Bitcoin - Passing fad? Disruptive technology? Either way it's now taxable!

Bitcoin has been making major headlines recently. Starting with a year-end high price of $817.12 which would have returned 56X or 5,600% in 2013 to the over $500 million theft from the Japanese exchange Mt. Gox in February. Then, Apple removes the Bitcoin app from its app store and finally the IRS announces its position on the taxability of virtual currencies on March 25, 2014.

Which raises the question, is Bitcoin a passing fad or disruptive technology that we need to take seriously? And what about this IRS notice?

In case you aren’t familiar with this 'digital currency’, according to CoinDesk, "Bitcoin is a form of digital currency, created and held electronically. No one controls it. Bitcoins aren’t printed, like dollars or euros – they’re produced by lots of people running computers all around the world, using software that solves mathematical problems. It’s the first example of a growing category of money known as crypto currency.”

The IRS guidance comes as a surprise as it prescribes capital gains treatment for "open-flow" and certain "hybrid" transactions with virtual currencies. The big deal is that the IRS ruled that Bitcoin and other virtual currencies that can be exchanged for real world money should be treated as “property”. This makes it more like stock than a currency and complicates the original concept that bitcoin envisioned.

This means that if you use bitcoin to pay for "real" goods and services, you will have to consider the price fluctuation of the bitcoin (or other virtual currency) as a separate gain/loss with the transaction. Which requires accounting for the original cost or basis and allocation of fractional shares as applicable. It is the equivalent of paying with gold or silver for goods and services (here is an example of a Bitcoin price calculator to determine the current exchange rates). Imagine that you are using Bitcoins to pay for micro-transactions, like a magazine article on a website. Say you pay $1.00 for the article. This new ruling would require you to determine the gain/loss of the Bitcoin transaction used to pay that $1.00 at the time of that transaction. This will significantly reduce one of the major benefits of Bitcoin for frictionless (and no fee) e-transactions.

Yet there are some legitimate tax issues with virtual currencies. The GAO did a study and report issued on June 17, 2013 and identified the following tax issues related to virtual currencies which it requested the IRS to address:

• Taxpayer lack of knowledge about tax requirements
• Uncertainty over how to characterize income (barter, capital gain, ordinary income)
• Uncertainty over how to calculate basis for gains
• Challenges with third-party reporting (1099s, W-2s, and other information returns)
• Evasion (and the risk of money laundering)

Specifically the IRS notice lays out several key areas that must be considered when using virtual currencies like Bitcoin:

• 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.