United States: Is Your Bitcoin Tax Compliant?

Last Updated: June 20 2017
Article by Asher Rubinstein Esq

The value of Bitcoin has surged 125% in 2017 alone. In addition to its value ascent, it has also gained in legitimacy. While it was once the currency of choice on the illicit Silk Road "dark web", shut down by the U.S. Department of Justice in 2013, Bitcoin is now accepted for payments by Amazon.com and other mainstream businesses. Whether you've weathered the Bitcoin roller coaster or invested recently, you must ensure IRS compliance for Bitcoin.

The IRS has taken an interest in Bitcoin for various reasons. First, Bitcoin is largely unmonitored and stands apart from the traditional structure of U.S. banking with 1099 forms and regular reporting. There is a huge mass of Bitcoin value that is relatively unknown to the IRS, and gains in value are essentially hidden from the IRS, and the IRS doesn't like that. In addition, Bitcoin has a large potential for tax non-compliance, both because its very nature is anonymous, and because Bitcoin holdings give rise to significant IRS reporting (the "FBAR" form, IRS Form 8938, IRS Form 8949, capital gains taxes, etc.) and many Bitcoin owners don't heed (or even know) the reporting requirements.

In November 2016, the IRS obtained a federal court authorization to issue a "John Doe" summons to Coinbase, Inc., a web-based global digital currency wallet and platform. The IRS has in the past successfully used the "John Doe" summons to obtain information from financial institutions (e.g., UBS, HSBC and Cayman Islands banks) for a broad class of U.S. taxpayers who are not individually named but whom the IRS has reason to believe may have utilized the financial institution to improperly evade tax. The John Doe summons upon Coinbase seeks records from 2013 through 2015 for any Coinbase user with a US address, telephone number, e-mail domain, etc., and all records related to disbursement of funds to any user. A recently filed Affidavit by an IRS agent in the Coinbase enforcement litigation revealed that in 2015, only 802 taxpayers revealed Bitcoin information to the IRS on Form 8949, which is the form applicable to capital gains and losses. Other virtual currency platforms, such as Localbitcoins, Kraken and ItBit may receive similar summonses for transactions with Bitcoins and other virtual currencies like Ethereum and Litecoin.

Bitcoin's anonymity feeds its non-compliance, and there are many opportunities to run afoul of tax law and IRS requirements, intentionally or inadvertently. One issue is the failure to report income with respect to Bitcoin. In 2014, the IRS issued Notice 2014-21 describing how various income recognition and other US tax principles apply to virtual currency transactions. In that Notice, the IRS clarified that virtual currencies are "property" subject to income tax, capital gains tax, etc. This means that if Bitcoin is sold for a profit, that profit is income and is subject to capital gains tax. The income is reportable on IRS Form 8949 which is then attached to Schedule D of Form 1040. If you exchange your Bitcoin for goods or services, that too is a taxable event, as the IRS considers you to have earned income on the value of the good or service, less your cost basis in the Bitcoin (i.e., your Bitcoin purchase price).

If you are audited by the IRS regarding Bitcoin, you may have to show multiple cost bases for multiple transactions. Proper record keeping with respect to Bitcoin is essential. The IRS could take the position that your cost basis in your Bitcoin is zero, and you would pay tax on the full value of the Bitcoin on the date of the transaction, unless you can provide records of your purchases of Bitcoin.

In addition to income tax issues on Bitcoin income, there are reporting issues irrespective of income. Because a Bitcoin wallet would be considered by the IRS to constitute an "account", if you hold your Bitcoins in foreign wallets or on foreign Bitcoin exchanges, then foreign account reporting requirements are triggered, including the FBAR (FinCEN Form 114, Report of Foreign Bank and Financial Accounts) and IRS Form 8938 (Statement of Specified Foreign Financial Assets). If you invested in a foreign fund that invested in Bitcoin, the IRS may consider the fund to be a "PFIC" (Passive Foreign Investment Company), which has its own tax methodology, and IRS Form 8621 would be due. Penalties for non-reporting foreign accounts are significant, including potentially 50% of the value of the account.

Clearly, the IRS' increased interest in Bitcoin necessitates proper compliance with respect to Bitcoin assets. The IRS offers opportunities to come into compliance before the IRS obtains information about unreported assets (virtual or actual) and income, including via a pre-emptive voluntary disclosure (offshore or domestic) of digital currency income and accounts. A voluntary disclosure also provides the opportunity to calculate, with a reasonable degree of certainty, the total cost of resolving open tax issues, along with peace of mind and finality.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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