On March 25, 2014, the Internal Revenue Service issued Notice 2014-21, describing how existing tax principles apply to transactions using virtual currency, in the form of questions and answers.  The ruling is not surprising, but is informative in many respects.  This article addresses the tax implications of this Notice, and not the advantages and disadvantages of using virtual currency such as Bitcoin, or the attendant social policy issues, such as anonymity and the potential for money laundering.

Background.  Virtual currency may be used to purchase goods and services, or held for investment.  In the words of the IRS, “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.”  In some contexts, it operates like “real” currency; it circulates and is customarily used as a medium of exchange in the country of issuance.

The Notice only addresses convertible virtual currency, such as Bitcoin, which means virtual currency that has an equivalent value in real currency.  Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.  See Financial Crimes Enforcement Network (FinCEN) Guidance on the Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (FIN-2013-G001, March 18, 2013).

Key assumptions of the Notice are that: (i) the taxpayer’s functional real currency is the U.S. dollar; (ii) the taxpayer is on the cash basis method of accounting; and (iii) the taxpayer is not under common control with any other party to a transaction.

Highlights.  The main point of the Notice is that convertible virtual currency (hereinafter, “virtual currency”) is treated as “property,” rather than real foreign currency, and is subject to general property transactions principles.  Accordingly:

  1. a taxpayer that receives virtual currency as payment for goods or services must include its “fair market value” (defined below), measured in U.S. dollars, on the date of receipt, in computing gross income, which will also be the virtual currency’s tax basis;

  1. “fair market value” of virtual currency listed on an exchange where the exchange rate is set by market forces is determined by converting the virtual currency into U.S. dollars at the exchange rate, in a reasonable manner that is consistently applied;

  1. if property is purchased with virtual currency, gain or loss will be recognized if the fair market value of the property is more than or less than the tax basis of the virtual currency;

  1. a taxpayer who “mines” virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) realizes gross income upon receipt of the virtual currency resulting from such activities (the Notice assumes that no cash or other property is paid by the miner for the virtual currency); and

  1. a third party that contracts with a substantial number of unrelated merchants to settle virtual currency payments from customers is a third party settlement organization (TPSO), which must report payments made to a merchant on Form 1099-K, Payment Card and Third Party Network Transactions, if, for the calendar year, both (1) the number of transactions settled for the merchant exceed 200, and, (2) the gross amount of payments made to the merchant exceeds USD $20,000 (aggregated with real currency transactions).

The Notice, by no means, purports to address all of the issues involved with virtual currencies, but, it provides useful information, pending further guidance.