Treasury addresses skyrocketing “underground” virtual currency—IRS to follow?

From:  Yahoo Group

Bitcoin, an alternative virtual currency, has been making headlines for its apparent exponential increase in value while the rest of the economy is still slowly recovering. With its cumulative value reported as high as $1.5 billion, Bitcoin has been the recent subject of FinCEN guidance, and if its momentum continues, it may well have to be addressed by IRS as well. Although the main tax concepts appear fairly straightforward, enforcement could prove to be tricky.

Background on Bitcoin. Bitcoins are a peer-to-peer virtual currency created by a complex process called “mining.” There are currently around 11 million Bitcoins in existence, and Bitcoin mining will end once a finite number (21 million) of Bitcoins have been created.

Although not mainstream, Bitcoins are accepted by certain businesses and individuals as currency in purchasing goods and as payment for services. They are essentially an unregulated and untraceable currency, and the lack of bank and government involvement, as well as the anonymity, are seen by many as a selling point of Bitcoins.

The value of Bitcoin has skyrocketed recently. Many attribute this in part to the financial instability in Cyprus—that some Europeans view the digital currency as safer and more stable than their own. The creator of Bitcoin has said of the currency that it's “completely decentralized, with no trusted parties” (i.e., no trust in the government not to devalue the currency, and no trust in banking institutions to keep your money safe).

Another aspect of Bitcoins that some may find appealing is their ability to be anonymously transferred on an international basis.

FinCEN Guidance. Treasury's Financial Crimes Enforcement Network (FinCEN) issued guidance on Mar. 18, 2013, clarifying the applicability of the Bank Secrecy Act regs to virtual currency users. Although the guidance doesn't specifically mention Bitcoin, it is seen as largely targeting it.

FinCEN's guidance, as applied to Bitcoin users, says that:

• A Bitcoin “miner” (described in the release as “a person that creates units of this convertible virtual currency”) that uses it to purchase “real or virtual goods and services” isn't subject to regulation as a money transmitter.
• However, a Bitcoin miner that sells Bitcoins to another person for “real currency or its equivalent” is a money transmitter and accordingly is subject to regulation and must acquire a money transmitter license.
• A person that accepts Bitcoins from one person and transmits them to another, “as part of the acceptance and transfer of currency, funds, or other value that substitutes for currency,” is both a money transmitter and an exchanger.

Tax law implications. In general, the tax law implications of Bitcoin appear to be relatively straightforward:

• Under Code Sec. 61, gross income includes all income, from whatever source derived. This broad definition is generally interpreted to include all accessions to wealth, and exclusions from income are narrowly construed. (Commissioner v. Schleier, (Sup Ct 1995) 75 AFTR 2d 95-2675)
• Under Code Sec. 1001, gain from the sale or other disposition of property is the excess of the amount realized over adjusted basis, and loss is the excess of the adjusted basis over the amount realized. With some exceptions, gain or loss realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income or as loss sustained. Capital gain results from the sale or exchange of a capital asset, which is broadly defined (with listed exceptions) in Code Sec. 1221 as property held by the taxpayer, whether or not connected with his trade or business.

So, applying these general principles, people who provide services or sell goods in exchange for Bitcoins would have income under Code Sec. 61, and those who exchange their Bitcoins for cash would realize gains to the extent of any appreciation (short or long-term). The capital gain treatment of Bitcoins generally follows the logic of those who argue that Bitcoin behaves more like a commodity than a currency, pointing to its volatility and the fact that people could be converting traditional currency into Bitcoin with an intent to make a profit rather than to spend it.

There are a few less clear areas, including the tax implications of “mining” a Bitcoin and the effect of dealing with it on an international basis.

IRS next? If Bitcoin continues its current momentum, IRS may, like FinCEN, be forced to address the issue. However, given the traceability and anonymity inherent in Bitcoin transactions, and the extreme fluctuations in value, cracking down on Bitcoin could prove difficult.

Many observe that the current fascination with Bitcoin will likely have an inevitable “bubble” effect, so the actual financial imprint of Bitcoin could become less significant over time (or overnight). However, it is also argued that, regardless of whether Bitcoin itself ultimately survives, it has established a model which will no doubt shape future transactions

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