Photo

Bitcoin is a digital representation of value, not a real currency, according to the latest pronouncement from the Internal Revenue Service.

The I.R.S. on Tuesday released guidance indicating that Bitcoins and other so-called virtual currencies that do not have the status of legal tender in any jurisdiction would be treated as property, not currency, for tax purposes. The guidance also indicates that Bitcoin transactions are subject to the same information reporting and withholding requirements as similar transactions in dollars.

There were “no real surprises” in the guidance, according to Omri Marian, a University of Florida law professor who has written about the potential for Bitcoin to be used to evade taxes. The I.R.S. guidance follows similar action by taxation authorities in Japan, Canada and Australia.

Until Tuesday, Bitcoin users have been forced to speculate about the proper tax treatment of actions such as mining Bitcoins, performing services in exchange for Bitcoins, or buying and selling items denominated in Bitcoins.

While most tax experts agreed that such transactions were taxable, it was unclear if the Bitcoins themselves, once acquired, were capital assets. The I.R.S. guidance, Notice 2014-21, sensibly takes the position that Bitcoin is property, not currency, for tax purposes. Investors who buy Bitcoins can treat those Bitcoins as capital assets, potentially qualifying for the lower tax rate applicable to certain capital gains.

Video

Gains or losses in foreign currency transactions generally give rise to ordinary income or loss under section 988 of the Internal Revenue Code.

Neither the tax code nor the I.R.S. guidance defines the term “currency,” although one can perhaps infer its meaning to be fiat currency accepted as legal tender in a country or jurisdiction. Transactions in foreign currency normally generate ordinary income or loss, not capital gains or losses. For instance, if you buy euros today for $100 and sell them a year from now for $120, you have $20 of ordinary income, even if you were holding the euros for investment purposes.

The guidance is important to prevent whipsaw. In the absence of guidance, taxpayers holding Bitcoins for investment purposes might report capital gains if they appreciate, but ordinary losses if they depreciate. The I.R.S. guidance requires taxpayers to use one method or the other, depending on their trade or business.

A few opportunities for gamesmanship remain. Determining the value of a Bitcoin is more subjective than determining the value of a foreign currency. Taxpayers are supposed to convert the value of Bitcoin into dollars by looking up the exchange rate at the time of their transactions.

But the Bitcoin market is not as stable and efficient as the market for foreign currencies. Different online exchanges list different prices. While the I.R.S. says that Bitcoin users are expected to make conversion calculations in a “reasonable manner that is consistently applied,” aggressive taxpayers might shade values in their favor for tax purposes.

From a business perspective, the most important aspect of the guidance may be buried in the plumbing. Payments made using virtual currency are now clearly subject to the same information and backup withholding requirements as other property transactions.

Suppose you are self-employed, and you hire a virtual assistant in the Philippines to help manage your administrative tasks, and that person accepts payment in Bitcoin. Under the I.R.S. guidance, you have to obtain a taxpayer identification number from the assistant, just as if you were paying the person in dollars.

To the extent that Bitcoin’s success depends on anonymity and on avoiding the burden of government regulation, this I.R.S. guidance is an unwelcome blow. Bitcoin users are not accustomed to telling their counterparties who they are, let alone what their Social Security number is.

While some people may choose to ignore the I.R.S. guidance, more established digital economy merchants (like Etsy and eBay vendors) and settlement systems (like PayPal) will tend to comply.

Bitcoin cannot thrive in the underground economy alone, and unless its users pay taxes like other grown-ups, the I.R.S. guidance virtually ensures that it will be a passing fad.