The Government Accountability Office released a report on May 15 which discussed the responsibility of the IRS for providing taxpayers with guidelines about the tax liabilities involved with the use of virtual currencies. The most common of these virtual currencies are Bitcoins. The GAO suggests that Bitcoins are “similar to a foreign currency”. Bitcoins can be exchangeable for legal currency, although at a very volatile rate. Since Bitcoin users can also use Bitcoins to purchase actual goods and services, they are considered taxable income.
According to this report, there are tax liabilities for people who exchange Bitcoins for legal tender and for those who use Bitcoins to purchase non-virtual goods and services. There is even a tax responsibility for Bitcoin miners.
It is very difficult, though, for the IRS to determine the value of revenue it is entitled to from these Bitcoin transactions. The ability to estimate the size of the virtual economy revolving around Bitcoins would be a struggle for the IRS, and most likely a waste of resources that would result in an unsuccessful endeavor. This is because exchanges involving Bitcoins are conducted across the globe and some individuals choose to have more than one virtual wallet for storing their Bitcoins. Most importantly, since Bitcoins are designed for transfers to be anonymous in nature, it would be very difficult to track how many Bitcoin users are even American taxpayers–if not impossible.
The GAO report also pointed out five specific tax risks that could occur with respect to virtual currencies:
1. Some people may not be aware that Bitcoin exchanges are actually taxable income. There is a lot of false information on the web that would lead one to believe this.
2. While some people may recognize Bitcoins as taxable income, they may not know how to characterize Bitcoins when filing their taxes with the IRS.
3. It may be very difficult for people to determine how much added value they earned from their Bitcoin exchanges and therefore the income they report to the IRS would not be accurate.
4. Bitcoins are not controlled by any central regulator and are rather difficult to track. They are merely an address, which is a string of numbers and letters that people exchange between digital wallets. These wallets are not associated with their owner’s personal information. For these reasons, it would be extremely difficult for any third party involved in Bitcoin transactions to track them, a tool that the IRS often depends on when trying to collect more tax dollars.
5. Finally, there is always the risk of plain, old school tax evasion. Evasion is much simpler with digital currencies since it is difficult to track and usually not linked to a person’s identity.
As a final solution, the GAO report suggests that the IRS publish basic guidelines for Bitcoin users on IRS.gov. In 2009, the IRS did something similar for virtual economies, but those guidelines did not deal with open-flow virtual economies. These economies allow people to trade Bitcoins for real goods and services or exchange them for legal currencies.
There is an alternative option that would better suit this occasion; one which the IRS has used in the past for a similar issue. Back in 2002, the IRS made the announcement that “the IRS will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles or other in-kind promotional benefits attributable to the taxpayer’s business or official travel.” This announcement had the effect of basically exempting frequent flyer miles from taxation.
As you can see, the reasoning was somewhat different for why frequent flyer miles are hard to track than the reasoning for virtual currencies. What is important, though, is the common, inherent factor that both are difficult to track which makes it hard for the IRS to hold taxpayers responsible. If the IRS was willing to give a pass to frequent flyer miles, then it makes sense for them to do the same with Bitcoins. The auditing of Bitcoins would be a costly endeavor for the IRS and probably not something that they have the money or man power for, in light of Obamacare implementation and recent scandals.