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Linden Dollars, Bitcoins, and the brave new (taxable) assets

It is a truism in the world of tax planning that dollars are fungible. That is, if I have two dollars in my wallet, there isn’t much between the dollar that I took out of the bank yesterday and a dollar that I took out of the bank today. If I use them to buy a cup of coffee, I don’t have to worry about whether one dollar was more valuable than the other dollar. Similarly, if I convert my US Dollars to Japanese Yen, I don’t necessarily have to worry about a recognizing gain because forms of money are freely exchangeable for other forms of money.

Assets, in comparison with money, have characteristics that are unique to that asset and that increase or decrease the value of that particular item relative to other items. The tax code, however, works in terms of dollars and the IRS has a dim view of unreported barter transactions. We know that a taxpayer’s gross income can come in many forms including money, property, or services. This was the basis for the IRS’s war during the 1970s on barter transactions. So, if I have a chicken and exchange that chicken for dental services, the IRS will say that the value of the chicken on the day that I exchanged it for dental services was $X and I exchanged it for $X of dental services. Depending on how I acquired the chicken and how long I had it, I might have to recognize gain on the disposition of the chicken. My dentist would have to recognize the receipt of income on that day in the amount of $X.

Several years ago, the tax community began to mull over the idea of virtual assets. The debates started with the online gaming community where players had items that they could transfer to other players. Eventually, players began to sell online items in real life (usually via online auction sites) for US Dollars. This implicated a lot of real-world tax questions – specifically, what is your basis in your virtual asset and when do you have a recognition transaction.

In May, 2013, the GAO released a report called “Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks.” This report distinguished between “Closed-flow” systems (where virtual assets, services, and currencies could not be exchanged for “real” assets, services, and currency) and “Open-flow” systems (where they can be exchanged). The report also noted “Hybrid” systems which would have elements of the other two systems. An example of a hybrid system would be a popular online game where you exchange real dollars for virtual goods – like buying a cow in a virtual farm. You can’t sell the cow for US Dollars, so the flow of dollars is entirely into the online platform.

The GAO and the IRS are particularly concerned about the recent rise of virtual, alternative currencies such as Bitcoin. Bitcoin is designed to exist as a substitute for government-backed currencies, such as the US Dollar or Japanese Yen. Bitcoins are initially generated by computer algorithms that “mine” for them. Merchants can accept Bitcoins in exchange for goods or services. However, similar to the tulip mania that captivated 17th Century Holland, investors have been purchasing bitcoins on the secondary market in the hopes that the currency will increase in value. Reputable financial publications were commenting on the investment potential of bitcoins.

On March 25, 2014, the IRS finally issued guidance on how it will tax virtual currency transactions. Notice 2014-21 states that virtual currency that has an equivalent value in “real” currency will be treated as property and not as currency. The general tax principles that apply to property transactions (like barter transactions) will apply to virtual currency transactions. So, if I have ten virtual coins and use them to purchase dental services in the real world, the IRS will look at what the dentist usually charges for those services in US Dollars ($X) and say that the fair market value of my ten virtual coins on that day is $X. My dentist would take a basis in the virtual coins of $X. Of course, if I traded my chicken (worth $Y) for the virtual coins for a month ago, the difference between the two is my gain on the transaction.

The IRS guidance also clarifies that the character of the gain or loss depends on the character of the currency in my hands. If I’m in the business of trading virtual currency, such currencies may be inventory in my hands.

The 1099 reporting rules apply, so if I pay someone with virtual currency worth, on the date of payment, more than $600, I have to issue them a IRS Form 1099-MISC. Similarly, the rules regarding self-created income and self-employment tax will apply to the first tier of virtual currency holders. So, if I mine bitcoins, I have to recognize the fair market value of the coins on the date that I receive them. That income will be subject to self-employment tax.

The March 25 IRS guidance is silent about the treatment of virtual currency for estate and gift tax purposes, but the lawyers of Samuels Yoelin Kantor, LLP have been advocating for clients to address disposition of virtual assets in their estate plan. The recent guidance suggests that, while some of these assets (e.g., passwords, online social networking profiles) may not be includable in your gross estate when you die because they have no economic value, other “Open-flow” assets might be includable. Similarly, if things that we don’t think of as having intrinsic value develop a market they may become a part of your taxable estate.