Tax Treatment of Virtual Currency Transactions

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Any bookkeeping, business or tax article contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor can it be used to avoid tax-related penalties. If desired, we would be pleased to perform the requisite research and provide you with a detailed written analysis. Such an engagement may be the subject of a separate engagement letter that would define the scope and limits of the desired consultation services.

If you’ve invested in Bitcoin and decide to sell you need to consider the impact of virtual currency transactions on your taxes. Here’s what you should know:

Background

Prior to 2014, there was no IRS guidance and many people did not understand that selling virtual currency was a reportable transaction. They may have found themselves with a hefty tax bill – money they were hard-pressed to come up with at tax time. Others were unaware that they needed to report their transactions at all or failed to do so because it seemed too complicated.

In 2018, the IRS announced a Virtual Currency Compliance campaign to address tax noncompliance related to the use of virtual currency through outreach and examinations of taxpayers, and in August 2019, began sending letters to taxpayers with virtual currency transactions that potentially failed to:

  • report income and pay the resulting tax from virtual currency transactions; or
  • did not report their transactions properly.

More than 10,000 taxpayers received these letters, whose names were obtained through various ongoing IRS compliance efforts. There were three variations of the letter: Letter 6173, Letter 6174 or Letter 6174-A. All three versions strive to help taxpayers understand their tax and filing obligations and how to correct past errors.

In October 2019, the IRS expanded their guidance to include two additional pieces of information that help taxpayers understand their reporting and tax obligations with regard to virtual currency transactions. This expanded guidance includes:

  • Answers to common questions by taxpayers regarding the tax treatment of a cryptocurrency hard fork
  • FAQs that address virtual currency transactions for those who hold virtual currency as a capital asset

Definitions

Virtual Currency – a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.

Cryptocurrency – a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.

Hard Fork – when a single cryptocurrency splits in two. This may result in the creation of a new cryptocurrency on a new distributed ledger such as blockchain in addition to the legacy cryptocurrency on the legacy distributed ledger (e.g., blockchain).

Virtual Currency Taxed as Property

Virtual currency, as generally defined, functions in the same manner as a country’s traditional currency and is treated as property for U.S. federal tax purposes. The same general tax principles that apply to property transactions also apply to transactions using virtual currency such as:

  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
  • Payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply. Normally, payers must issue Form 1099-MISC.
  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2 and are subject to federal income tax withholding and payroll taxes.
  • Certain third parties who settle payments made in virtual currency on behalf of merchants that accept virtual currency from their customers are required to report payments to those merchants on Form 1099-K, Payment Card and Third-Party Network Transactions.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.

What to Do if You Failed to Report Transactions

The good news is that if you failed to report income from virtual currency transactions on your income tax return, it’s not too late. Even though the due date for filing your income tax return has passed, taxpayers can still report income by filing Form 1040X, Amended U.S. Individual Income Tax Return within 3 years after the date you filed your original return or within 2 years after the date you paid the tax, whichever is later.

Note: In October 2019, the IRS issued a draft version of Schedule 1 (Form 1040) that includes a question at the top regarding whether the taxpayer has received, sold, sent, or exchanged virtual currency.

Noncompliance

Taxpayers should also be aware that forgetting, not knowing, or generally pleading ignorance about reporting income from these types of transactions on your tax return is not viewed favorably by the IRS. Taxpayers who do not properly report the income tax consequences of virtual currency transactions can be audited for those transactions and, when appropriate, can be liable for penalties and interest.

Taxpayers who did not report transactions involving virtual currency or who reported them incorrectly may, when appropriate, be liable for tax, penalties and interest. In more extreme situations, taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions. Criminal charges could include tax evasion and filing a false tax return. Anyone convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Anyone convicted of filing a false return is subject to a prison term of up to three years and a fine of up to $250,000.

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