IRS Could Begin Taxing Bitcoin and Other Virtual Currencies

July 9, 2013 — 1 Comment

Virtual World Transactions (VWT) occur when there is a sale of goods or services and they are used exclusively in a virtual world. As participation in these virtual worlds increases, the boundary between virtual and real world transactions has started to get muddled.

According to Zachery Jones, member of the Yale Law Journal, “although IRS agents are not counting virtual earnings quite yet, they may begin to take notice of VWT on a broader scale if one of three events occur”:

  1. courts grant property rights to virtual world participants in the virtual items they amass;
  2. vendors begin accepting virtual items (such as virtual currency) on a regular basis in exchange for real goods and services; or
  3. Congress adopts legislation requiring owners of virtual worlds to report certain transactions to the IRS.

So, what are examples of virtual world currencies?

“In a closed-flow system, virtual tools amassed by players can be traded in a game for other in-game assets or to advance to higher play levels, but they hold no value outside of the game and cannot be cashed out for dollars or other government-issued currencies.”

An example of this is when one purchases items to use within an online game such as the ever popular, Farmville.

“In an open-flow system, a taxpayer who receives virtual currency as payment for real goods or services may have earned taxable income since the virtual currency can be exchanged for real goods or services or readily exchanged for government-issued currency, such as U.S. dollars.”

Second Life, a product of Linden Lab, has its own virtual world currency. Users create their own avatars and property, which they can then sell or rent to other residents. They can also use these Linden Dollars at the LindeX exchange, which uses third-party payment networks to process the payments. This allows residents to cash out of the Second Life world to convert into U.S. dollars.

Moreover, another virtual currency, Bitcoin is not government issued and does not have a physical coin or bill associated with its circulation, such as a Federal Reserve note.

Bitcoins act as a real-world currency in that users pay for real goods and services, such as coffee or web development services, with Bitcoins as opposed to U.S. dollars or other government-issued currencies. Third-party exchanges allow Bitcoin users to exchange their Bitcoins back to government-issued currencies, such as U.S. dollars, euro or yen.”

Here are a few examples of taxable situations:

  1. Davis is a Bitcoin miner. He successfully mines 25 Bitcoins. Davis may have earned taxable income from his mining activities.
  2. Ecobay makes T-shirts and sells them over the Internet. She sells a T-shirt to Davis, who pays her with Bitcoins. Ecobay may have earned taxable income from the sale of the T-shirt.

Will these open flow currency systems ever be taxed?

In June, the Government Accountability Office (GAO) said that the IRS could do more to provide basic, informal information to taxpayers about how their online activities could result in a real-world tax bill.

The GAO also noted in its report that many virtual currency users were not trying to evade taxes but instead, they did not realize that they had tax liability tied to their virtual activity. If they did know about the liabilities, many remained unsure on how to calculate or characterize the respective taxes.

“The IRS has not provided taxpayers with information specific to virtual currencies because of other priorities, resource constraints, and the need to consider the use of these recently-developed currencies, according to IRS officials. By not issuing guidance, IRS may be missing an opportunity to discuss virtual currency tax compliance risks,” GAO stated in it’s virtual currency report.

The IRS’ response…

“The Service is aware of the potential tax compliance risks posed by off-shore and anonymous electronic payment systems, and we are working to address these risks,” wrote former IRS acting commissioner Steven T. Miller in a May 3 response to the report.

“Our efforts have included discussions with other federal agencies, evaluating our agents’ expertise, developing continuing professional education curricula, proving online and classroom training, and creating lead sheets and questionnaires for agent use during examinations. We agree that providing taxpayers with information on the basic tax reporting requirements for transactions involving virtual currencies could further aid our efforts.”

My question then becomes… will the GAO and IRS start federally mandating income taxes from all garage and yard sales too?

JDKatz: Attorney's At Law

JDKatz, P.C. is a full-service law firm focused on tax law and estate planning. We are dedicated to minimizing your existing liability and risks while providing valuable tax planning to streamline your tax issues in the future. Please call us at 301-913-2948 to schedule an appointment to meet with one of our trusted attorneys.

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