IRS Provides Guidance on Tax Treatment of Bitcoin

Its status has been up in the air for some time now, but today the IRS provided guidance on the tax treatment of online currency such as Bitcoin.  The official position is that virtual currency is not to be treated as legal-tender currency, but should be treated as property instead.  Bitcoins, therefore, should be reported and taxed as ordinary income, or as assets subject to capital gains, as the case may be.

[V]irtual currency is treated as property for U.S. federal tax purposes.  General tax principles that apply to property transactions apply to transactions using virtual currency.

Therefore, in real world applications, employees who are paid in virtual currency must pay taxes on that income just as they would pay taxes on dollars.  And an employer would have to withhold taxes, report these wages on a W-2, and comply with payroll tax laws.  And, of course, a 1099 is required for the self-employed who are paid in Bitcoin.

Perhaps of greater concern to some Bitcoin users around the world is the impact this IRS notice will have on “miners” (computer geeks who compete to unlock new Bitcoin by cracking codes).  If they want to be 100% legit, they will have to go back and determine how much Bitcoin they mined throughout the year, its fair market value on the date it was mined, and include it in their income.

Are Bitcoin Transactions Taxable?

In an IRS audit today I was amused by all the preliminary questions about income sources.  The auditor asked about wage income, 1099 income, interest, dividends, royalties, alimony, child support, law suit settlements & awards, reimbursements, gifts, inheritances, grants, scholarships, life insurance proceeds, tips, etc., etc.  But the one thing she failed to ask about was digital currencies, like Bitcoin.  And I don’t mention this because I think the auditor missed something or that the client failed to report all his income.  He probably wouldn’t even know what Bitcoin is.  I mention this to illustrate the fact that the IRS has been slow to recognize digital currencies as income and/or supply guidance as to the specific reporting requirements.  But they’re going to have to act on this soon because it is becoming more prevalent:

In the four months between July and December 2013, bitcoin usage has increased by over 75 percent — from about 1,700 transactions per hour to over 3,000.  Over the same period, the market value of bitcoins in circulation increased more than ten-fold from about $1.1 billion to $12.6 billion.  Over 10,000 businesses reportedly accept payment in bitcoin.

~ TAS 2013 Annual Report to Congress

The only guidance (if you can call it that) from the IRS is found on a single web page on irs.gov entitled “Tax Consequences of Virtual World Transactions.”  The IRS essentially likens virtual currency to bartering, gambling, and hobby income:

The IRS has provided guidance on the tax treatment of bartering, gambling, business and hobby income – issues that are similar to activities in online gaming worlds.

It’s clearly not the same thing.  Legitimate law abiding geeky businesses (and individual geeks) deserve some more guidance from the IRS on this issue.

Better to be Employed when Filing OIC

The Offer in Compromise (OIC) is an IRS program whereby some taxpayers are able to settle their tax debts for less than what they owe.  But the OIC is not for everyone.  For instance, if the fair market value of taxpayer’s assets adds up to more than what is owed, then OIC is not an option.  Also, OIC is not a good option if a taxpayer’s income is too high.

So how does the IRS calculate income while reviewing an OIC filed by a taxpayer who is unemployed?  There are many different options:

  1. Unemployment Income – If the Offer Examiner is focused purely on what the taxpayer is earning at the present, then it would make sense to simply use the monthly unemployment benefit amount. However, it is unusual for the IRS to go this route because unemployment benefits tend to be temporary. If the IRS is going to wipe the slate clean then they want to be sure they are getting every last dime they can possibly get from the taxpayer. Unemployment income is normally an understatement of one’s true earning potential.
  2. Income history – Sometimes the IRS compares a taxpayer’s current income with income reported via tax returns going back 1, 2, 3, or even more years. If the present year income appears to be an anomaly, then the IRS may elect to calculate an average income using several years’ tax returns.
  3. Income potential – This is similar to using an income history because it seeks to determine what the taxpayer can theoretically make rather than taking the current income for face value. One example of using income potential would be to increase the income of a taxpayer who is close to finishing school and who will be moving into a high-paying field of work.
  4. Impute income – I have seen the IRS simply impute/assign minimum wage when a taxpayer is unemployed.  However, the IRS is not likely going to do this if the taxpayer has a history of high wages.
  5. Reject the Offer – I put rejection as a final option because, in reality, if the IRS is unable to determine what the taxpayer’s income is, they are more likely to reject the offer than struggle too long figuring it out.

Income is one of the most important factors that the IRS looks at when determining whether to accept or reject an Offer in Compromise. Based on my experience, the IRS simply does not believe it when someone claims their income is $0.  Since the IRS is going to resort to one of the above analyses or simply reject the offer when unemployed, then it is safe to say that an OIC is a more successful form of tax relief for those who have a steady job.

Bartering: IRS Gets Theirs Even When Cash is not Involved

Today the IRS reminds us that the value of goods or services received through bartering is taxable (IRS Tax Tip 2013-29).

Bartering is simply trading one product or service for another product or service without an exchange of currency.  I was introduced to bartering in about 3rd grade where the hottest products being traded were Garbage Pail Kids cards and (this is going to make me seem really old) . . . marbles.  You know, little colorful glass spheres that you shoot with your thumb.  Ok, nevermind.  The point is, most people move on from bartering when they grow up and get a job that pays in currency for the work they perform.  But not everyone.

Some people barter informally with people they know, such as the plumber who fixes a leaky pipe for his dentist friend in exchange for dental work (this is the IRS Tax Tip example).  Others barter through organized “exchanges” like the one I found on the internet with a highly redundant name: “Barter Trade Exchange.”  Their home page explains how it works:

In times past people traded live stock, vegetables, grain etc. for  things they needed. It worked fine if you located who needed what you had and had what you needed. It was hard to find them, that’s why money was invented; Stones, Beads, Shells, Pearls, Coins, Silver, Gold and finally paper money.

In an Exchange, you deal with fellow members buying/selling goods and services using trade dollars, not cash. Offer what you have to earn trade dollars to spend. It is an easier way (not free) to acquire what you need without money.

I’m not sure how common bartering is; it is definitely not on my short list of typical tax problems.  And I’m not sure the IRS knows either because my hunch is it doesn’t get reported like it should.  That’s why the IRS came out today (a few weeks before the filing deadline) with a few important points they would like taxpayers to know about bartering.  Here they are:

  1. Barter exchanges must issue form 1099-B to their members
  2. Trade dollars (and the value of goods/services) received in barter must be reported as income
  3. Besides income taxes, there may also be self-employment, employment, or excise tax implications for those who barter
  4. Be sure you understand the specific reporting requirements that apply (for additional information, see the IRS’ Bartering Tax Center)

 

End of Year Tax Tips – Part 1

‘Tis the season for holiday cheer … and last minute tax planning. Bah humbug!  With the tax year about to end, tax season will officially begin; it’s finally the time to ensure that you will not need to hire a tax relief attorney in April 2013.

My usual end of the year advice includes comparing your prior year tax returns with your present year income, tax withholdings, financial transactions, and withdrawals to determine whether you need to make late December moves to ensure you don’t owe a tax debt. This usually includes ensuring that you properly withheld taxes on your income throughout the year and/or made your estimated tax payments, and invested accordingly. While this advice is still sound, as of the date of writing of this article, if things in Washington D.C. remain the same, my advice also includes, earn it now if you can.

Being mindful to not illegally manipulate your income, i.e. you earn your income when you have a right to receive the income; accelerate your income in 2012, if you can. Since your tax rate may increase beginning January 1, 2013, the money you earn now is worth more now than it will be in just a few weeks because your tax rate is likely to increase. Likewise, self-employed individuals who have the ability to time the payment of deductible expenses may want to defer those expenses for tax year 2013, because those expenses will be more valuable in tax year 2013 than in tax year 2012.

Reporting Gambling Winnings

Joe goes to Las Vegas for the weekend with $1,000 to spend.  On Saturday he wins $9,000 playing blackjack.  Then on Sunday he loses $8,950 playing blackjack.  He comes home with  $1,050.  Joe knows that he must report his gambling winnings because the tax code defines gross income as “all income from whatever source derived.”  Assuming this was the only time he gambled all year, he can report $50 in gambling winnings as income on his tax return, right?

Wrong.  Taxpayers must include the full amount of gambling winnings in gross income.  They may not reduce gambling winnings by gambling losses with only the net difference included, otherwise it ceases to be gross income.  Instead, taxpayers can deduct gambling losses (up to the amount of gambling winnings) as an itemized deduction [see Internal Revenue Code section 165(d)].

So Joe needs to report his $9,000 in winnings and then claim his $8,950 in losses as an itemized deduction.