As tax time approaches for many, taxpayers and tax professionals alike are engaging in the annual ritual of gathering their cryptocurrency transactions and seeking out the latest and greatest guidance from the IRS on the subject. As luck would have it, the IRS recently released an internal memorandum fleshing out its stance on the taxation of virtual currency received in exchange for providing services. The memorandum describes the taxation of virtual currency received in the “crowdsourcing labor market”—for example, for performing microtasks or other projects—but its principles are applicable much more broadly.
The IRS memorandum was quietly made public on August 28. It is a reminder that the IRS continues to receive requests for additional cryptocurrency tax guidance. In the memorandum, the IRS lays out its view that convertible virtual currency is “property” for federal tax purposes, and that its receipt in exchange for performing services gives rise to gross income. But let’s look a little deeper at the IRS’s reasoning.
For tax purposes, the IRS defines “virtual currency” as a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value other than a representation of the U.S. dollar or a foreign currency. Cryptocurrency—a type of virtual currency—uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Virtual currency that has an equivalent value in real currency, or that functions as a substitute for real currency (Bitcoin is the most prominent example), is treated as “convertible” virtual currency and is considered “property” for federal income tax purposes. As such, transactions involving convertible virtual currency are subject to the same general tax principles that apply to transactions involving property.
Those general principles include the fundamental general rule under section 61 of the Internal Revenue Code: Gross income includes all income from whatever source derived. The concept of gross income, as used in section 61, has a broad scope indeed. As the Supreme Court held more than a half century ago in the seminal case of Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955), it generally includes all gains or accessions to wealth, clearly realized, and over which a taxpayer has complete dominion.
When it comes to performing services, compensation is subject to taxation whether it is received in the form of currency, property, or any other thing of value. If property is transferred to a person for performing a service, the fair market value of the property (less the amount, if any, paid for the property) is included as gross income to the service provider when that person obtains a right to the property that substantially vests. Such income is generally treated as ordinary income. These general rules, according to the IRS, all apply to income received in the form of cryptocurrency. So when an individual performs a service and is paid with Bitcoin, they have gross income.
A taxpayer who receives virtual currency for providing services as an independent contractor will generally be subject to self-employment tax. Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on in a capacity other than as an employee. As a result, the fair market value of virtual currency received for services performed as an independent contractor is self-employment income and is subject to the self-employment tax.
Likewise, if an employer pays wages in the form of virtual currency, that payment is subject to Federal income tax withholding, Federal Insurance Contributions Act (FICA tax), and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage, and Tax Statement. In other words, it makes no difference that the payment is made in the form of virtual currency—it is still “wages” for employment tax purposes.
When a taxpayer sells their virtual currency, the taxpayer is generally required to recognize any capital gain or loss on the sale, subject to any limitations on the deductibility of capital losses. Of course, while most transactions involving the sale or disposition of virtual currency will give rise to capital gain or loss, such transactions may produce “ordinary” income or loss where the virtual currency is held for purposes that give rise to ordinary income treatment. Taxpayers with unanswered questions about the tax treatment of cryptocurrency should consult their tax professional. Resources such as frequently asked questions and other IRS guidance will likely continue to evolve as the IRS seeks to keep pace with technology and advancements in the cryptocurrency space.