Tax & Accounting News

Bitcoin Transactions Coming Under IRS Scrutiny

1/2/2017

The Internal Revenue Service has recently served what is known as a “John Doe” summons on Coinbase, the country’s largest bitcoin exchange firm, in an effort to gain information and documents about its customer transactions. The summons is a reflection of the tremendous growth in the number of organizations and individuals who are using virtual currency in both business transactions and investment, and the agency’s concern about how the virtual currency market may be skirting its tax obligations.

The John Doe summons is allowable under the Internal Revenue Code specifically for situations in which the agency needs a way to find information for all of the taxpayers who may be in a certain category: examples of the groups that they may be looking for are all of a financial institution’s account holders, or all of those who are involved in a specific type of tax shelter or who own certain tax-exempt bonds. Unlike situations in which the IRS needs information about a known and specific taxpayer, when a John Doe summons is needed the agency needs to obtain approval from the federal courts. In the case of the recent summons, the agency is looking for the specifics on all of Coinbase’s customer transactions between 2013 and 2015.

A bitcoin is a type of virtual currency – in fact, with Bitcoin representing more than 80% of all virtual currency in use, it is clearly the most popular of these digital units of exchange. Still, there are approximately 250 different types of virtual currency that are currently being used, and according to the government Accountability Office, virtual currencies are not backed by any government as tender. The use of bitcoins has grown dramatically in the last few years, increasing from roughly 11.2 million in May of 2013 to 15.4 million in April 2016. Perhaps an even greater reflection of the increased usage of digital currency is better reflected in the number of transactions, which in the same period of time grew from under 60,000 to over 220,000.

Bitcoins have a value that is tracked on an exchange rate, just as other types of currency are. The currency conversion site Oanda.com includes bitcoins’ exchange rate on their site, and as of December 1, 2016 the bitcoin’s total market value was over $12 billion, and each individual bitcoin value was approximately $744.

What is most important to the IRS regarding bitcoin is its tax treatment: according to Notice 2014-21, virtual currency is property, and therefore is to be treated in the same way as any other exchange involving property. Any trading of bitcoins is viewed in the same way as capital asset sales are, and if employees or contractors are paid using bitcoin or other virtual currencies, those payments are still subject to both W-2 or 1099 reporting and withholding. In this way, they are no different from being paid in wages. Employees have to report the on their 1040s and independent contractors have to include them on their business return and pay quarterly estimated taxes on them.

What is most important to you as a taxpayer is what happens if you fail to report transactions that use virtual currency. Just as is the case with being paid in cash, if you fail to report income or capital asset sales, you face significant penalties. Examples of the potential penalties are:

Fraud – 75% of the taxes that were due
Negligence – 20% of the taxes that were underpaid
$260 per return for each failure to file information
The underpayment is subject to statutory interest

And of course, you will still have to pay the original tax that you owed. With the Internal Revenue Service beginning to take action to track and identify digital currency transactions, it is in your best interest to do the right thing and report and pay taxes on your bitcoin earnings.

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Jorge Gomez

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As an economist, management accountant, and certified tax planner, I draw on over 20 years of experience supporting small businesses with their tax and accounting needs. I’ve made it my mission to help my clients have access to financial capital while building and maintaining healthy accounting systems to achieve tax compliance and savings. I specialize in working with distribution, wholesale, franchise, and manufacturing businesses while offering a focused approach to saving them money while

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