Reporting virtual-currency payments: Taxation of virtual currency, part III

Dec. 10, 2014

by Elizabeth Prehn

When it comes to bitcoins and other convertible virtual assets, anonymity may not be all it’s cracked up to be. For one thing, an underlying assumption is that individuals who keep their financial transactions hidden have something illegal to hide.

Earlier this year, for instance, in Brisbane, Australia, a bitcoin ATM owned by a local café was seized by the authorities as part of a drug investigation -- apparently the "Bandidos Bikie Gang" was using the café in a multimillion-dollar methamphetamine trafficking network.

IRS Notice 2014-21 now makes it a requirement to report all convertible virtual currency payments.

Part I of this series on taxes and virtual currency, "It's not money," dealt with calculating gains or losses, as well as tracking basis and sales value. Part II, "Taxing virtual-currency income," addressed wages, self-employment income and income as a result of mining. In this third and final installment of the series, I'll hit on the basics of reporting virtual-currency payments, the penalties, and other tax-related trends to be on the watch for.

Reporting virtual currency

Payment received in the form of convertible virtual currency is now subject to federal income tax withholding, payroll taxes, and information reporting to the same extent as payment earned in any other manner.

  • Payments made to an independent contractor in convertible virtual currency worth $600 or more must be reported on Form 1099-MISC.
  • If a taxpayer identification number has not been obtained from the taxpayer, the payor must withhold "backup withholding."
  • Third-party settlement organizations (TPSOs) are required to report payments to a merchant on Form 1099-K if the number of payments to that merchant exceed 200 in a calendar year and the gross amount of payments exceeds $20,000.

The amount reported should be the fair market value of the virtual currency (in U.S. dollars) on the date of payment.

Penalties for noncompliance

Taxpayers who have failed to pay tax or file an information return regarding their convertible virtual currency transactions prior to the date of the IRS guidelines (March 25, 2014) may be subject to penalties under Internal Revenue Code section 6662.

Relief, however, is available to taxpayers who can show “reasonable cause” for their underpayment or failure to properly file their returns.

The intent here appears to be a warning to traders and virtual currency businesses to heed their income-tax responsibilities.

On the horizon

There is no such thing as the anonymity of convertible virtual currency transactions. Since your virtual currency holdings are not FDIC-insured, you should at least know and trust the people you work with. As with any business, those that deal in virtual currency need a certain level of professional recognition to build their reputation, something that client anonymity cannot provide.

Further, online exchanges may be forced at some point to report their clients’ accounts, as do banks and brokerage firms; these exchanges may eventually be classified as financial institutions for purposes of FATCA reporting.

In addition, by classifying convertible virtual currency as property, IRS Notice 2014-21 may lead to a situation in which cities and states demand that sales tax be applied to virtual-currency transactions. All we know at this point is that the IRS has finally taken notice of virtual currencies -- and you should as well.

Elizabeth E. Prehn is the Firm Administrator at Moskowitz LLP, a San Francisco-based tax law firm that covers the full spectrum of tax law for individual and business needs. Founder and Senior Partner Stephen M. Moskowitz has been a professor of law, tax and accounting at the Golden Gate University School of Law, the University of San Francisco School of Law and San Francisco State University. 

Topics: Bitcoin, Convertible Virtual Currencies, Regulation, Taxes

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