Today is an historic day where the country and the world are absorbing what portends to be a sea change in America’s place in the world. It is hard to see what the direct impact a Trump presidency is going to have on tax administration. With control of the White House and both branches of the legislature I suspect that there will be an appetite and capacity for significant tax legislation.
At the same time, even apart from the political changes of the day, technological advancements suggest that tax administration is in the midst of a disruptive period. We have discussed some of those issues in looking at IRS Future State plans, as well as changes in Appeals as it shifts from person to person conferences and looks to virtual conferences as a way to connect with taxpayers and practitioners. One of the technological changes we have not discussed is the invention of bitcoin and the growth of virtual currencies. Those virtual currency developments highlight special challenges for tax administrators around the world, both with respect to traditional tax compliance issues and issues relating to bank secrecy that some tax agencies such as the IRS administer.
We have largely ignored the growth of virtual currencies, and while IRS issued a notice about them in 2014 (Notice 2014-21) it seems that IRS and Congress have likewise not focused sufficient energy on some of the issues associated with the use of bitcoin. At least that is the message in TIGTA’s As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions Are Needed to Ensure Taxpayer Compliance. In the report TIGTA warns that the spread of virtual currencies creates special challenges for tax administrators who rely heavily on the combination of self-reporting and third-party reporting to backstop income tax compliance. It also notes that IRS received significant comments in response to the issuance of its 2014 notice yet has failed to publicly address those comments or spend significant resources on educating the public on the difficult tax compliance issues that flow from the mining and use of virtual currency. IRS generally agreed with TIGTA’s recommendations but noted that it faces challenges in allocating scarce resources among competing priorities so there does not seem to be much agency urgency on these issues.
This is a brief post on a topic that deserves more attention. For those looking to wrap around the history and mechanics of bitcoin, I recommend a 2011 New Yorker article by Joshua Davis called The Crypto-Currency. A 2016 New Yorker article by Adrian Chen discussing the importance of the search for the mythic Saroshi Nakomoto, the creator of Bitcoin, connects the development and growth in virtual currency to a deep distrust of international and national monetary powers, a theme close to the surface in President-elect Trump’s messages. A Forbes piece by contributor Karl Whelan called How is Bitcoin Different From the Dollar also nicely summarizes and links some academic papers on the topic.
IRS in its 2014 notice provides that virtual currency is treated as property for U.S. federal tax purposes. Once you start from that premise, as IRS explains in a summary of its notice, “[g]eneral tax principles that apply to property transactions apply to transactions using virtual currency.” In other words, when you use property (like virtual currency) rather than old-fashioned US dollars to pay for goods and services you have a separate tax consequence that stems from in effect the tax system treating the use of virtual currency as a deemed sale for its fair market value upon a taxpayer using it to purchase goods or services.
As the IRS in its 2014 summary notes, that has major implications:
- 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 TIGTA report flags some of the complications that spin off that IRS starting point:
Notice 2014-21 requires a taxpayer who receives virtual currency as payment for goods or services to compute gross income using the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency is received. However, because bitcoins are divisible to eight decimal places, this means that each bitcoin can be divided up into 100 million pieces. Based on this general guidance, when a portion of a bitcoin is used to make a purchase, taxpayers will have to treat the transaction as property and determine their tax basis for the bitcoin on the day of the purchase. For example, if a taxpayer uses a portion of a bitcoin to buy a cup of coffee each day for one week, he or she will have to determine what portion of the bitcoin was used to make the purchase based on the daily exchange rate, convert it into U.S. dollars, and keep a record of each transaction so that the gain or loss from his or her virtual currency property can be properly reported. Notice 2014-21 does not provide taxpayers with guidance on what records should be kept and how the records should be maintained. Due to the potential complexity of reporting otherwise simple retail purchase transactions related to virtual currencies, further guidance is needed to help taxpayers voluntarily comply with their tax obligations.
While tax compliance does require some effort, to put consumers through the hoops needed to determine consequences on each use of bitcoin is unreasonable. TIGTA compared the Australian treatment with IRS’s treatment. It seems that the Australian Taxation Office also determined that bitcoin use could trigger a taxable event but the ATO “decided that there will be no income tax implications if the person is not in business or carrying on an enterprise and is simply paying for goods or services. Any capital gain or loss realized from the disposal of the virtual currency is to be disregarded provided its cost is $10,000 (Australian dollars) or less.” The de minimis carve out goes a long way in removing complications that spin from using virtual currency from day to day consumption transactions and pegs compliance costs for larger purchases.
TIGTA also notes that while reporting applies to payments made in virtual currency IRS information returns (e.g., 1099 W-2 etc) “do not provide the IRS with any means to identify that the taxable transaction amounts being reported were specifically related to virtual currencies.” Without that ability the reporting of those virtual payments (if in fact payors comply) does not contribute to IRS use of that information to test compliance on the user-level. TIGTA sensibly recommends that IRS “revise third-party information reporting documents to identify the amounts of virtual currency used in taxable transactions.” IRS agreed with that recommendation though it stated that due to competing funding priorities it did not view that as a priority.
Conclusion
The world changes at an increasingly fast pace. The buzzword in industry and academics is disruption. Disruptive changes can have disastrous effects on those who fail to adapt. Tax agencies are not immune to those forces. The growth in the use of virtual currencies over the past five years combined with the growing distrust in institutions as reflected in some of the recent political events in Europe and here suggest that there may be major changes in the way that people interact with each other in the commercial sphere. Consumers who use traditional greenbacks place faith in the United States. Consumers who use virtual currencies place faith in technology and code, which ensures that people are spending a bitcoin or fraction thereof only once.
Bitcoin was born when its creator was disgusted with the financial meltdown in 2008, with its creator thinking that people should and could not trust governments to behave responsibly. If governments move down the path of irresponsibility we may be entering a new phase in the use of virtual currency. In fact today bitcoin values have soared in light of the election (see e.g., The Telegraph’s Bitcoin price jumps as investors flock to safety after Donald Trump election victory . A tax agency that ignores those possible changes does so at its peril.