As technology gives us new ways to earn money and spend it, it’s only logical that new forms of currency will be created as well. Since 2008, digital currency known as altcoins or cryptocurrency has been on the rise. The undisputed leader in this market is Bitcoin.
This new digital currency poses a unique challenge for accountants and tax preparers. It’s one more thing that must be accounted for when you’re filing taxes for clients, but altcoins aren’t as clear-cut as other income and assets.
Financial professionals who are interested in looking out for their clients’ best interest should become familiar with the way cryptocurrency works, especially when dealing with investment options like Bitcoin mining.
How Are Altcoins Used?
Altcoins are exchanged through online transactions only since they are strictly stored in virtual wallets. However, altcoins can be used in a number of ways. They can be:
- Used to make peer-to-peer, consumer-to-business and B2B transactions for goods and services.
- Exchanged for any type of legal tender.
- Traded on exchanges.
Transactions over the Bitcoin network are verified by “miners” who check the authenticity by collecting data, confirming the accuracy and notating it on a general ledger.
How Are Bitcoins Mined?
Because Bitcoin is the most widely used cryptocurrency, it helps if accountants and tax preparers know how to mine Bitcoin and the basic concepts behind their generation. It’s also important to know because some people earn income by “mining” bitcoins.
Bitcoin transactions are contained in boxes that are sealed with a virtual lock. Miners are people who use computer software or a cloud service to locate the key to the virtual lock and examine data sequences of transactions known as “blocks”. Using mathematical equations, miners are able to shorten the sequence into what’s called a “hash”. Blocks are built on the hashes that were created before it. The system helps to verify the accuracy of transactions.
Once the box is unlocked and the transaction is verified the miner receives bitcoins for their efforts.
Calculating the Value of Bitcoins
One of the difficulties of notating bitcoins on taxes is determining the value. Cryptocurrency values fluctuate frequently, and each one has a unique valuation. Accurately calculating the cost of bitcoin for your clients is absolutely necessary.
There are two ways to value bitcoins when reporting taxes:
- You can convert bitcoins to U.S. dollars for each transaction (purchases and sales) using the Bitcoin market price for that day.
- The other option is to use Bitcoin as a functional currency, then use the average Bitcoin vs. U.S. dollar conversion rate for the current tax year.
IRS Guidelines for Taxing Bitcoin
Although Bitcoin and other altcoins aren’t issued by a government or official entity, they are recognized as a form of currency that can be earned and exchanged. In 2014 the Internal Revenue Service issued a notice with official virtual currency guidance.
The first thing that all financial professionals should know is that the Internal Revenue Service (IRS) considers Bitcoin and other convertible virtual currencies to be “intangible property”, not currency. The tax principles that generally apply to property transactions also apply to transactions involving virtual currency.
If employees are paid with virtual currency those wages are subject to payroll taxes and federal income tax withholding and must be reported on a W-2. Bitcoin miners must also report the virtual currency that they earn as income. The income should be based on the market dollar value of bitcoins on the day they’re earned. Virtual currency paid to service providers and independent contractors should be recorded on a 1099 form. The payments are taxable and subject to self-employment taxes.
Capital gains and losses from trading altcoins must also be reported on taxes using the realization method. Each transaction should be accounted for on the tax forms whether or not funds are repatriated back to the U.S. The process if very similar to handling a foreign-based brokerage account that consists primarily of foreign currency.
This is a new financial situation that will likely continue to increase in the coming years. If you have questions that aren’t answered in the tax guidelines, protect your client’s by contacting the IRS for additional information.