bitcoin isba v3
TRANSCRIPT
Bitcoin and Virtual Currencies:
Understanding What They Are and How They Are Taxed
Jonathan Morton
Di Monte & Lizak, LLC
216 Higgins Road
Park Ridge, IL 60068
847.698.9600
James Creech
Law Offices of James Creech
30 N LaSalle St Suite 2825
Chicago IL 60602
(312) 469-0883
Three Takeaways from
Today’s Presentation
• Bitcoin Is Misunderstood. Instead Of Seeing It As A
Currency It Should Be Thought Of As A Technology
• The Current Set Of IRS Rules Make Bitcoin
Unwieldy And Difficult To Use
• Bitcoin Misconceptions Will Make Audits And
Controversies More Difficult
What Is Bitcoin?
Simple Explanation:
bitcoin And Other Virtual
Currencies Are Internet Cash
The Following Companies
Accept bitcoin• Expedia - Discount Travel Website
• newegg.com - Electronics Retailer
• overstock.com - Clothing And Home Goods
• Dell - Computer Maker
• Microsoft Digital Content
• Sacramento Kings - NBA Team
In Addition To Being A Virtual
Currency Bitcoin Is Also A
Technology
Bitcoin The Technology
Is
A Globally Distributed
Transaction Database Where
The Order Of Transactions Is
Determined By Everyone
Simply Stated
Bitcoin Technology Is Decentralized
Trust
The Basic Rules Of Bitcoin Were
Created By The Original Code
• How Transactions Work
• The Rewards For Processing Transactions
• How Often Transactions Are Confirmed
• How Many Coins Are Available. This Is A Limited
Number That Is Released In Decreasing Amounts
As Rewards For Processing Transactions
Mechanics Of A Bitcoin Transaction
• There are three important parties in every bitcoin transaction. The
buyer, the seller, and the miner.
• Buyer and Seller each have a key.
• The Buyer has a private key which is equivalent to secure password for
the account that contains his bitcoins. The private key would look
like:18E14A7B6A307F426A94F8114701E7C8E774E7F9A47E2C2035D
B29A206321725
• The Seller has a public key which is equivalent to a bank account
number. This public key would look like:
3J98t1WpEZ73CNmQviecrnyiWrnqRhWNLy
• The Seller provides the Buyer with his public key and the Buyer enters
his private key and the amount of bitcoins to be transferred to the Seller
• The public and private keys are combined and published to the Bitcoin
network
• The Bitcoin network computes the transaction and orders it amongst
other bitcoin transactions using timestamp and a mathematical formula.
The network confirms that the Buyer owns enough coins to complete the
transaction based upon previous transfers and then uses a random
mathematical outcome to confirm the transaction. There are thousands
of computers all competing to solve the formula at the same time
• The first computer to solve the mathematical formula associated with the
transaction produces a Hash
• A Hash is a combination of the private key and the public key which
results is a new code such as:
D61967F63C7DD183914A4AE452C9F6AD5D462CE3D277798075B1076
15C1A8A30
• This code is a one directional code meaning you can see what the
Buyer’s and Seller’s keys are but you cannot alter the keys without
changing the Hash
• The individual computer publishes the Hash to the network. Other
computers verify the Hash is correct
• If the Hash is correct it goes into the blockchain. Every 10 minutes a
blockchain is updated and the transfer is complete
• The computer that correctly generated the Hash is rewarded with
new bitcoins. The number of bitcoins rewarded is based upon the
original bitcoin code and the number of bitcoins currently in existence
• This process of verifying transactions in exchange for new bitcoins is
called Mining
Anyone Who Is Interested Can
Search The Blockchain And Learn
The Time, The Amount Of The
Transfer, And The Keys That Are
Making The Transfer
The Only Thing The Public Does Not Know
Is Who Owns Bitcoin Keys Involved In The
Transaction
Bitcoin Transactions Are Anonymous
What Are The
Advantages Of Bitcoin
Technology?
• Transaction Fees
Anonymity
Minimal Equipment Is Needed To Access A
Bitcoin Based Financial System
Speed
Security
Ability to Do Business With Someone You
Don’t Trust
IRS Guidance Notice 2014-21
Notice 2014-21 Covers All
Virtual Currency Not Just bitcoin• What Is Virtual Currency For Tax Purposes?
• How Should bitcoin Gains Or Losses Be Treated?
• How Should Exchanges Of property For bitcoin Be Treated?
• What Are The Reporting Requirements?
• Withholding Requirements
• How Is Mining Treated?
• Penalties For Inconsistent Treatment
The IRS Considers bitcoin
To Be Property• bitcoins Are Not Currency For Tax Purposes
• Have To Use General Tax Principles From Property
And Barter Transactions To Determine Tax
Implications Of bitcoin Transactions. This Makes
Simple Transactions More Complicated And
Requires More Record Keeping
• Virtual Currencies Must Be Priced If There Is A
Taxable Event. However The Taxpayer May Do
This Valuation Using Any Reasonable Method
When We Have A Client With bitcoin
Gains Or Losses There Are A Minimum
Of Three Questions You Need To Ask:
How Did You Get The bitcoin?
How Long Have You Held It?
What Did You Get Upon Dispossession?
bitcoins Become More Complicated
When Exchanged For Services
• Notice 2014-21 Imposes The Same Withholding
Restrictions As Bartering For Services For Both
Independent Contractors And Employees
• If The Services For An Independent Contractor Are Over
$600 In bitcoin Converted To Dollar Terms The Payor Is
Responsible For Issuing A 1099
• If An Employee Is Paid In bitcoin The Employer Must
Issue A W-2 That Provides The Wages In Dollars. They
Must Withhold Income And Employment Taxes In Dollars
Bitcoin Mining
If A Taxpayer Owns A Computer That Verifies bitcoin
Transactions And Is Rewarded With bitcoins, The
bitcoins Are Immediately Considered Income
If The Mining Activities Are A Trade Or Business They
Owe Employment Taxes On That Income As Well
Common bitcoin
Situations
Hypo 1
Bill Is A Web Designer. He Prepares A
Website For Steve’s CPA Firm. Steve
Pays Him 2.775301 bitcoins (BTC) For
The Website On March 12. The Value
Of bitcoin On March 12 Was $500.
Hypo 1
Bill Has Income. His Income Is 2.775301
BTC x $500 Or $1387.65
Steve Has A Business Expense Of $1387.65
Steve May Also Have Capital Gains Based
Upon His BTC Basis
Hypo 1
Both Steve And Bill Need To Document The Transaction
More Extensively Than They Would If Steve Paid With A
Check
Steve Would Have To Substantiate How He Got His bitcoins,
How Long He Had Held Them, And Any Gain Or Loss That
Occurred Based Upon The Fair Market Value Of Bill’s
Services
Bill Would Have To Keep A Record Of What His Basis Is In
The bitcoin For A Future Transaction
Hypo 2
Sue Is Employed By An App Developer. The Developer Pays Her
In bitcoin. Sue’s Salary Is 160 BTC (Roughly $80,000 At $500
Per BTC) Per Year And She Gets Paid 6.15 BTC Every Two
Weeks. At The Start Of The Year BTC Is Worth $500 But It
Fluctuates During The Year. Sue Converts 4 BTC Into Dollars
Every Pay Period To Pay Bills. She Saves The Rest Because
She Is Planning On Quitting Next Year And Traveling The World.
Hypo 2
Sue’s Employer Requirements
Sue’s Employer Is Still Responsible For Sue’s Withholdings.
It Must Withhold Both Income And Employment Taxes For
The BTC It Pays Sue. These Withholdings Have To Be Paid
In US Dollars. The Employer Must Calculate The Wages It
Paid Sue In Dollars And Issue Sue A Dollar Based W-2
Hypo 2
Sue’s Impact - Income Tax
Sue Has Ordinary Income Based Upon The
Wages She Received From Her Employer. She Is
Responsible For Paying Tax On That Income
Based Upon The FMV Of The bitcoin She
Received. She Must Pay Her Taxes In Dollars
Hypo 2
Sue’s Impact - Converting BTC To Dollars
In Addition To Ordinary Income, Sue Also Has Gains And Losses
From Converting BTC To Dollars Based Upon The Volatility Of BTC
during her holding period.
For Example If Sue Is Paid 6.15 BTC On Friday. On Friday BTC has
A Value Of $500 Per BTC. By The Time She Converts 4 BTC To
Dollars On Tuesday, BTC Has Fallen To $440. Sue Has A $240 Short
Term Capital Loss.
When It Is Time To Go On Vacation 18 Months Later, Sue Converts
The Remaining 2.15 BTC To Dollars. During That Time BTC Has
Risen To $800. She Has A Long Term Capital Gain Of $645. She
Must Do This Calculation Separately For Every Pay Period.
Hypo 3
Ted Is A Computer Parts Vendor. He Buys And Resells
New And Used Computer Equipment Online. He
Purchases Six “Fast-Hash-One Platinum bitcoin Mining
Machines” Online. Ted Pays 12 BTC Each At $500 Per
bitcoin. Ted’s Basis In Each bitcoin Used To Buy The
Machines Is $300. He Then Immediately Resells Five Of
The Machines At 13 BTC At $530 Per bitcoin. Ted Keeps
One Machine And Uses It To Mine bitcoins.
Hypo 3
Ted’s Basis In Each Machine Is The Number Of BTC He Paid For
Each Machine Multiplied By The Exchange Rate Of BTC At The Time
Of The Purchase. Ted’s Basis In Each Of The Machines Is 12 x $500
Or $6000. He Sold Them For 13 x $530 Or $6890. Ted’s Ordinary
Income From The Sale Is $890 Per Machine Or $4450 For 5
Machines. In Addition To Ordinary Income, Ted Also Has A Capital
Gain From The Appreciation Of The bitcoin Used To Buy The
Machines. This Gain Would Be $200 Per BTC or $14,400 (12 BTC x 6
Machines x $200). His New Basis In The BTC received Is $530
When Ted Mines bitcoins With The Machine He Kept He Has Ordinary
Income When The bitcoin Is Mined. He May Owe Employment Taxes
If The Mining Activity Is More Than Just Sporadic
Bitcoin AuditsHow To Represent Your Client
Audits Of Clients With bitcoin
Gains And Losses Are Coming
• Prior To 2013 The Price Of bitcoin Was Not
Sufficient To Lure Speculators And Business Users.
• The Notoriety And Volatility Have Increased Number
Of Taxpayers Will Have Taxable bitcoin
Transactions
bitcoin Price Fluctuations
• In 2010 The Price Of bitcoin Was $.01, In 2012 The
Price Was $4.70. On January 1, 2013 The Price Was
$13.55
• On November 17, 2013 bitcoin Hit An All Time High
Of $1216.73
• The Price Of bitcoin Then Crashed To $340 In April,
2014 Only To Rebound To $650 In June Of 2014
• The Price Of bitcoin In Early January 2015 was $270
Before The Audit Begins
• Request The Client Provide You Will All
Documentation Relating To The Transactions
• Ask The Client To Go Into Their bitcoin Wallet And
Provide You With Their Public Key Information As
Well As Any Transaction Confirmation Messages
• Document What The Holding Periods Were For
Each bitcoin Transaction
During The Audit The First
Job Is Education• Demystify bitcoin And It’s Uses. Show The Auditor How
It Is Used For More Than Money Laundering And Buying
Illegal Items
• Explain How The Open Source Ledger Works And How
It Makes It Possible To Find The Date And Time The
Transfer Was Made.
• Show Them How To Look Up The Historical BTC To
Dollar Exchange Rate
• Have A Copy Of Notice 2014-21
The Message Should Be: bitcoin Is
New But It Is Transparent. We Can
Substantiate Everything Using
Publicly Available Information
Be A Resource To The Agent
You Will Most Likely Understand The Issue
And The Mechanics Better Than They Do