Virtual-currency taxation, part II: Taxing virtual-currency income
by Elizabeth E. Prehn, Firm Administrator at Moskowitz LLP
In Part Iof this series, we discussed the IRS guidelines on the taxation of gains and losses associated with convertible virtual currency. Here, we'll focus on the taxation of income -- wages, self-employment income and income from the mining of virtual currency.
James Howells of the UK began mining bitcoins in 2009, when the pastime of creating virtual currency by having your computer solve mathematic problems was done exclusively by tech geeks and the value was minimal. A few years later, Howells cleaned house and threw away an old computer with a digital store of 7,500 Bitcoins. In November 2013, he realized that those bitcoins were worth $7.5 million. With no backup, the only way of retrieving the Bitcoins was to go through 25,000 cubic meters of waste and earth at the nearby landfill -- an obviously hopeless task.
Today, a growing number of US taxpayers are now earning in bitcoins and other convertible virtual currency, and IRS Notice 2014-21 provides guidelines on how this income is treated for income-tax purposes. In sum, income in the form of convertible virtual currency is treated no differently than income received in more traditional ways:
- Wages: Employees paid in virtual currency must pay taxes on their earnings, at the fair market value on the date of payment. This income is subject to federal income tax withholding and payroll taxes. The wages must be reported by the taxpayer's employer on Form W-2.
- Self-employment Income: Virtual currency received for services performed as an independent contractor are subject to the self-employment tax. This self-employment tax is imposed on the fair market value of the income as of the date of receipt (measured in U.S. dollars). Payers must issue a Form 1099 to the taxpayer for the annual payment of more than six hundred dollars when the payment is incurred as an ordinary and necessary expense of the payor's business.
- Mining virtual currency:If a taxpayer generates new bitcoins or other convertible virtual currency, the fair market value of that virtual currency on the date of receipt is includible in the taxpayer's gross income. If the taxpayer mines virtual currency as their trade or business, and the taxpayer is not mining as an employee, the taxpayer's gross income from mining (less allowable deductions) is considered self-employment income and is subject to self-employment tax.
Looking to the not-so-distant future
San Francisco’s first Bitcoin Teller Machine (BTM) was installed this past September at the Workshop Cafe on Montgomery Street, not far from our firm's offices. The BTM allows users to convert their bitcoins to cash (and get a great cup of coffee in the process). We will be keeping a close eye on how the new tax guidance affects the bitcoin and other convertible virtual-currency markets, and whether bitcoin will proceed to develop as a form of "currency" for ordinary transactions. In the meantime, keep track of your virtual currency -- and please don’t throw it out.
In Part III of this series, I'll address reporting requirements for employees, employers, independent contractors, and third-party settlement organizations, as well as the penalties for noncompliance.
Elizabeth E. Prehn is the Firm Administrator atMoskowitz 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.