Bitcoin, a virtual currency that uses cryptography to secure transactions and control the creation of new units of value, seems poised to become the next step in tax evasion, replacing tax havens maintained by law firms like Mossack Fonseca & Co. As many people employed in the fast-growing technology sector look for ways to conceal their earnings, Bitcoin would seemingly offer them another benefit in addition to those provided by the shell corporations disclosed in the Panama Papers: they would also allow the possessor of the currency to manage his money without the aid of a financial institution or law firm. The IRS has increased its scrutiny of offshore accounts and has become more adept at discovering taxpayer income that has not been reported, as discussed elsewhere on this blog, but Bitcoin servers present an extra-judicial challenge unlike anything seen before.
As use of this virtual currency increases, taxpayers need to understand how the IRS treats Bitcoin. Employees receiving wages in Bitcoins--as some tech sector workers now demand--must have these wages reported on a W-2, and pay income tax withholding and payroll taxes. Independent contractors who are paid in Bitcoins must receive Form 1099s from employers contracting their services. The IRS treats payments made via Bitcoin like other payments made in property. For a cash basis taxpayer, income is recognized (received) when the coins are transferred to her account, not when the coin is sold. The Bitcoin then has a basis equal to the value of the work provided. When the Bitcoin is eventually sold, the rules which govern stock and barter transactions are applied.
For example, if you provided $500 in work on June 1, 2016, for which you received 1 Bitcoin in June of 2016, you have income in 2016 (either W-2 or 1099-Misc) of $500.00, and the coin now has a basis of $500.00. Now assume that you exchanged that coin in 2017 for cash $750 or traded it for a new TV. In 2018, you will have a capital gain of $250 because the increase in value is taxable. Capital gains are calculated by taking the basis in the property (Bitcoin here) from the value of the property or cash received, thus $750-$500=$250 capital gain. Here, the gain will be long-term, because the Bitcoin was sold more than a year after it was received. However, if the coin lost value, dropping to $250 in 2017, and you exchanged it for cash or a television worth $250 that year, the loss in value would be treated as a capital loss and could be used only to offset other capital gains.
That said, it seems inevitable that savvy tax-evaders who wish to avoid detection may soon transition to using Bitcoin. So far, enforcement mechanisms allowing state and federal revenue services to track the deployment of Bitcoins are in their infancy. One expert estimated that if even 1% of funds currently sitting in offshore accounts were transferred to Bitcoin, the value of this virtual currency could increase substantially (currently, a single Bitcoin is worth roughly $580).
In addition to the tax issues, there may be foreign account reporting requirements depending on where or how the digital currency is held. IRS has publically stated that bitcoin does not have to be reported on the FinCen Form 114 (the FBAR). However, the IRS could change its opinion on Bitcoin and require FBAR reporting in future years. Another concern is FATCA reporting. While the IRS has stated Bitcoin does not have to be reported on the FBAR, it has not stated that it is not a foreign asset for purposes of Form 8938. Depending on where and how your digital currency is held, there is a good possibility that it will be a specified foreign assets and will be reported.
Taxpayers considering a decision of this sort, or taxpayers who have already moved their offshore holdings to Bitcoin, need to recognize that the IRS will eventually develop means of dealing with such activities. As a reminder, tax evasion and intentional failure to file tax returns are felonies with punishments ranging from financial penalties to jail time. Furthermore, the IRS has an unlimited statute of limitations to assess taxes and penalties for unfiled or fraudulently filed tax returns. As such, those taxpayers not currently in compliance with their IRS’ reporting requirements should develop a strategy to become compliant as quickly as possible.
For a free phone consultation regarding Bitcoin, the FBAR, or other tax matters, please contact the Law Office of Aaron P Richter, a Bethesda-based law firm with expertise in Tax Controversy, Business Formation, Estate Planning, and Tax Preparation.