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Practical issues related to bitcoin

Tax, other considerations

Shehan Chandrasekera, CPA | Footnote

Editor's note: Updated April 29, 2019

In the ever-evolving world of bitcoin, blockchains and the newest and greatest technological innovations, it’s easy to feel like your head is spinning. Then when you start to think how these advancements might apply to your work — both in practice, and how taxation is applied — it can quickly move from inquisition to confusion.

Let’s take a closer look.

Understanding the digital world


Bitcoin is a form of digital currency (commonly referred to as cryptocurrency) invented in late 2008 by a person (or a group of individuals) called Satoshi Nakamoto. It’s the most well-known of the approximately — and continually growing — 1,600 digital currencies. Bitcoins are not physical coins; they represent a unit of virtual value that is transacted electronically through its own network. Bitcoin is not backed by any commodity, government or bank. It derives its value by relying entirely upon the mutual trust and acceptance of its users.

The blockchain is the underlying technology that facilitates peer-to-peer bitcoin transactions. This system allows payments to be sent between users without passing through a central authority, such as a bank or payment gateway. Bitcoins are held in digital wallets and are not printed like dollars or euros.

The main purpose of bitcoin is to serve as a medium of exchange in commerce. Bitcoin usage in commerce is becoming increasingly prevalent in today’s economy, especially with big brands like Starbucks, Overstock.com, Newegg.com and others accepting such payments from customers. Compared to traditional currency, bitcoin transactions offer several key benefits, such as low transaction fees, higher transparency, improved control and security.

However, as with any technology in its infancy, transacting in bitcoin creates many unwelcome practical challenges in day-to-day commerce as well. And, for those of you overseeing the business side of these operations or working with clients dabbling in this, you’ll want to be well-equipped to advise on the matter.

Volatility challenges


First and foremost, price volatility is the single biggest challenge related to bitcoin transactions.

This has significantly curtailed the mass adoption of bitcoin as a medium of exchange. For example, in 2011, one bitcoin was valued at approximately 30 cents. In late 2017, the value of one bitcoin increased to $20,000. At the time of this publication, the value of one bitcoin ranges between $3,500 and $4,000.

Price volatility has caused people to use bitcoin as a speculative asset rather than a stable medium of exchange. Consequently, paying or receiving bitcoin in exchange for goods and/or services is a double-edged sword. With high-price volatility, you could overpay for items purchased or be underpaid for items sold, depending on which side of the transaction you are in.

For example, in May 22, 2010, an early blockchain programmer purchased two large Papa John’s pizzas using 10,000 bitcoins. This was only worth $30 at that time. But, now it’s worth more than $40 million. As the market matures, the price volatility is expected to go down. However, at the moment, using bitcoin as a true currency is a risk-versus-reward proposition.

Taxing issues


Taxation related to bitcoin transactions is another practical issue. Bitcoin transactions are governed by IRS Notice 2014-21. This notice lays out some ground rules regarding cryptocurrency taxation. Chief among them is that virtual currency is treated as property for tax purposes and governed by general tax principles applicable to property transactions. This creates a massive practical challenge. Property treatment of cryptocurrency means that every time you dispose of bitcoins, there is a gain or loss to be recognized. Gain or loss is the difference between the cost basis of the bitcoin disposed and the amount realized.

For example, imagine you go to Overstock.com and buy a couch that is worth $3,500 by using one bitcoin. Under the property treatment, a taxable event is established when you dispose one bitcoin to obtain the couch. To calculate the gain/loss, first, you need to know how much you obtained that one bitcoin for. Assume it was purchased in 2015 for $2,000. Second, the amount realized should be calculated. In this case, it is $3,500. Therefore, you will have a long-term capital gain of $1,500 ($3,500-$2,000), which you will have to report on your current year income tax return and pay related taxes in U.S. dollars.

Tracking basis and amount realized on every day-to-day transaction is impractical; this is a burdensome task to do by hand, and various software platforms are just now developing or fine-tuning products to automate the gain/loss tracking process. In fact, the current property treatment by the IRS greatly hinders bitcoin usage as a medium of exchange.

Bitcoin for compensation


It’s a common practice for many blockchain startups to use bitcoin as a method of compensating employees and contractors. The aforementioned price volatility and property tax treatment once again pose practical operational challenges. From the employer’s point of view, paying their employees with bitcoin is a taxable event. There will be a gain/loss at the time you pay your employees because there is a difference between the amount you acquired the bitcoin for and the fair market value of them at the time of payment.

Again, tracking basis for every payment is a cumbersome task, which is time-consuming and prone to inaccuracies. Also, in the case of wages, payroll taxes and withholding payments must still be remitted to respective agencies in U.S. dollars irrespective of the underlying bitcoin transaction. Making sure that a sufficient amount of U.S. dollars is available to meet those obligations is another nonvalue-added administrative task that, again, undermines the benefits of bitcoin usage.

Regulation and interpretation


Finally, a murky regulatory environment and different interpretations by various governing bodies have posed a lot of practical challenges to CPAs and attorneys in consulting clients who transact in cryptocurrencies. Currently, regulatory bodies do not have a uniform treatment for bitcoin.

As discussed earlier, the IRS treats bitcoin as property. The U.S. Commodities Futures Trading Commission (CFTC) labeled bitcoin as a commodity under the Commodity Exchange Act (CEA). Although the Securities and Exchange Commission (SEC) has not taken any formal position on bitcoin, various comments from the SEC chairman, Jay Clayton, has indicated that bitcoin is a non-security. The Financial Accounting Standards Board (FASB) has not taken any formal positions, either.

For clients with bitcoin transactions, practitioners have used the process of elimination to figure out balance sheet classification. Classification as cash is a good starting point; however, it’s technically not legal tender or backed by any form of government. The next logical step is to look toward classifying it as a financial instrument (carried at fair market value). Bitcoin fails this test because it does not contain any contractual right to receive cash at a future point in time.

As we work down the balance sheet, inventory classification is the next stop. While this seems like a possible place for bitcoin, the problem is that it clearly is not a tangible asset — a foundational test that must be passed to be considered inventory or fixed assets.

The analysis leaves practitioners with only intangible asset classification. The only problem is that intangible assets are generally carried at cost and evaluated for impairment (with no opportunity to write up assets if they increase in value).

This leaves accountants with the unsavory conclusion that a highly volatile asset, which has a readily assessable fair value in an open market place is, at best, frozen in time in the financials.

This is only the beginning

Bitcoin is a revolutionary medium of exchange, which, we must remember, is still in its infancy. Its usage as a medium of payment is greatly hindered by practical issues such as high price volatility, IRS property tax treatment and unclear regulations.

Despite these issues, bitcoin adoption is steadily increasing, and governing bodies are paying more and more attention. As the market matures and regulatory agencies consolidate on their opinion on this new class of asset, practical challenges will slowly disappear. You’ll find that the better prepared you are, the more your practice can and will benefit.

Shehan Chandrasekera, CPA is the founder of JAG CPAs & Co. in Houston, Texas, and leads the technology and startup niche in the practice. He is a published author, CPE instructor and frequent technical contributor to various social media platforms. You may find more about him at http://jagcpa.com/shehan and reach him at shehan@jagcpastx.com or 713-346-9908.