Bitcoin tax rules needed for clarity

The U.S. Internal Revenue Service should give taxpayers clear rules on how it will handle transactions involving Bitcoin and other digital currencies, Nina Olson, the National Taxpayer Advocate, said today.

Spending Bitcoins to purchase goods may trigger capital gains and losses or ordinary income and losses, which have different tax rates, Olson said in her annual report to Congress.

“It is the government’s responsibility to inform the public about the rules they are required to follow,” she wrote. “The lack of clear answers to basic questions such as when and how taxpayers should report gains and losses on digital currency transactions probably encourages tax avoidance.”

Olson, who runs an independent office within the IRS, listed digital currency as one of the 25 most serious issues encountered by taxpayers.

Atop Olson’s list was the absence of a clear set of taxpayer rights and the decline in IRS service and enforcement stemming from budget cuts, issues on which she has repeatedly urged change.

Olson has a new audience this year in John Koskinen, who was sworn in as IRS commissioner Dec. 23.

“What taxpayers need and deserve is the transformation of the IRS from a traditional enforcement-focused tax agency to a forward-looking modern agency that embraces technology even as it recognizes the specific needs of taxpayers for personal assistance,” she wrote.

Virtual Currencies

Introduced in 2008 by a programmer or group of programmers under the name Satoshi Nakamoto, Bitcoin is the most prominent of a group of virtual currencies -- money that exists mainly as a string of code -- that have no central issuing authority. “Miners” unlock new Bitcoins by using ever-faster computers to solve complex mathematical problems, and transactions are recorded anonymously in a public ledger.

Today, even with its young age and regulatory uncertainties, Bitcoin can be used to pay for T-shirts, food or an appointment with a Manhattan psychiatrist.

The IRS hasn’t offered guidance on Bitcoin, beyond saying that it is working on the issue and that it has been monitoring digital currencies and transactions since 2007.

‘These Risks’

The IRS “is aware of the potential tax compliance risks posed by offshore and anonymous electronic payment systems, and we are working to address these risks,” Steven Miller, then the acting IRS commissioner, wrote in the agency’s response to a May 2013 Government Accountability Office report.

Miller was forced out later that month after the IRS disclosed that it had applied extra scrutiny to some small-government Tea Party groups based solely on their names.

According to Olson’s report, a big distinction for the IRS to make is whether Bitcoin is property, in which case capital gains rules would apply with a top basic rate of 20%. If it’s treated like a “nonfunctional currency,” ordinary income tax rates would apply with a top rate of 39.6%.

The IRS can’t outlaw Bitcoin, said Joshua Blank, a tax law professor at New York University. It can use past experience to require information reporting about transactions.

Tax compliance rates are highest when there is third-party reporting, particularly with wage data that employers send to the IRS. Compliance rates are lowest with no such reporting, as with self-employment income.

“The danger is the creation of an electronic black market, similar to the cash economy,” Blank said. “That’s what the IRS wants to avoid.”

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