Insights: Article

Bitcoin—What Should You Know

January 25, 2018

Glowing bitcoin signs on dark background

Technology—it shapes our lives in new and exciting ways, even if we aren’t aware it is happening.

You have probably heard the term Bitcoin and all the media buzz about this new technological evolution of currency, but you may not understand the clamor. Supporters of Bitcoin, particularly the millennial generation that is accustomed to electronic transactions, will tell you it’s a different, some would say better, type of currency, and it’s unique in that it has no physical form, just a digital one. Cryptocurrency, also referred to as virtual currency, is just what it sounds like: digital money, but with one basic difference from the dollars and coins residing in your pocket. While the value of Cryptocurrency may go up or down, that value exists solely with the people that create it and those that accept it as a replacement to the more recognized forms of payment.

Bitcoin is one of the most popular forms of virtual currency, and the only one most people recognize. But it would probably surprise you to know that there are more than 1,000 other cryptocurrencies in circulation.

About Bitcoin
Bitcoin was developed in 2009 by an unknown programmer under the alias Satoshi Nakamoto.

While tangible money is minted or printed, a Bitcoin has no physical form. As provided by the Bitcoin cryptocurrency system, it is produced virtually through what is called a “mining” process; a process in which computers solve intricate math problems and are rewarded (well, really the individuals that assist the computers) with one or more Bitcoin for the correct solution. But, the supply of Bitcoin has been limited from the beginning. Under the Bitcoin cryptocurrency system, only 21 million Bitcoin are available to be mined, and it is said that more than 15 million Bitcoin are already in circulation. That leaves only 6 million more to be mined. This definitive number of available Bitcoin seems to give Bitcoin owners comfort in supporting Bitcoin value, but the recent volatility in value might say otherwise.

Once mined, Bitcoin can be used just like any currency so long as it’s accepted—to pay for goods/services or for investing—except its primary function is for use online, and the transactions are often done anonymously. According to the IRS, cryptocurrencies such as Bitcoin are classified as “a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” It’s important to note that at this point in time, cryptocurency, including Bitcoin, has legal tender status in extremely few governmental jurisdictions. The U.S. is not one of them, and Bitcoin has no central banking system. However, Bitcoin does fall into the category of “convertible virtual currency,” which is a form of virtual currency that can be purchased in or exchanged into real, tangible U.S. dollars.

Bitcoin Mining Example
The details of Bitcoin mining are fairly complicated, involving hash functions and checksums, and other terms the common person may not understand. Basically, when a complex mathematical function is solved correctly by Computer A, the owner of Computer A is awarded X amount of Bitcoin. The benefit to the Bitcoin community is the solution of the math problem. These problems act as security checks to help prevent Bitcoin fraud and improve transactions. And, once Bitcoins are produced through the mining process, they can be used in the market, which moves the Bitcoins into the potential hands of the general public for use as wages, for purchases, for conversion to real cash, or to be traded on an exchange or for other services or goods.

In the beginning of cryptocurrencies, the primary problem centered around how to create, hold and transfer the cryptocurrencies. Because there is no central banking system for Bitcoin or other cryptocurrencies, the digital footprint for these virtual currencies is recorded in a virtual digital wallet. Entities were then formed to act much like banks, but without the regulations and oversight, to assist in the one-on-one cryptocurrency transactions and to create historical records of those transactions. Most times the exchanges worked, but other times they did not and some were forced out of the marketplace.

Creating Value
If this sounds complicated, it is. But remember that for cryptocurrencies to work as envisioned, the process requires a key element—acceptance of value.

First, there is the value received by the Bitcoin miner. The Bitcoin miner has traded time and resources for a certain number of Bitcoin. In that process, a value has been established. Next the Bitcoin miner needs to turn the Bitcoin into something they want or need, which too has a value to those that will provide the service or good to be sold. So once again, the acceptance of value of the Bitcoin becomes a requirement of the process. With the recent recognized exchange trading classification of Bitcoin, valuation has become much less complicated, but other cryptocurrencies will still need to make a separate determination of value.

It should also be noted that the acceptance of Bitcoin is on the rise. Established mainline businesses like Microsoft are accepting Bitcoin for certain transactions. And also pointing to more widely recognized acceptance of Bitcoin is the establishment of ATMs in various foreign capitals (most of the activity in the use of Bitcoin is still foreign-based) that are designed to exchange Bitcoin for what we might call real cash.

While Bitcoin has been receiving more acceptance in a wide array of financial transactions because of the ability of anonymous use, Bitcoin has been linked to drug dealing, money laundering and other large-dollar money transfers for cross-border transactions. Therefore, it’s not unusual for a certain degree of interest to be generated within governmental agencies when large Bitcoin transactions are involved.

Taxation in General
The IRS says that Bitcoin is to be treated as property for federal tax purposes. This means that the same general tax principles that apply to property transactions will apply to any transaction involving cryptocurrencies. Under these principles, taxpayers receiving Bitcoin in exchange for providing goods or services will recognize income equal to the fair market value of the Bitcoin received on the date of receipt. With the volatility of Bitcoin over the last few years, and particularly the last few months, this could indicate a very wide range of values.

Taxpayers must document the cyrptocurrency’s fair market value (in dollars, if a U.S. taxpayer) at the time of receipt, as this value establishes both the taxpayer’s income on the transaction as well as the taxpayer’s basis in the cryptocurrency that will be used to determine the taxpayer’s future gain or loss when the virtual currency is disposed or used.

If a taxpayer mines Bitcoin or other virtual currency as a trade or business, and the mining is not done as an employee, the net earnings from this mining will be subject to self-employment tax. And, any independent contractor who is paid in virtual currency for their services will be subject to self-employment tax on the cryptocurrency’s fair market value as well. In addition, if a company pays its employees’ wages in virtual currency, the fair market value of said wages will be subject to the usual federal income tax withholding, and will need to be reported on their W-2. Note that all of those U.S. taxes due will be paid in U.S. dollars—the IRS does not accept Bitcoin or other cryptocurrencies.

Since cryptocurrencies are not classified as currency for U.S. tax purposes, international taxation can add another layer of complexity. 

Bitcoin is still a fairly new technology, which means tax treatment of virtual currency transactions is still being developed. However, with the increase in use and established values, it is likely to gain more interest from the IRS. We will have more articles exploring the various aspects of taxation when using Bitcoin or other cryptocurrencies, as well.

If you have questions about how to remain in compliance when dealing in virtual currency, contact your Eide Bailly professional, or a member of our National Tax Office team for more information.