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IRS: Mined Bitcoins are Taxable

March 25th, 2014 2 comments

Let’s applaud the Internal Revenue Service for issuing fresh guidance on the agency’s application of the tax law to virtual currencies.

I was nodding along until reaching the discussion of “mining” virtual currency:

When a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.

You’ll be taxed upon the creation of bitcoin, says the IRS. Mining bitcoins is a reward in exchange for providing services required to operate the bitcoin payment network.

Taxing fiat currency when received in exchange for providing services is a fundamental principle of U.S. taxation. But here, the IRS has explicitly said that bitcoin is property, and not foreign currency, under the tax code.

If I receive property, such as a car, in exchange for providing legal services, I have to pay tax on the fair market value of the car upon receipt.

But what if I build a car for people to drive? When would I have to pay tax on that? Not until I sell or exchange it.

The sale or exchange moment is formally known as a “realization” event under the tax code. There is no taxable income without a realization event.

There is no realization event when I merely produce a car for resale. And I’d argue that there may be no realization event when I produce bitcoins from mining.

That’s why I think the IRS may have gotten it wrong: Mined bitcoins shouldn’t be taxable until they are traded on an exchange or exchanged for other property or services.

According to blockchain.info, approximately 1,371,425 bitcoins have been mined within the last year. Assume a conservative average exchange rate of $250 per bitcoin over the past year. If all mined bitcoins are subject to U.S. income tax (they’re not), that’s $342 million of potentially taxable income.

A big win for the U.S. Treasury this round.

(Thanks to William Lewis for bringing this to my attention.)

Categories: IRS, Virtual Currency Tags: ,

GAO: Bitcoin Presents Tax Compliance Risks

June 27th, 2013 4 comments

Last month, the U.S. Government Accountability Office (GAO) issued a report to the U.S. Senate Committee on Finance titled Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks.

I first learned of the report in a piece from Accounting Today. Before going into the GAO report, though, I must comment on how the title to the Accounting Today piece, “IRS Could Begin Taxing Bitcoin and Other Virtual Currencies,” is misleading.

The Internal Revenue Service does not make tax laws. Instead, it enforces them, and promulgates regulations and issues guidance based on interpretations of the Internal Revenue Code. In fact, even the GAO report notes that “IRS must implement the laws Congress enacts through detailed guidance.”

So we shouldn’t say the IRS may decide whether or not to tax Bitcoin. Either transactions involving Bitcoin are taxable under the Internal Revenue Code or they are not.

Of course, the IRS can issue guidance on how it will treat various types of Bitcoin transactions under the IRC. Perhaps the title of the Accounting Today piece meant to convey that the IRS may look to issue such guidance. Even if we see IRS guidance, it doesn’t mean the IRS view is absolute, of course, as it can be challenged in court.

Back to the GAO report. It emphasizes two points in particular several times:

  1. Transactions involving virtual currencies may be taxable.
  2. The likelihood of taxpayer noncompliance regarding such transactions is high because of the lack of guidance on these issues.

The report defines virtual currency as a digital unit of exchange that is not backed by a government-issued legal tender. In virtual worlds, there are “closed-flow” transactions, “open-flow” transactions, and hybrid transactions.

Transactions in closed-flow virtual currency systems don’t generate taxable income because the virtual currency has no value outside of the system. Simple as that.

In the middle of the road hybrid virtual currency system, some of the flow between the virtual currency and items outside the system is closed, but there is a (third-party) exchange allowing users to exchange virtual goods for real money.

Example: In the multiplayer online-role playing game World of Warcraft, users create avatars that acquire skills and traits, and these avatars may be sold to other users for real dollars.

In an open-flow virtual currency system, virtual currencies can be used to purchase both real and virtual goods and services, and can be exchanged for government-issued currency.

Example: Bitcoin.

Back to point #1, whether transactions involving virtual currencies may be taxable. The report discusses one example in a hybrid system:

  • Ann plays an online game and amasses virtual tools that are valuable to her avatar. The online game does not allow users to directly exchange their virtual tools for U.S. dollars, but rather they can do so using a third-party, making this a hybrid system. Ann uses a third-party exchange not affiliated with the online game to coordinate the transfer of her virtual tools to another player in exchange for U.S. dollars. The transfer is conducted by the third-party exchange and payment is mediated by a third-party payment network. Ann may have earned taxable income from the sale of these virtual tools.

And two examples involving Bitcoins:

  • Bill is a bitcoin miner. He successfully mines 25 bitcoins. Bill may have earned taxable income from his mining activities.
  • Carol makes t-shirts and sells them over the Internet. She sells a t-shirt to Bill, who pays her with bitcoins. Carol may have earned taxable income from the sale of the t-shirt.

In other words, a transaction happens so it may be taxable. Gee, thanks. I believe the report doesn’t take a more firm position by analyzing the possible tax treatment of the transactions because it doesn’t have the answers.

Sure enough, on the page following the Bitcoin examples, the report notes

characterization depends on whether the virtual economy activity or virtual currency unit is to be treated as property, barter, foreign currency, or a financial instrument. . . . [S]ome virtual currency transactions could be considered barter transactions.

It also notes basis issues, but that’s pretty much it. By not delving into the arguments in favor of or against each of the characterization types, the report punts on trying to figure out proper tax treatment of transactions involving Bitcoin and other virtual currencies.

So yeah, taxpayers may not be compliant on transactions involving Bitcoin because they don’t have the answers either.

I can only take the GAO’s punt as a challenge to the IRS—and practitioners like me—to figure it all out.

We’re on it, GAO. Stay tuned.

Intrastate iGaming: Federal Wagering Tax

January 16th, 2013 No comments

So far, we’ve discussed how federal withholding and reporting obligations and the Bank Secrecy Act may be implicated with intrastate internet gaming activity in the U.S. This time we examine the possible applicability of another type of tax imposed by the Internal Revenue Code (“IRC”), the excise tax on wagers made under section 4401.

The federal wagering excise tax may apply for bets accepted on U.S. internet gambling sites. For accepted wagers authorized under state law, the excise tax is 0.25 percent of the wager amount and is paid by the entity accepting the wager. For all other wagers (i.e. wagers not authorized by state law) the tax jumps to two percent.

To determine whether the tax may apply to intrastate iGaming, the first question we must ask: What is a taxable wager under the statute?

IRC section 4421 provides taxable wagers include those placed:

  1. on a sports event or contest with a person engaged in the business of accepting such wagers;
  2. in a wagering pool on a sports event or contest conducted for profit; or
  3. in a lottery conducted for profit.

As an aside, any wager placed in a sweepstakes, wagering pool, or lottery which is conducted by an agency of a State acting under authority of State law is exempt from the tax. So if a state or an agency of a state operated an iGaming site, then the federal wager tax wouldn’t apply to wagers accepted on the site.

In general, the federal wagering tax applies on wagers accepted by race and sportsbook establishments in the U.S.

Online horse wagering exists today, and operators are required to collect and remit the tax on wagers placed. (Note: Parimutuel horse race wagers pursuant to state law are exempt.) Online sportsbooks at this time are not authorized under any state law, so those accepting wagers would be required to pay the tax at the higher two percent rate.

Does the tax apply to offshore online sportsbooks accepting wagers from U.S. customers? Probably not, unless the party accepting the wager is a U.S. citizen or resident.

IRC section 4404 provides that the tax applies only to wagers:

(1) accepted in the United States, or

(2) placed by a person who is in the United States (A) with a person who is a citizen or resident of the United States, or (B) in a wagering pool or lottery conducted by a person who is a citizen or resident of the United States.

This provision extends the wager tax to cross-border wagers accepted by American bookies. If the bookie located offshore is not a U.S. citizen or resident, then the tax should not apply. If, however, the bookie is located in the U.S., then the wager placed is taxable regardless of where the person placing the wager is located.

What types of bets may fall under the third type of a wager subject to the tax, “a lottery conducted for profit?”

Treas. Reg. 44.4421-1(b)(1) states “lottery” includes the numbers game, policy, and similar types of wagering. A lottery conducted for profit

includes any scheme or method for the distribution of prizes among persons who have paid or promised a consideration for a chance to win such prizes, usually as determined by the numbers or symbols on tickets as drawn from a lottery wheel or other receptacle, or by the outcome of an event.

Poker may be considered a lottery conducted for profit.

The regulation at least implies that the game must be one of chance. In IRS Revenue Ruling 57-521, the Service considered whether a puzzle contest was a lottery conducted for profit. Because “the element of skill rather than that of chance determines the winners” in the puzzle game, the IRS stated, the puzzle contest was not considered a lottery. Applying the skill versus chance analysis to poker, there is at least an argument that poker is not a lottery conducted for profit, especially in light of the recent Dicristina decision.

Even if poker falls within the definition of a lottery conducted for profit, it may nevertheless be exempt from the wager tax.

IRC section 4421(2)(A) provides that the term lottery does not include any game of a type in which usually the wagers are placed, the winners are determined, and the distribution of prizes or other property is made in the presence of all persons placing wagers in such game. Treas. Reg. 44.4421-1(b)(2) applies the exemption to card games and concludes, “no tax would apply in the case of card games.”

It’s clear that in-person poker cash games and tournaments are exempt. It’s far from clear, however, that we can deduce the same conclusion with respect to online poker wagers.

One can argue that the standard for “in the presence of all persons” is not merely physical presence, but also extends to virtual presence on the same online poker table.

Some slightly bad news: In Rev. Rul. 79-146, the IRS applied a physical presence standard to certain types of keno games. We shouldn’t place too much emphasis on this particular revenue ruling, however, because it was written well before virtual poker tables were around.

Another possible argument is online poker wagers are placed in “coin-operated devices,” as the wagering tax does not apply on any wager placed in a coin-operated device. Treas. Reg. 44.4402-1(b)(2)(v) says the following is an example of a coin-operated device:

A coin-operated machine that displays a poker hand or delivers a ticket with a poker hand symbolized on it that entitles the player to a prize if the poker hand displayed by the machine or symbolized on the ticket constitutes a winning hand.

Of course, nobody is putting coins into their computers to play online poker. (Note: Bitcoin enthusiasts may disagree.) But there have been indications the definition of a “coin-operated device” is not strictly construed to require actual insertion of coins to play poker, giving rise to an argument for regulated online poker wagers in the U.S. to fall under the exemption.

As you can see, intrastate iGaming in the U.S. raises more questions than answers for purposes of the federal wagering tax. Next time we will shift the tax discussion from federal to state by examining some gaming taxation models that states may consider adopting.

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