Nothing is Certain Except for Death and Taxes, Unless You Trade in Bitcoin

Stacks of coins with bitcoin symbol against a currency chart

Most paychecks are now direct deposited after standard state and federal taxes are deducted. When shopping, most of us generally pay with a debit card rather than writing a check or using cash; and state and local sales taxes are still due on the majority of these transactions. In both situations the money being earned, then spent, is never actually seen or handled, much like cyber-currency.

Following that line of reasoning, since Bitcoins are considered a fiduciary currency as opposed to a commodity based currency, but are becoming accepted worldwide by nationally recognized retailers, legally should they not be subjected to the same taxation rules and regulations as traditional tender? Or because they aren’t backed by any government or financial entity does this provide this new digital currency format the right to be tax exempt?

Before exploring the potential tax liability associated with purchasing and trading with Bitcoins, it is important to understand how digital money works. Bitcoins came on the scene in 2009 and over the years have had its share of problems. As a cyber-centristic entity, Bitcoins have a unique set of concerns when it comes to nefarious criminal activity including everything from fraud to internet theft to unscrupulous individuals setting up websites selling illegal substances and accepting only Bitcoins because of their anonymity.

The Federal Reserve Bank of Chicago has one of the better Bitcoin explanations available online today. This primer deals with everything from Bitcoin mining to how Bitcoin exchanges function. It details how value is determined, how Bitcoins are regulated and delves into Bitcoin’s validity in the retail world. Because now, six years later, with Bitcoins exhibiting remarkable staying power, federal, state and local revenue departments have begun the arduous process of ensuring they get their fair share.

In March of 2014, the Internal Revenue Service via IRS Notice 2014-21 decreed cyber-currency “does not have legal tender status in any jurisdiction.” However, when purchased and subsequently sold, any financial profit awarded from the sale could be considered a taxable capital gain. Federal taxes could also apply when this virtual currency is used to make any type of purchase which falls under federal tax guidelines. This also applies to individuals who are paid with Bitcoins for providing or performing a service.

Another major consideration is how and who determines fair market value in terms of Bitcoin taxation with convertibility playing a major role. Taking a cue from the Financial Crimes Enforcement Network, the IRS now has in place two stipulations for determining if cyber-currency should be taxed. One: this digital money must have a tangible equivalent in real currency. The IRS requires that cyber-currency be “listed on an exchange and the exchange rate is established by market supply and demand.” Two: this currency must be able to be used in a tangible real-world financial transaction. Per the IRS: “the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.”

Because of these current IRS guidelines, state revenue departments have begun to take notice with many including California, Wisconsin and Kentucky mandating taxable products and/or services purchased with virtual currency is no different than any other commodity in terms of taxability. Any retailer selling a taxable good or service in any one of these three states is required to collect and remit sales tax based on the sales price in United States dollars.

Does this mean a person mining or exchanging Bitcoins must pay sales taxes in the above mentioned states? Only Wisconsin and Missouri, (which is interesting since the issue of sales tax being collected on Bitcoin transactions is still a bit murky,) have formally declared the actual sale of Bitcoins are not taxable since they are intangible. While all fifty states have begun to address the tax implications of Bitcoins and other different forms of digital money, only a handful at this time actually have set rules and regulations in place when addressing state sales tax.

The same IRS Notice 2014-21 addresses federal withholding tax requirements for employers, the fact that employees who are paid in Bitcoins must claim these earnings when filing year-end taxes and self-employed individuals are also required to count the value of this cyber-currency when filing their taxes as well. Again, if the federal government has regulations in place, it is only a matter of time before all 50 states follow suit.

Then for cities and counties where there is an additional sales tax on tangible goods and/or services, very few have at the present begun to tackle the challenges of collecting taxes on virtual currency. Either they have neither the manpower nor software in place or they believe Bitcoins are simply a passing fad. Unfortunately, as these municipalities take a “wait and see” attitude, they are ultimately losing legitimate income due to the fact the way most local tax laws are written, the form of currency is irrelevant.

Most experts all agree if Bitcoins do fail, some other form of cyber-currency will be waiting in the wings to take its place. As the entire world continues to make remarkable technologic advances, it is only logical that digital currency could easily one day change the financial footprint as we know it.