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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.

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