Understanding Virtual Currency and Taxation
The IRS has ruled that bitcoins and other convertible virtual currencies are considered property and not treated as currency. Virtual currencies are property for tax purposes, meaning you will have capital gain or loss when disposing of virtual currency. Income is taxable, even if you are paid in virtual currency.
Spending virtual currency is really two transactions:
- Disposing of the virtual currency
- Spending the dollar-equivalent amount
Business transactions in bitcoin are subject to all the normal rules for sales tax, withholding, and information reporting.
Definition of Virtual Currency
- Virtual currency is a digital representation of value that functions as:
- A medium of exchange
- A unit of account
- A store of value
- Virtual currency does not have legal tender status in any jurisdiction.
- Convertible virtual currency is one that has an equivalent value in real currency or acts as a substitute for real currency.
Example: Bitcoin is a convertible virtual currency. It can be digitally traded between users and exchanged for U.S. dollars, Euros, and other currencies.
Tax Treatment of Virtual Currency
For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.
Income Reporting Requirements
A taxpayer who receives virtual currency as payment for goods or services must:
- Include the fair market value of the virtual currency, measured in U.S. dollars, as of the date it was received
- Report transactions using virtual currency in U.S. dollars on the tax return
- Determine the fair market value using a reasonable and consistently applied method when the currency is listed on an exchange
Tax Implications of Bitcoin Dispositions
When bitcoins are disposed or exchanged, four things happen:
- Income is realized from any gains on the property
- Gain is measured by the change in dollar value between:
- Cost basis (purchase price)
- Gross proceeds (selling price)
- Applicable tax rates depend on whether the property was held:
- Short-term
- Long-term
- Tax reporting is done using:
- Schedule D & Form 8949
- Or Form 4797 for business-related gains/losses
These forms require taxpayers to “show the math” when calculating gain or loss.
Paying Employees in Bitcoin
If paying employees in bitcoin:
- First: Withhold all applicable payroll tax in U.S. dollars
- Then: Net pay can be paid out in bitcoin
Important: Taxes are paid in dollars, not in bitcoin.
- Regularly converting bitcoins to dollars is good practice to avoid double entries and complex records
- Sales and expenses are recorded in dollars
- Gains or losses from holding bitcoin are recorded as trading gains on:
- Form 4797
- Or Schedule D, as appropriate
Frequently Asked Questions
What is virtual currency according to the IRS?
Virtual currency is treated as property for tax purposes by the IRS. This means any gains or losses from its disposal must be reported similarly to other property transactions, not like traditional currency exchanges.
Do I pay taxes if I receive bitcoin as payment?
Yes. If you receive bitcoin (or any virtual currency) as payment, you must report its fair market value in U.S. dollars at the time of receipt as income on your tax return.
How is spending virtual currency taxed?
Spending virtual currency is considered two separate transactions: disposing of the virtual currency and purchasing an item or service. This triggers a capital gain or loss based on the difference between the cost basis and the fair market value at the time of the transaction.
What forms do I use to report bitcoin transactions?
Bitcoin transactions are typically reported using Schedule D and Form 8949 for personal transactions, or Form 4797 if related to business activities. These forms require detailed gain/loss calculations.
Can I pay employees in virtual currency?
Yes, but payroll taxes must be withheld in U.S. dollars first. The net pay may be issued in bitcoin. Employers must still report wages and ensure accurate dollar-based recordkeeping.