In essence, the IRS said that paying for goods or services in Bitcoin or some other virtual currency could result in a capital gain or loss. (IRS Notice 2014-21)
Here’s the whole story: Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. However, it does not have legal tender status in any jurisdiction.
Under the new ruling, virtual currency is treated as property for U.S. federal tax purposes. The same general tax principles that apply to property transactions also apply to transactions using virtual currency. Among other things, this means:
- Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2 and are subject to federal income tax withholding and payroll taxes.
- Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply. Normally, payers must issue Form 1099.
- The character of gain or loss from the later sale or exchange of the virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
- A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
The IRS has provided additional details in a set of 16 questions and answers.
Tax experts are still trying to wrap their heads around this concept. It would seem that a consumer who buys a $10 pizza pie with Bitcoin acquired for $8 would have to realize a $2 capital gain, while the restaurant must report $10 of taxable income.
Tip: Expect additional guidance from the IRS on this issue.