CARL WATTS & ASSOCIATES

April 07, 2014

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The IRS and
the Virtual Currency
The virtual world with its 3D games and avatars, has extended for several years now and has incorporated systems for sale of goods through virtual interfaces and using virtual currencies.

Bitcoin, the best-known virtual currency, started circulating in 2009 and at present its market value is around $8 billion, with up to 80,000 transactions occurring daily.

Recently, the currency came under new regulatory scrutiny after the failure of Mt. Gox, a Tokyo-based exchange, that filed for bankruptcy after losing an estimated $650 million worth of customer Bitcoins. The irony is that Bitcoin was originally embraced especially for its independence from control or backing by any government or central bank.

In the real world, it took until March 2013 for the Financial Crimes Enforcement Network (FinCEN) of the Treasury Department to offer insights into the virtual world, and till May 2013 for the U.S. Government Accountability Office (GAO) to note the lack of legal definitions for a virtual economy or currency.

Until a couple of weeks ago, the IRS had just a webpage titled “Tax Consequences of Virtual World Transactions” which provides little information, such as:

“Cyber-economic activities in the online world may have tax consequences that real world avatar counterparts need to consider.

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.


If you receive more income from the virtual world than you spend, you may be required to report the gain as taxable income. IRS guidance also applies when you spend more in a virtual world than you receive, you generally cannot claim a loss on an income tax return.”

On March. 25, the IRS issued a notice (2014-21) providing answers to frequently asked questions on virtual currency, such as Bitcoin. These provide basic information on the U.S. federal tax implications of transactions in, or transactions that use, virtual currency.

The major decision reflected in the guidance is the IRS’s classification of Bitcoin and similar virtual currencies as property for federal tax purposes and, as such, general rules for property transactions apply.

Among other things, this means that:

  • 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.
  • 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.
  • 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.
  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.

The IRS notice defines virtual currency as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.  In some environments, it operates like ‘real’ currency, but it does not have legal tender status in any jurisdiction. 

Real currency is described as the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance.

Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to in the notice as convertible virtual currency.

The IRS notice is generally good news for taxpayers who hold virtual currency as investments, because lower capital gain tax rates may be applicable to those who have held their virtual currency for more than one year, rather than the higher ordinary income rates which apply to almost all transactions in foreign currency. 

New bitcoins come from a process called mining. Computer programmers around the world compete to crack an automatically generated code and the first to do so is rewarded with a small stash. This happens about every 10 minutes.


If a taxpayer’s “mining” of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute self-employment income and are subject to the self-employment tax.

Virtual currency held mainly for sale to customers will likely be treated as noncapital assets.  In such case an exchange that sells virtual currency to customers in its trade or business has gross revenue equal to the value for which the virtual currency was sold.

Any disposition of virtual currency generally is a taxable event, including where virtual currency is used to acquire another asset.

Use of virtual currency in a retail transaction is taxable to the person paying with the virtual currency if the value of the merchandise received is higher than their basis in the virtual currency.

Be aware that the decision to treat virtual currencies as property will require extensive record-keeping on the part of tax filers, including tracking details like the date and time at which coins were acquired and spent.

Even if more regulations are bound to follow, the new IRS guidance provides some clarity for taxpayers who want to ensure that they're doing the right thing when utilizing bitcoin and other digital currencies.

As we always advise you, if you want to do the right thing, whenever you have to deal with the IRS, make sure to enroll professional help.
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