If the phrase “virtual currency” fills you with the uncertainty of a middle schooler at their first dance, you’re in very good company. The very concept is mystifying to a lot of people. Though virtual currency isn’t brand new – Bitcoin was invented in 2008 – it’s not yet commonly accepted by American businesses. But considering the speed with which technology moves, the day when a client asks about paying for services with virtual currency could arrive sooner than you anticipate.
Adapting to virtual currency isn’t something your business will be able to do overnight. It’ll take a major shift in the way you approach accounting and taxation, and there may be a steep learning curve associated with making this transition. To that end, the IRS recently released two new resources to help taxpayers prepare to use virtual currency. For business owners, both pieces of guidance could prove useful within the next few years.
What the IRS Considers Virtual Currency
Because “virtual currency” is a non-specific term, business owners who may want to accept this currency in the future must first understand how the IRS views it.
The IRS defines virtual currency as “digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.” IRS guidance only concerns convertible currency, which has some equivalent value in real currency. It’s different from non-convertible or closed currency, which only has value within a given community. For example, the multiplayer role-playing game World of Warcraft uses virtual gold for in-game purchases, but because it has no value outside of the game, it’s not convertible currency. Essentially, any type of currency that isn’t issued and controlled by a government, and that is convertible, will be treated by the IRS as virtual currency.
New Guidance #1: FAQs
The first piece of guidance released by the IRS is a Frequently Asked Questions (FAQs) page on its website. The FAQs answer questions about a wide range of tax and accounting issues that could arise from using virtual currency and holding it as a capital asset. Answered questions include: How to record and calculate gains and losses from sales made with virtual currency; whether or not virtual currency constitutes taxable income, and under what circumstances it’s taxable; how to calculate contribution deductions when donating virtual currency to charity; and how to determine cryptocurrency’s fair market value at the time that the currency is received.
New Guidance #2: Revenue Ruling 2019-24
The second piece of IRS guidance is Revenue Ruling 2019-24. It establishes parameters for how the IRS views income derived from virtual currency. Specifically, it addresses two questions related to hard forks and cryptocurrency. If those terms are unfamiliar, it’s important to understand some background before getting into how the IRS is involved.
Cryptocurrency is a particular type of virtual currency. (Bitcoin is one well-known example.) Transactions made with cryptocurrency are recorded using technology called blockchain. It’s a kind of virtual ledger that verifies and records those transactions without having to involve any middlemen, like banking institutions. Each computer that’s connected to a given blockchain is called a node, and all the transactions in a given blockchain may be accessible to all nodes. When a new transaction is created, all the nodes verify the information provided. Every new transaction is bundled with other transactions to create a block that’s added to a chain of previously-created blocks. All the same information is available on all the nodes and is constantly updating as new transactions are recorded.
Imagine you get together with a group of friends to create a central database to store information about a shared hobby. It’s always open and running on your computer, and changes constantly as other users add information. Occasionally, everyone who uses the database might get together and decide that the software that drives the database needs to be updated. Everyone must download the new software to be able to continue to access the database. If you don’t download the new version, the current version on your computer won’t be compatible with the new software.
Something similar can happen when blockchain protocol is changed, an event that’s called a hard fork… all of which brings us back to revenue ruling 2019-24. It clarifies the IRS position on a few different circumstances that may affect taxpayers who receive units of cryptocurrency as the result of a hard fork.
Sound complicated? It is, and will continue to be in the coming years. Adapting to use virtual currency may be a bit like learning a new language. It will take time, and you’ll almost certainly have a lot of questions. So don’t panic if you think you’re not ready to accept virtual currency. It’s likely that the IRS will offer more guidance in coming years, and LGA will be here to help you understand it.