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Elizabeth R. Carter Louisiana State University, U.S.
Elizabeth R. Carter is Professor of Law at Louisiana State University, U.S.
In 2014 the Internal Revenue Service (“IRS”) announced that it intended to treat convertible virtual currency—like Bitcoin—as property for tax purposes. This article contemplates some of the potential tax consequences and pitfalls of treating convertible virtual currency as property rather than fiat currency.
Currency—as we generally understand it in the U.S. for purposes of most federal laws—means fiat currency or physical currency. Fiat currency is the “coin and paper money” of a country “that is designated as legal tender and that circulates and is customarily used and accepted as a medium of exchange in the country of issuance.” 1 Currency can also be digital. Virtual currencies possess some, but not all, of the features of traditional currency. In particular, virtual currency is not the legal tender of any particular country.
There are two types of virtual currency—nonconvertible and convertible.
Nonconvertible virtual currency is a virtual currency that is intended to be used in a particular domain or digital world and cannot be exchanged for ordinary currency. For example, many online role-playing games allow users to acquire some form of virtual currency within the game in order to purchase goods or services within the game.
The popular game “Pokémon Go” is a helpful example. The game has an in-game currency called “Pokécoins”. Players need the coins in order to purchase useful items and for inventory upgrades. Players can obtain Pokécoins two ways: (1) they can earn Pokécoins in the course of playing the game; or (2) they can also pay real currency to purchase Pokécoins (which is how the game makes money). Pokécoins have no value or use outside of the games—except, perhaps, on a secondary black market.
Convertible virtual currency (“CVC”), in contrast, is a virtual currency that has an equivalent value in real currency and that can be exchanged for U.S. dollars, euros, or some other fiat currency. Bitcoin is probably the best-known CVC—but many others exist: of these, Litecoin, Dogecoin, Peercoin, and Darkcoin currently occupy the most significant share of the market. CVC is also called “cryptocurrency”—a reference to the fact that CVC uses software-aided cryptography as a means to control the issuance of new units of currency and to otherwise secure and control transactions.
CVCs offer some unique advantages. CVCs offer varying levels of anonymity—which has raised concerns that they might be used to finance terrorism and to engage in other criminal activities. However, many legitimate uses do exist for CVCs, as discussed below.
One major allure of CVCs is their ability to avoid various transaction fees. Unlike credit cards, CVCs often have no (or a minimal) transaction fee associated with their use. Merchants who accept virtual CVCs can therefore avoid paying high credit card transaction fees. CVCs also allow international buyers to avoid paying fees associated with converting money from one country's currency to that of another. Similarly, CVCs may be used to transfer money from one country to another while avoiding fees.
The value of CVCs can be volatile. For example, at the end of November 2016, one Bitcoin was worth about $730. At the same time the previous year, Bitcoin was worth about $356. For that reason, some individuals may purchase CVCs for investment purposes.
In developing countries many people lack access to traditional banking services. CVCs offer a means of securely spending and receiving money for people without bank accounts.
CVCs—while volatile—may be less volatile than some national currencies. Some CVCs—like Bitcoin—should be immune to inflation because only a fixed number of coins can ever exist.
The IRS offered guidance on how existing tax principles should be applied to transactions using CVCs in IRS Notice 2014-21 (the “Notice”). Notably, the IRS has taken the position that CVC is considered property—not currency—for tax purposes. As a result, the tax consequences from transactions involving CVCs turn on general principles applicable to the taxation of property transactions. The Notice directly addresses some—but not all—of those principles.
Fair market value (“FMV”) of CVC is determined in accordance with general tax principles of valuation. If the
virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.” 2
On the issue of basis, the Notice generally takes the position that the basis in CVC is determined by reference to the transaction in which the CVC was acquired. For example, the Notice explains that “[t]he basis of virtual currency that a taxpayer receives as payment for goods or services…is the fair market value of the virtual currency in U.S. dollars as of the date of receipt.” 3 Although it is not explicit on this point, the Notice seems to suggest that a person who purchases CVC with real currency would have a basis in the CVC equal to his or her cost of acquisition in accordance with Chapter 26 of the United States Code (26 U.S.C. §1012). Presumably, this same principle would apply to CVC received by gift or inheritance. In the case of a gift, the donee's basis in the CVC would be the same as the donor's basis (subject to the prohibition on shifting losses). 4 In the case of an inheritance, the recipient's basis in the CVC would be the FMV of the CVC as of the date of the decedent's death or the alternate valuation date. 5 Finally, if the inherited CVC represented a decedent's half interest in community property then, presumably, the surviving spouse would be entitled to a new basis on his or her half interest of the CVC as well. 6
The Notice makes it clear that when a taxpayer exchanges CVC for property or actual currency he may have a gain or loss on the transaction and explains that the gain or loss could be capital or ordinary depending on the circumstances. What is less clear is under what circumstances CVC might be held as a capital asset versus an ordinary asset or as inventory.
The Notice makes it clear that any “payment made using virtual current is subject to information reporting to the same extent as any other payment made in property.” 7 Similarly, “[p]ayments made using virtual currency are subject to backup withholding to the same extent as other payments made in property.” 8
The treatment of CVC as property rather than currency is important for a number of reasons—some of which are not readily apparent from the Notice. These will be discussed below.
One issue made clear by the Notice is that because CVCs are considered property they cannot result in a foreign currency gain or loss for U.S. tax purposes.
Taxpayers can delay the recognition of gain by exchanging property for other like-kind property—a so-called 1031 exchange. 9 Of course, 1031 exchanges are subject to a number of rules and limitations—but it is possible that transactions involving CVC could qualify as 1031 exchanges under the appropriate circumstances. The Notice does not address whether CVC could be the subject of a 1031 exchange: if, however, CVC is property then it is at least conceivable that it could be the subject of a 1031 exchange.
When CVC is sold in exchange for real currency the transaction should, presumably, be treated as the sale of intangible property rather than an exchange of currency. For example, suppose Alice sells two units of a virtual currency to Bob for $600. The tax consequences of the transaction should be determined by treating Alice as having sold intangible property. If Alice's basis in the two units of virtual currency was $200 then Alice has realized a $400 gain on account of the sale. Bob has no gain or loss on the transaction. However, if Bob later sells the virtual currency he may have his own gain or loss.
When CVC's are exchanged for goods or services the transaction should, presumably, be treated as a barter transaction. For example, suppose Alice transfers two units of a virtual currency to Bob and in exchange Bob transfers two widgets to Alice. Further suppose that the FMV of two units of virtual currency is $600 and that Alice's basis is $200. Suppose also that the FMV of two widgets is $600 and that Bob's basis is $100. The tax consequences of the transaction are complicated by the fact that the virtual currency must be treated as property. In this scenario both Alice and Bob must realize taxable income. Alice has realized $400 on the transaction and Bob has realized $500 on the transaction. Each time Alice uses CVC to purchase goods or services she must also realize a gain or loss on the disposition of the CVC. From a practical standpoint, this requirement makes CVCs impractical for daily transactions because of the accompanying unwieldy accounting burden.
If, instead, Alice gives two units of virtual currency to Bob in exchange for Bob performing some service for her that was worth $600, then the tax consequences would change. Alice would still likely realize $400 of gain on the transaction. Additional tax consequences, however, would depend on Bob's employment status. 10 If Bob is an independent contractor then he has received self-employment income in the amount of $600. If Bob is Alice's employee then the FMV of the two units of virtual currency received by Bob may be subject to federal income tax withholding. 11 In either case, Bob's basis in the CVC he received in exchange for his services would be the FMV of the CVC on the date of receipt. 12
Because CVC is treated as property, taxpayers must keep careful accounts of basis. Yet the Notice does not indicate what type of accounting method should be used with CVC—Last-in, First-out, First-In, First-out, or some other method. Moreover, traditional accounting methods are challenging in the CVC context because some CVCs—like Bitcoin—lack specific identification techniques. Unless each individual unit of CVC is housed in a separate “wallet”, accounting for the basis in each individual unit is practically impossible. “Wallets”, in the CVC context, are a sort of passkey that can be associated with a particular owner.
To visualize this problem, suppose a taxpayer has two widgets that he acquired at different times and in which he has differing acquisition costs. Suppose widgets are small items and the taxpayer can house them together in a single shoebox. If the widgets are identical in appearance and lack serial numbers or other types of unique identifiers it can be difficult—if not impossible—for the taxpayer to tell them apart at a later date. One solution to this problem is to house each widget in a separately labeled shoebox. Bitcoin operates in a similar fashion because there are no unique identifiers attached to an individual Bitcoin: rather, to accurately track basis a taxpayer needs to keep each Bitcoin in a separately labeled wallet. This, of course, adds to the administrative burden placed on the taxpayer and may render CVC impractical for daily transactions. Moreover, it does not entirely solve the problem, because some CVCs can be further divided into smaller units.
All income tax liabilities must be paid in U.S. dollars. Income tax determinations are usually required to be made in the taxpayer's functional currency. 13 Generally, a taxpayer's functional currency is the U.S. dollar. 14 A so-called qualified business unit (“QBU”), however, is typically required to use “the currency of the economic environment in which a significant part of such unit's activities are conducted and which is used by such unit in keeping its books and records.” 15 If a QBU's functional currency is some currency other than the U.S. dollar then the QBU typically determines its profits and losses on an annual basis in its functional currency. Then, to determine the QBU's income tax liability, the end-of-year profits and losses are converted to U.S. dollars using an average exchange rate for the year. 16 By requiring CVC to be treated as property for U.S. tax purposes, the Notice presumably precludes a QBU from having a CVC as its functional currency. This could negatively impact a company which primarily deals with CVC.
Taxpayers holding CVC for investment purposes may wonder whether the CVC ought to be treated as a security or a stock for a variety of reasons. Such treatment, for example, would dictate the appropriate accounting method for calculating gains or losses. 17 It would also clarify whether dealers in CVC should treat the CVC in their hands as inventory rather than a capital asset. 18 It could also clarify the appropriate source rule to be applied for determining gains and losses on transactions with international implications.
By treating CVC as property it is at least plausible that the valuation of CVC involved in a particular transaction might be subject to a valuation discount or premium—particularly in an estate or gift tax situation. For example, a discount for blockage might be appropriate where a single taxpayer owns a large number of CVCs—particularly a CVC like Bitcoin that has a fixed upper limit of available units. Blockage discounts have been recognized in estate tax situations involving shares of stock and works of art and the same analysis would seem to apply to a CVC. 19
Elizabeth R. Carter is Professor of Law, Paul M. Herbert Law Center, Louisiana State University, U.S.She may be contacted at: firstname.lastname@example.orgNOTES
131 C.F.R. §1010.100(m).
2 IRS Notice 2014-21.
3 IRS Notice 2014-21.
4 See 26 U.S.C. §1015.
5 See 26 U.S.C. §1014.
6 See 26 U.S.C. §1014(b)(5).
7 See IRS Notice 2014-21.
8 See IRS Notice 2014-21.
9 See 26 U.S.C. §1031.
10 See IRS Notice 2014-21
11 See IRS Notice 2014-21
12 See IRS Notice 2014-21
1326 U.S.C. §985(a).
1426 U.S.C. §985(b).
1526 U.S.C. §985(b).
16 See26 U.S.C. §987.
17 See 26 C.F.C. §1.1012-1(c).
18 See 26 U.S.C. §475.
19 See e.g. 26 C.F.R. §20.2031-2(e); 26 C.F.R. §20.2512-2(e); Smith's Estate v. C.I.R., 57 T.C. 650 (1970); Estate of O'Keeffe v. C.I.R., T.C. Memo 1992-210.
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