Guide: Bitcoin Taxes 101

Once again, the sky is falling. The IRS is looking into bitcoin holders and picking a fight with Coinbase, and possibly scarring Circle out of the bitcoin business if you believe what some are saying (just Google it, you'll find plenty of source material). 

Now everyone has they're eyebrows raised, shuffling through paperwork to see what they did and didn't file, mouthing off on forum boards, and filling the media with stories of the end of all things that are good in the world because the IRS wasn't properly taxed capital gains. We're seeing stories about tax-free economies crashing to earth as if they were anywhere remotely in sight in the first place.

FIRST lets get the obvious out of the way. One common question is this:

Do I need to worry about taxes with bitcoin.

The answer: Yes.

Now with that out of the way, here's a few tips and things to consider this tax season.

About That Bitcoin Tax

As it sits today, the truth is that tax and bitcoin are a rather simple thing and the way bitcoin is taxed is like any commodity and that's nothing new. It's been around for decades. 

The IRS is not going to come hunt you down because you made a mistake and didn't report a couple bitcoins you have tucked away in Coinbase or Blockchain.info for a rainy day. In fact they don't even care about them. That's not what they are looking to find, they are looking to find those who had bitcoins tucked away and realized the capital gains without reporting them. Not reporting as in a couple hundred in fiat value, reporting as in a couple hundred thousand or million in fiat value.

In reality, to piss the IRS off, you have to work at it. You'll need to build a substantial deficit or show some unexplained funds movement before they'll make you a priority. Sure, they may ask a few questions, levy a asset, dip into your bank account, and various other annoying things to get your attention, but they're not after you. They're after the big fish owing many of thousands to millions in intentional tax evasion or criminal activity. Most small amounts are generally mistakes, bad accounting, or just plain negligence that is likely balanced with numerous past mistakes where they ended up taking more of your money than you had to give them.

So first thing is first, relax, they are not going to break in your door tomorrow and storm your property with an armada of agents looking for that hidden bitcoin. If you think you owe some back taxes or are unsure what to do this current year the most important thing to do is relax and just focus on working the problem.

If they think you owe them something they have plenty of easier ways to make your life miserable enough without raiding your home and office and arrest you at gunpoint. The likely hood of you getting swarmed with federal agents where you end up a black hooded pile of surveillance van stuffing is slim. You have much larger concerns like getting truck by lightening, hit by a bus, or winning multiple lotteries resulting in a problematic inability to spend it and these are all more likely to happen than the aforementioned scenario with the IRS.

That's not saying it can't, they can, but typically shit doesn't go down that way. What the IRS will do is slap you around a little if you do not respond to their letters, but digging a safe-house in the backyard in preparation to battle civil forfeiture may be slightly misappropriated.

Bitcoin Tax 101

Here's a few things to help you keep things on the right track and the IRS out of your hair and note that whereas we're saying "bitcoin", this is applicable to all tokens of value such as Ether, Dash, ZCash, or Litecoin for example. Note this is geared for businesses but individuals can find useful information here as well. 

1. Keep Your Records. 

Everything, if you don't know if it's "keep-worthy" then keep it. It's easy to throw shit away later, it's hard to remember every single purchase and  or when you made it in the event you end up needing a receipt for proof of purchasing an asset. 

2. File Your Taxes

File them on time and/or file an extension. If you missed the date, don't blow it off, file it as soon as you can. If you're self-employed then pay your quarterly taxes and don't buy into the "I can make my money work for me and pay it all at once" tendency of thinking. That is because others are out there trying to get your money to work for them instead ... this is a brutal industry with its fair share of with fraudulent activity and things can go from riches to rags overnight. 

Unless you just enjoy salt in your wounds, nothing adds more insult to injury than a big fat tax bill you failed to bother paying right before you lost it all. 

3. Employ a CPA

That stands for certified public accountant and the certification is a fancy way of saying that somebody with accreditation said they gave an individual a test and that individual passed that test, and assuming they didn't cheat, they have enough knowledge to adequately do the job.  Note the word "adequately" because good CPA's are good because they are fantastic at what they do and not because they passed a test. There's certainly no reason in hell to use anyone that can't pass a CPA exam. 

This is true with all professions, there's shitty attorneys and shitty computer scientists as well and they passed lots of tests. Going to school and passing tests allow you an opportunity to compete for a position that if obtained, will allow you to ultimately record performances on a resume as a perception of quality but it doesn't mean anything other than that until you prove otherwise. 

In any case, the point is that there's no reason to hire anything less than a CPA even if it is going to cost you a couple extra bucks because they will more than pay for themselves.

Moreover, a CPA is versed in the tricks of the trade and the boundaries of the laws that govern them. Meaning they know how to reduce your taxable income by properly evaluating your taxable income, allowed deductions, expenditures, assets, enrollments, and other things you may or may not be aware of that result in that overall reduction in what you have to pay the government.

It's rather humorous how people operate. They do everything within their power to increase their income during the year and then get pissed at tax time and do everything they can to make it appear as if they made less.

4. Understand Capitol Gains and Loss

This is about where bitcoin comes into the mix and under the prerequisite that all of the above conditions are satisfied with the exception of #2 since your CPA will do that, you may or may not have to help educate the accounting professional you trusted with your financial life since they may or may not know a damn thing about a bitcoin.

The IRS has offered little to no guidance outside of its classification as property, which makes bitcoin taxable as a commodity, which is what the CFTC considers it, and subject to capitol gains tax but not money, which is what FinCEN treats it as, and there both advantages and disadvantages to this approach.

The core disadvantage is that its taxable at all. Bitcoin doesn't exist. What is being taxed is the value of the intellectual property owned by you or held by a custodian on your behalf. That being the private key that allows you to do whatever you want to do with your bitcoin. This may sound a bit like a stretch on the part of the Internal Revenue Service, but any intellectual property that has value is taxable when the value of that asset is realized. In other words, if Coca-Cola has a safe somewhere and in that safe resides the formula to Coke Classic, whomever holds the combination to the lock has a valuable asset in the eyes of the IRS (and Coke lovers) and if that asset is sold, traded, lost, stolen, or otherwise realized then it is subject to taxation. Even if its nothing more than a memorized number.

However, the key takeaway out of that is the word "realized". Realized means that the value of that asset is converted into another form of compensation and even if that's another digital currency, gift-card, or a crate of jelly beans, the value of that compensation then becomes the offset of the acquisition value resulting in either a capitol loss or gain of which is taxable.

That may sounds very confusing and when you start adding in applicable tax code it can be, however the basic concept is rather simple. Lets review the following example.

4.1 Example:

2016 bitcoin buy/sell capital gains example

#	Bitcoin amount	Purchase Price	Holding Period	Price Sold	Class	Variance
1	1.0000000	$432.04	11 Months	$746.52	Short	$314.48
2	1.0000000	$432.04	13 Months	$782.01	Long	$349.87
3	1.0000000	$432.04	6 days	$567.96	Short	$135.92
4	1.0000000	$432.04	3 Months	$382.02	Short	($50.02)

In each case we are purchasing a bitcoin for $432.04 USD. We have an investment holding term of 11 months, 13 months, 6 days, and 3 months which means other than line item #2 this is subject to a taxation as a short-term capital gain/loss. Line #2 is going to be taxed as a long-term capital gain and unless you are in the higher income bracket of 39.60% (over $466,950 annually) highlight in  red below, or a lower bracket of 0%-15% shown below in  green ,the tax rate is going to be 15% on capitol gains. The lower bracket is 0% and the upper 20%. 

2016 federal income tax brackets

Tax rate on ordinary income	Single		Tax rate on qualified dividends and long term capital gains
	over	to
10%	$0	$9,275	0%
15%	$9,275	$37,650	0%
25%	$37,650	$91,150	15%
28%	$91,150	$190,150	15%
33%	$190,150	$413,350	15%
35%	$413,350	$415,050	15%
39.60%	$415,050		20%
	Married filing jointly / Qualifying widow or widower
	over	to
10%	$0	$18,550	0%
15%	$18,550	$75,300	0%
25%	$75,300	$151,900	15%
28%	$151,900	$231,450	15%
33%	$231,450	$413,350	15%
35%	$413,350	$466,950	15%
39.60%	$466,950		20%

Based on the above table, we will use a regular income bracket of 25% for the following example which is a breakdown of our Example A.

#	Return	Gain	Fees	Expense	Deductions	Gross	Bracket	Tax	Net
1	81%	$314.48	$23	$80.00	($103.00)	$211.48	25%	($52.87)	$158.61
2	81%	$349.87	$23	$80.00	($103.00)	$246.87	15%	($37.03)	$209.84
3	31.5%	$135.92	$23	$6.67	($29.67)	$106.25	25%	($26.56)	$79.68
4	(13%)	($50.02)	$23	$20.01	($43.67)	($93.70)	25%	$23.43	($70.28)

On line item #4 there's a $23.43 tax credit. That doesn't mean if you lose enough money you'll eventually start getting paid by the IRS, it's actually worse in that case because whereas at a 25% tax rate you'd receive a $23.43 credit, the tax rate of $0 is 0% resulting in $0 tax credits resulting in a full loss of $93.70 rather than the loss of $70.28 had the tax credit been applicable. 

Line item #4 appears terrible in that the tax is significant along with a low return, however this was a short-term gain with a 30 day ROI meant to be duplicated all year long rather than a long-term hold. This is a model of which day-traders focus on a daily or weekly basis and thus a bit misleading.

The drastic difference to be cognizant is the difference between lines #1 and #2. The tax on #1 is higher than the tax on line #2 and line #2 had the highest capital gain. That's because at 13 months the tax bracket for long-term capital gains on a regular income bracket of 25% is reduced to 15% rather than taxed at the same 25% resulting in a 10% tax break over the 11 month hold which would be taxed at a full 25%. 

In all cases note that the taxable income is the taxable capital gain. Not the value of the bitcoin.The $432.04 used to purchase the bitcoin has already been taxed and not subject to a secondary tax outside of sales tax that may be applicable in some cases if purchased locally from a local vendor or bitcoin ATM.

6. Meet Your Friend, COGS 

COGS is your friend, do not ignore your friends. COGS stands for cost-of-goods-sold in cost accounting present in most retail and supply-chain models and represents exactly what it sounds like, the cost of the goods you are selling prior to the retail or wholesale markup.

If we take a look at example A again and highlight the COGS, we can see that there are $23 in fees and $103 in expenditures which you might have noticed or even been curious about previously.

#	Return	COGS		Expense	Deductions	Gross	Bracket	Tax	Net
		Gain	Fees
1	81%	$314.48	$23	$80.00	($103.00)	$211.48	25%	($52.87)	$158.61
2	81%	$349.87	$23	$80.00	($103.00)	$246.87	15%	($37.03)	$209.84
3	31.5%	$135.92	$23	$6.67	($29.67)	$106.25	25%	($26.56)	$79.68
4	(13%)	($50.02)	$23	$20.01	($43.67)	$93.70	25%	$10.92	($32.75)

  

In this case a CPA will do his diligent discovery based on the information you give the professional and expose the COGS as they are shown in the breakdown of $23 in fees and $103 expenditures. $23 in fees can be trading fees, exchange fees, blockchain transaction fees, monthly service fees, etc.. and the $103 can be anything from electricity in your office to gasoline in your car to your cell phone bill if these expenses were legitimately used for business purposes. 

To build on that, this is where incorporating as an LLC, Corporation, or other legally structured entity starts to make sense if your transactions, expenses, and revenue start accumulating substantially. The tax advantages far outweigh the expense of incorporation and in most states incorporating is rather reasonable. In Kentucky for example this can be accomplished for about $50 in state fees and as little as $50 for an attorney or business consultant to prepare and file the paperwork, Texas on the other hand will cost over $300 in state fees alone but note that you can start a business in any state you wish so long as you have a registered agent arranged in that state.

Know which entity best fits your business model as well. For example, with capital losses there's a $3000 cap on deductions from a capitol loss aggregate for individuak tax payers. This is also true for Sole Proprietors and single member Limited Liability Companies (LLC's). However, Corporations have no limit so a peer-to-peer trading company who suffers losses from scams and other fraudulent activity would be better served forming an S-Corporation rather than a single member LLC.

COGS are deducted from the gross receipts of revenue and that results in the taxable income prior to any tax calculation. Thus in the example the taxable revenue on line #1 is actually $211.48 rather than the $314.48 of actual capital gains. These are just deductions, other tax credits are also possible on top of this and again why you also want a CPA to inject themselves thoroughly into your affairs and find every applicable penny that can be deducted.

7. Industry Specific Practice Taxation

FinCEN (Financial Crimes Enforcement Network) considers bitcoin related entities on one or more of the classifications of User, Exchanger, and Administrator. If you fall under the user category then you're not really making any money off of bitcoin outside of some personal investments that do not involved anyone else other than regulated exchanges and/or other investors buying and selling, be careful here however if you do this outside of a regulated exchange without the explicit knowledge that your trading partner is not doing this for any other reason and can prove for up to 7 years that this is the case, you can find yourself in other hot water.

Users will be taxed at a much higher bracket and need not worry about the longer form. Administrators and Exchangers however have many more tax advantages including regulatory requirements. Yes, everything you spend getting registered on a federal level with FinCEN, the CFTC, or other regulatory agencies including state licensing as required by law is tax deductible right off the top which is why this is something you should employ a professional for. In addition to this, Miner fees, Western Union fees, bank fees, exchange fees, and just about any fee you can think of in regards to mining or purchasing bitcoin for sale or use with your business model is tax deductible, however, you will not find a "miners fee" itemized anywhere on any IRS form, you'll have to categorize this as an COGS expense of you own design on your chart of accounts which in turn will show on a profit/loss report.

8. Bitcoin Spending of User Assets

Going by FinCEN's category of a user, that being an individual purchasing bitcoin for his or her own personal use (aka: saving or spending), what does a User do with saved bitcoin and spent bitcoin? Saved bitcoin is exactly that, saved. It's not touchable. Think about it, you either mined this coin or purchased this coin with fiat currency that has or will be already taxed. You're not going to be taxed again outside of any applicable sales tax when you bought the coin. 

When bitcoin is spent to buy something or converted into fiat, another currency, including another digital currency, or a gift card, then that is a different story. That is realizing a capitol gain.

This is where allot of people get confused and for good reason, it's a little confusing. Let's review the following example.

8.1 Example:

John buys 1 bitcoin at cost for $812.36, John hold that bitcoin for 3 months and the price is $1005.15 when he purchases a laptop computer for $996.74 and uses his bitcoin to pay for it.

That capitol gain is realized, however the taxable income is not $996.74, rather it is $191.17 that becomes taxable. This is because $812.36 is a deductible expenditure and only the realized portion of the capital gain is taxable.

It breaks down like this:

To calculate this we'll let Y = 996.74, which is the price of the laptop purchased, X = 1005.15, which is the price of bitcoin when the laptop was purchased, and J = 812.26, the price when using the equation Y = P% * X

Calculate the equation for P

P% = Y/X
P% = 996.74/1005.15
p = 0.9916

We can convert decimal to percent:

P% = 0.9916 * 100 = 99.16%

Thus, 99.16% of he gain was realized in John's transaction. However, for the next equation we'll use p (0.9916) to calculate the taxable gain of T = (X - J ) * p

Calculate the equation for T

T = (X - J ) * p
T = (1005.15 - 812.36) * 0.9916 = 191.17

Here's the long version:

t = X - J
t = (1005.15 - 812.36) = 192.79
T = t * p
T = 192.79 * 0.9916 = 191.17

$191.17 is the taxable gain from the laptop purchase.

That might seem a little complicated so let's further simplify and use another commodity as an example.

Let's say Susan bought 1 gold bar for $900. She breaks the gold bar in half and buys a widget for $500 when gold is worth $1000.

                                     
 1 gold bar purchased for $900    
 1 gold bar now worth $1000        
 -----------------------------------
 The capitol gain equals $100        
                                     

Quantity	Asset	Buy Price	Sold price	Gain
1	Gold Bar	$900	$1000	$100
			Taxable Gain	$100

However she broke the bar in half and spend it that way.

                                      
 1 gold bar purchased for $900      
 1/2 gold bar purchased for $450    
 1 gold bar now worth $1000        
 1/2 gold bar now worth $500        
 ------------------------------------
 1 gold bar capitol gain equals $100
 1/2 gold bar capitol gain equals $50 
                                      

Quantity	Asset	Buy Price Value	Sold price Value	Gain
1	Gold Bar	$900	$1000	$100
½	Gold Bar	$450	$500	$50
			Taxable Gain	$50

If she spent only 1/2 (0.5) gold bar, the taxable gain is $50.

9. Bitcoin ATM's and Local OTC

ATM operators and local OTC (over the counter) traders should note this particularly since a classification as property constitutes a good of which is taxable. However, this varies from state to state and should be carefully considered when placing an ATM or selling bitcoin locally.

OTC or over-the-counter sales are also known as on-person trades. FinCEN classifies them as IVTS transactions which stands for Informal Voluntary Transaction System and considers the activity money transmission, however its sister agency, the IRS, considers the activity a sales of property and subject to capital gains tax. Each state typically follows one or the other for taxation in that its either an intangible item not subject to sales tax, which is the FinCEN IVTS or OTC transaction model and would also cover ATM's, or they follow the IRS model whereas bitcoin is a good and applicable to sales tax.

This is synonymous with the Texas-New-York-Divide model where the country is divided taking either a Texas or New York approach to bitcoin regulation as pertaining to money transmission. Texas takes the IRS approach of bitcoin being property and no money transmitters license is required which is the exact opposite of what New York later did with its implementation of the BitLicense (NY 200 CRR) late in 2015 which requires a lesser money transmission license called a virtual currency license.

For example in Texas and Arizona the position of the IRS is taken and bitcoin sold through any mechanism, in-person, or online within their jurisdictions are subject to sales tax of the total value of the sale since electronically delivered goods (digital goods) are taxed as tangible goods. 

On the flip side, Missouri considers bitcoin intangible as digital product and thus not subject to sales tax and California currently does not tax the majority of digitally delivered goods (which has got to be one of the only taxes CA doesn't subject its residents to).

10. Merchants Accepting Bitcoin

In all cases, anything purchased with that bitcoin is also subject to sales tax and this is where it gets a little tricky for merchants. Merchants accepting bitcoin as payment must convert the portion of virtual currency to the equivalent value of USD at the time of sale and pay the sales tax of the good in United States dollars. Thus the merchant must either risk holding the virtual currency and hoping the price is exactly the same or higher every quarter when sales taxes are due or instantly convert the value into USD at the time of the sale. That's a big decision to consider since over three months allot of sales tax can accumulate of which is either earning with a bitcoin steady rise or doing nothing sitting in a commercial bank account. On the later, services offered by Bitpay and Coinbase make this easy to do simply by entering the sales tax % as the portion if bitcoin to be deposited as fiat.

11. Bitcoin Unspent on December 31st

If you're selling bitcoin as a business, what about that pile of bitcoin that becomes next years asset when the clock strikes 12 on December 31st? With fiat currency, anything left in the bank is considered taxable. Bitcoin however is considered a commodity, so nothing happens if it's sitting in your bitcoin wallet. It considered inventory at that point and not taxable until you sell it.

12. File your FBAR reports.

One item bitcoin and digital currency based businesses face more than other businesses are Foreign Bank and Financial Accounts (FBAR) reports. FBAR reports should be filed for any fiat currency sent abroad (for example to an exchange) that is in excess of $10,000 or more. Fiat, and only fiat currency should be reported. Digital currency is not subject to FBAR reporting.

FinCEN released this statement in December (12/16/2016):

The new annual due date for filing Reports of Foreign Bank and Financial Accounts (FBAR) for foreign financial accounts is April 15.  This date change was mandated by the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, Public Law 114-41 (the Act).  Specifically, section 2006(b)(11) of the Act changes the FBAR due date to April 15 to coincide with the Federal income tax filing season.  The Act also mandates a maximum six-month extension of the filing deadline.  To implement the statute with minimal burden to the public and FinCEN, FinCEN will grant filers failing to meet the FBAR annual due date of April 15 an automatic extension to October 15 each year.  Accordingly, specific requests for this extension are not required.  (Please note: The due date for FBAR filings for foreign financial accounts maintained during calendar year 2016 is April 18, 2017, consistent with the Federal income tax due date.) 

13. Accounting Software (Wake up, its 2017)

One of your biggest assets in business or personal finances when it comes to taxes is accounting software. You don't even need a decent computer or lots of space for records now days since there are plenty of cloudware options available. Not only does this stand a better chance of not getting destroyed, software does most of the work for you, reminds you of what needs to be filed, guides you through setting up your chart of accounts and other tasks, and most importantly, at tax time is spits out all of the necessary reports for your CPA such as your P&L.

Seriously, you can buy Quickbooks for all of $20/month or Zoho for $9/month. Get with the now.

14. Pay Your Taxes

The most important thing to do is to actually PAY your taxes. None of the above will amount to much of anything if at the end of the day you don't actually pay the damn bill.

Tricks and Loopholes

No, not really, two things you won't find here are tricks and loopholes. In fact everything above is for reference only and to help shed some light on the topic but not a guide of exactly what to do by any means. For that see #3 above and speak to a professional. This will give you an idea of what to expect and how to back-track and fix any errors or how to think about moving forward.  

It's also all likely to change in the future. The IRS is kicking around new tax laws for virtual currency but for now, it's treated like any other commodity on earth. The key difference is that with bitcoin, it can be spent just as fiat currency can be so this activity can generate allot of records that combined with a volatile market swing, can get messy quickly without proper record keeping. However, with a few tools and some proper reports, tax time should be a breeze even if you CPA doesn't have any clue about bitcoin.

Simply explain it's a commodity like gold, but digital and leave it at that. They'll take care of the rest.

That said, if you do owe a substantial amount of back taxes related to bitcoin you may consider moving out of the country or pony up the cash because it's clear the IRS has bitcoin on its radar and if the Coinbase fiasco shows us anything, it's that the IRS doesn't mind breaking the rules to catch those they don't know they're looking for so chances are they might uncover a thing or two.

That... or maybe Trump will shut down the IRS and this will all go away ... I wouldn't hold your breath.

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