IRS building in Washington. IRS building in Washington.

The Internal Revenue Service on Friday reminded taxpayers that income from virtual currency transactions is taxable by law and is reportable on their income tax returns.

The IRS issued guidance in IRS Notice 2014-21 for use by taxpayers and their return preparers that addresses transactions in virtual currency, also known as digital currency.

“Virtual currency transactions are taxable by law just like transactions in any other property,” the IRS states.

“Taxpayers who do not properly report the income tax consequences of virtual currency transactions can be audited for those transactions and, when appropriate, can be liable for penalties and interest,” the IRS said.

In more extreme situations, the IRS states, “taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions.”

Virtual currency “is a digital representation of value that functions in the same manner as a country’s traditional currency,” the Notice states.

As it stands now, more than 1,500 known virtual currencies exist, the Notice states.

Notice 2014-21 provides that virtual currency is treated as property for U.S. federal tax purposes.

General tax principles that apply to property transactions apply to transactions using virtual currency, the IRS states, which means that:

  • A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
  • Payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply.  Normally, payers must issue Form 1099-MISC.
  • Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2 and are subject to federal income tax withholding and payroll taxes.
  • Certain third parties who settle payments made in virtual currency on behalf of merchants that accept virtual currency from their customers are required to report payments to those merchants on Form 1099-K, Payment Card and Third Party Network Transactions.
  • The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.

— Check out Federal Judge Opens Door to CFTC to Regulate Virtual Currency on ThinkAdvisor.