Bar News - August 20, 2014
Bartering with Bitcoin: IRS Says Digital Cash Is Property
By: James McClure
What’s old is new again under recent guidance from the IRS.
In March, the agency announced that virtual currencies like bitcoin are “property,” not currency, for federal tax purposes. This renders consumers’ transactions with bitcoin – a form of digital cash – similar to the bartering that long predates our century-old Federal Reserve.
The analogy is fitting, as many of bitcoin’s early adopters wanted to avoid our modern currencies and the governments that control them. The IRS notice is just one piece of the rapidly evolving law surrounding bitcoin, and it has implications for clients, businesses, and law firms that transact with it.
What Is Bitcoin?
Bitcoin is a virtual currency. Created by an unknown person or group in 2009, it exists only electronically. No government backs it, and no single entity controls it. Transactions occur peer to peer, meaning a buyer can send bitcoin directly to a seller, without a bank or credit card company standing in the middle.
People use bitcoin to buy and sell a variety of goods and services. One can exchange US dollars for bitcoins online and then store them in a digital wallet. This wallet has a private key code for the authorization of payments, and it also generates a public key for receiving bitcoin. When the user wants to buy something – say, legal services – he accesses his wallet from a computer or mobile device and transfers bitcoins directly to the recipient’s wallet.
To prevent fraud, the bitcoin transaction is posted online, and programmers then solve a complex, cryptographic formula to verify it. They compete to receive a portion of the limited number of new bitcoins created each year, and they also might charge a small transaction fee. Once verified, the transaction appears on a public ledger showing the time, amount, and public keys, but no other identifying information.
Bitcoin for Legal Services
Manchester attorney Brandon Ross started accepting bitcoin last fall. When a client pays in bitcoin, Ross uses a payment processor that charges a 1 percent fee to convert bitcoins to dollars. This looks similar to a credit card payment, but simpler. There is no fine-print agreement as with a credit card company, and because bitcoin functions like digital cash, clients cannot initiate chargebacks. Ross says the transactions are quick, final, and relatively cheap.
Bitcoin as Property
When the IRS declared that bitcoin is “property” for federal tax purposes, it created a burden on consumers, whose everyday transactions could now result in a capital gain or loss.
When spending or receiving bitcoin, the taxpayer must determine its fair market value in US dollars. Fair market value is based on the BTC/USD exchange rate on the date of the transaction. Several exchanges list bitcoin, and rates can vary significantly. While it may be advantageous to price-shop, the taxpayer should calculate fair market value “consistently” and “in a reasonable manner.” IRS Notice 2014-21, 2014-16 I.R.B. 938.
To illustrate, suppose Jane Taxpayer trades $500 for 1 bitcoin on an online exchange. A week later, Jane pays her attorney with 1 bitcoin when the exchange rate has risen to $600. Jane realizes a $100 capital gain upon payment, and the gain is taxable income.
The property designation is less onerous for merchants because they already account for every transaction as a taxable event. The notice did not affect Ross because his office always treated bitcoin like a digital asset. His payment processor calculates fair market value at the time of payment and automatically generates the needed records.
Bitcoin as Money
But the bartering analogy only goes so far. Earlier this year, federal officials charged Ross Ulbricht with money laundering, among other crimes, for allegedly running a website that sold illegal drugs for bitcoin. United States v. Ulbricht (2014). Ulbricht pointed to the IRS designation of bitcoin as “property” to argue that it could not form the basis of a money laundering violation, since it was not a “monetary instrument” used for “financial transactions.”
Judge Katherine Forrest disagreed. The statute defines “financial transactions” broadly, to include “funds.” The ordinary meaning of “funds” is “money” – “an object used to buy things.” Because bitcoin functions like money, Forrest held that the defendant could launder money with bitcoin.
The disparate treatment of bitcoin illustrates that virtual currency is sui generis, as Ross terms it. It resembles property, may be held as an investment, and trades as fast and privately as cash.
In April, Congressman Steve Stockman (R-TX) introduced HR 4602, to reverse the IRS designation and treat virtual currency as currency for federal taxes. Regardless of the outcome, bitcoin users can be sure that their taxes remain inevitable, even when dealing with digital, stateless cash.
James McClure is a student at UNH School of Law and a summer intern at the Low-Income Taxpayer Project of the NH Bar Association. He is grateful to LITP Coordinator Barbara Heggie and Brandon Ross for their assistance with this article.