintained on a computer in abroad and if the bitcoin exceeds $ 10,000 any given year, should the bitcoin owner report the existence of account to Financial Crime Enforcement Network (FinCEN)? The current FBAR regulations do not include bitcoins or virtual currency.5
However, under the Bank Secrecy Act says US person's foreign financial accounts reach FinCEN. Even the US person holds the significant amount in stores of bitcoin abroad then does it need to files under FBAR or not then how the IRS tax treatment on the income generates from these foreign bitcoin reserves.
The use of bitcoins for tax evasion is potentially very significant. Bitcoins like cash transfers cannot be tracked by third parties and the IRS cannot track them. In bitcoin customers, they use the public key but personal identity is not attached. Therefore, bitcoin users purposely mislead the correct amount of income. Further to that if anyone transfer money through bank the service fee and remit tax is easily traceable but when using the peer to peer network transfers the IRS will lose lot of money receivable to the government as a tax. These factors will result in illegal activities such as money laundering, avoiding financial requirements, terrorist financing and finally evading taxes due to the IRS.
Another important tax issue relating to bitcoins is the treatment of bitcoin as property in order to IRS notice 2014-21.3 The IRS notice recognizes the bitcoin as property rather than currency, but the main question here is whether the IRS will treat the bitcoin as capital or noncapital assets. This disposition is important to understand because dispositions of a capital asset lead by a taxpayer for a year or more are subject to lower rates of taxation than dispositions of noncapital assets. This is less favorable for taxpayers. However, capital assets are defined in the IRC Sec. 1221 as "Property held by the taxpayer"(whether or not connected with trade or business).4 Thus, the default classification for property is a capital asset. The IRS does not recognize following assets as capital assets: inventory, real or depreciable property held for held for use in trade or business, intellectual property created by the taxpayer's personal efforts, accounts receivable, government documents, and certain dealer held derivative financial instruments, heading transactions and non-inventory supplies regularly used or consumed by the taxpayer in his trade or business. Therefore, the definition of a capital asset makes clear that the determination of whether an asset is capital depends on how it is held by a particular taxpayer.
Further to the above tax treatment the bitcoin activities giving rise to consider ordinary income rather than capital gain. For example, engaged in mining of bitcoin, income generates by bitcoin mining activities can be considered as ordinary income under the IRS notice 2014-21 at Q-8.3 However, later these bitcoins earned used to buy goods or services will be recognized as ordinary income rather than capital gain. The argument among bitcoin experts is important to discuss. In this case, the bitcoin is extracted from within a large source similar to mining ore or extracting oil from the earth. Therefore, bitcoin income from mining is normal ordinary income rather than capital gain income.
Bitcoin holders have another problem in using exchange rate where there is more than one is available? Is averaging allowed? Bitcoin is also has established exchange rate. Therefore, fair market value of bitcoin is easy to calculate. But when spending to acquire bitcoins the basis for tracking the exchange rate is unclear in order to IRS notice 2014-21. For example assume taxpayer ‘A” buys 10 bitcoins on January 01st. when bitcoin is worth $100 each, 20 bitcoins on January 10th when bitcoin is worth $120 each, and 30 bitcoins on January 20th when exchange rate dropped $110 each. Then the "A" spent 10 bitcoins on January 25th. Then what is his basis for the spent 10 bitcoins? The daily exchange rate permits taxpayer “A” to keep track of dates he purchased or acquire bitcoins. But bitcoin holder can use more than one virtual wallet to keep and segregate bitcoins purchases. This act avoids mixing of bitcoin with different bases. However, the related problem is if the taxpayer “A” has a different virtual wallet for each bitcoin transaction. This allows bitcoin holder to segregate bitcoins and could purposely pick and choose the highest basis to reduce his gain or creating a loss to gain tax benefit.
Another complex tax issue in bitcoin is no proper tracking and tracing method when a person engages in bitcoin mining. If a person engaged in bitcoin mining using his computer connecting to server or network of computers physically located in outside the United States. An issue related to this case is whether this income from mining process is properly calculated where the miner resides or where the computer is physically located. There is no proper tracking solution for this problem in the current IRS guidance.
Another problematic tax issue is in employer – employee compensation system in bitcoin. Bitcoin payments to employees are treated as wages and subject to employment withholding tax (IRS Notice 2014-21 at Q 11).3 Since the IRS does not accept bitcoin in a line of cash to meet employment tax withholdings. Therefore, the employer needs to liquidate bitcoins in order to generate dollars to pay required withholding tax. In this transaction, capital gain/loss realized to the employer due to exchange different of bitcoin to dollars. The transaction tracking exchange rate basis is a problem faced by IRS when calculating the employment tax. The other problem when employee converts bitcoin into dollars. The gain or loss on realization at the time of the exchange the bitcoin is taxable under the IRS regulations. However, these problems are real tax issues in the bitcoin system to fix by the IRS.
Another bitcoin tax issue is that bitcoin transactions are not necessarily required to report like credit card transactions. In order to the IRS Sec.6050 W, Payment settlements entity must report the amount paid to those who receive more than 200 payments (more than $20000 in total).6 The credit card entity has a contractual obligation to report these transactions. But bitcoin transactions use a peer to peer network and there is no such operating establishment. Therefore, in the bitcoin transactions there is no such regulating requirement enforced by the IRS. Therefore, IRS loses a lot of money on these kinds of transactions.
5. Conclusion
In this article discussed a few number of tax issues relating to bitcoins though there are many questions raised in the marketplace. Since the decentralized peer- to –peer currency does not control by any institution, the use of bitcoin is increasing rapidly day by day. Therefore, it is important to IRS and other legal entities need to prepare to face virtual currency system challenges how to regulate and taxed. The modern cyber technology provides great opportunities to deal with bitcoins and that enables to find loopholes to mislead and evade tax easily since there is no proper regulatory system.
Though the IRS notice 2014-21 in operation on bitcoins but my idea is that there is no acceptable and transparent guideline to bitcoin customers to record and report their income. The IRS primary purpose is to regulate the tax system while maximizing the tax revenue. But all rules applicable to bitcoin should not be too burdensome for taxpayers.

Notes
1. Satoshi Nakamoto, Bitcoin: “A Peer-to-Peer Electronic Cash System”, Bitcoin.org, available at: http://Bitcoin.org/Bitcoin.pdf
2. Pete Rizzo, “IRS to Tax Digital Currencies as Property, not Currency”, accessed March 29, 2015,http://www.coindesk.com/internal-revenue-service-treat-digital-currencies-property/
3. Internal Revenue Bulletin: 2014-16 April 14, Notice 2014–21 IRS Virtual Currency Guidance accessed April 01, 2015, http://www.irs.gov/irb/2014-16_IRB/ar12.html
4. Sasha Klein, Andrew Comiter: Are You Ready for This Change for a Dollar? Probate & Property Magazine: Volume 29 No. 02 5. FinCen (2013), “Application of FinCEN's Regulations to Persons Administering, Exchanging, or Using Virtual Currencies”.
6. “General FAQs on Payment Card and Third Party Network Transactions”. Accessed on April 01, 2015, http://www.irs.gov/uac/General-FAQs-on-New-Payment-Card-Reporting-Requirements. 7. “Six reasons to start accepting Bitcoin in your store”, accessed on April 02, 2015. https://coinofsale.com/whyAcceptBitcoin.