The IRS Will Treat Virtual Currency as Property for Tax Purposes

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1 Tax Alerts June 2014 The IRS Will Treat Virtual Currency as Property for Tax Purposes As virtual currencies such as Bitcoin rise in prominence and use, for the first time the Internal Revenue Service (IRS) has described how virtual currency will be treated for tax purposes. The agency concluded in new guidance (Notice ) that Bitcoin and other virtual currencies like it are not to be treated as property, but as currency. Definition of virtual currency Actual (or "real") currency is commonly defined as a system of money in general use in a particular country. The U.S. dollar is an example of actual currency. A single definition of virtual currency, on the other hand, has not yet achieved widespread acceptance. Virtual currency (sometimes referred to as "cryptocurrency") is a medium of exchange that operates like actual currency under some circumstances. Currently, virtual currency does not have legal tender status in any jurisdiction. How virtual currency works Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as "convertible" virtual currency. Currently, the most prominent example of a convertible virtual currency is Bitcoin, which can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real currencies. A Bitcoin is created, or "mined," electronically, according to a purely mathematical process. A complex computer algorithm is applied. As more and more Bitcoins are mined, the difficulty of doing so will increase as it becomes computationally more difficult to create them. This process was designed to mimic the production rate of a commodity such as gold. Companies like BitPay or Coinbase act as intermediaries in Bitcoin transactions. According to Adam White, the Director of Business Development and Sales at Coinbase, over a million customers use Coinbase as their "Bitcoin wallet," allowing Coinbase to accept Bitcoin payments on their behalf using its payment tools. This includes over 28,000 merchants. Fees associated with virtual currency transactions are relatively small in contrast with higher fees charged to businesses accepting credit cards. Credit card companies generally charge businesses a fee per swipe of the card, plus two to four percent of the total transaction. On the other hand, businesses that use a merchant processor pay fees of one percent, or less, for Bitcoin transactions. However, virtual currencies are volatile and involve high risk. For example, the value of a Bitcoin went from pennies to $1,200 in a five-year period and then back down to around $500, where it rested as of April 22, U.S. tax treatment The IRS acknowledged that virtual currency may be used to pay for goods or services or held for investment. The IRS issued guidance providing answers to frequently asked questions (FAQs) about virtual currency, offering Bitcoin as an example. The FAQs at present provide only basic information on the tax implications of transactions in, or using, virtual currency. 1

2 The IRS Will Treat Virtual Currency as Property for Tax Purposes (continued) Notice states that virtual currency will be treated as property for U.S. federal tax purposes. As such, it is governed by the same general principles that apply to property transactions generally. The sale or exchange of convertible virtual currency or its use to pay for goods or services in a real-world economy transaction, has immediate tax consequences that would not apply if it were considered pure "legal tender." Capital gain or ordinary income. 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. If the virtual currency is held as inventory, for example, for sale to customers in a trade or business, gain or loss on its disposition will be ordinary gain or loss. If the virtual currency is held as an investment, gain or loss on its disposition will be capital in nature. Information reporting. A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. Thus, a person who makes a payment of fixed and determinable income using virtual currency with a value in excess of $600 to a U.S. non-exempt recipient is required to report the payment to the IRS and to the payee. This includes payment of rent, salaries, wages, premiums, annuities, and compensation. 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. Also, payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply to such payments. Payers using virtual currency must normally issue Form 1099 to the payee. For more information about this article, please contact our tax professionals at [email protected] or toll free at 844.4WINDES ( ). FAQs: What are Applicable Federal Tax Rates for Tax Purposes? Applicable Federal Tax Rates (AFRs) are used for a number of federal tax provisions. For example, Internal Revenue Code (IRC) Section 1274 uses AFRs to determine whether a debt instrument has original issue discount (OID or imputed interest). This determination requires the calculation of the present value of payments made on the debt instrument; present value is calculated using a discount rate equal to the AFR, compounded semi-annually. Determining AFRs AFRs are based on the average market yield on outstanding marketable obligations of the United States government. Under IRC Section 1274(d), the AFR includes the federal short-term rate (based on the interest rates for debt instruments of three years or less); the federal mid-term rate (based on the rates for debt instruments of three to nine years); and the federal long-term rate (based on the rates for debt instruments exceeding nine years). 2

3 FAQs: What are AFRs for Tax Purposes? (continued) The IRS computes AFRs for each calendar month and publishes them in a revenue ruling. As an example, Revenue Ruling , published January 6, 2014, provided the AFRs for January AFRs may be compounded (and therefore applied) monthly, quarterly, semiannually, or annually. In addition, some amounts are calculated using a higher percentage of the basic AFR. The monthly revenue rulings provide AFRs equal to 110 percent, 120 percent, 130 percent, 150 percent, and 175 percent of the basic AFR. Applying AFRs The Tax Code uses AFRs to determine appropriate amounts under a multitude of provisions. These include: The present value of an annuity, life interest, term of years interest, remainder interest, or reversionary interest under IRC Section 7520; Loans with below-market interest rates, under IRC Section 7872 (the applicable rate depending on the term of the loan); Insurance reserves under IRC Section 807, as well as insurance provisions under Code Secs. 811 and 812; The present value of golden parachute payments under IRC Section 280G (120 percent of the AFR, compounded semiannually); Payments for the use of property or services under IRC Section 467; Unrelated business income and debt-financed income under IRC Section 514; and The recharacterization of gain from straddles under IRC Section The AFR revenue rulings also provide adjusted AFRs, which are used to determine the IRC Section 382 limits on NOLs following ownership changes, and to determine OID on tax-exempt obligations under IRC Section For more information about this article, please contact our tax professionals at [email protected] or toll free at 844.4WINDES ( ). 3

4 How do I Write Off Baseball Season Tickets to my Business? Internal Revenue Code (IRC) Section 162 permits a business to deduct its ordinary and necessary expenses for carrying on the business. However, IRC Section 274 restricts the deduction of entertainment expenses incurred for business by disallowing expenses of entertainment activities and entertainment facilities. Many expenses are totally disallowed; other amounts, if allowed under IRC Section 274, are limited to 50 percent of the expense. The income tax regulations define entertainment as any activity of a type generally considered to be entertainment, amusement, or recreation, such as entertaining at night clubs, lounges, theaters, country clubs, golf and athletic clubs, and sports events, as well as hunting, fishing, vacation and similar trips. There are special rules for the costs of facilities used to entertain the customer, such as a boat or a country club membership. Dues or fees for any social, athletic or sporting club or organization are treated as items involving facilities. Deduction allowed Expenses are allowed if the expense was either "directly related" to the active conduct of the taxpayer s trade or business or "associated with" the conduct of the trade or business. An activity is "associated with" business if the activity directly precedes or follows a substantial and bona fide business discussion. Entertainment expenses are not directly related to the business if the activity occurred under circumstances with little or no possibility of engaging in the active conduct of the trade or business. These circumstances include an activity where the distractions are substantial, such as a meeting or discussion at a night club, theater, or sporting event. However, taking a customer to a meal at a restaurant or for drinks at a bar can be considered conducive to a business discussion, if there are no substantial distractions to a discussion. Substantial business discussion For expenses that are either directly related to or associated with business, the taxpayer must establish that the he or she conducted a substantial and bona fide business discussion with the customer. The Internal Revenue Service (IRS) has said that there is no specified length for a discussion to be substantial; all facts and circumstances will be considered. The discussion is substantial if the active conduct of the business was the principal character of the combined business and entertainment activity, but it is not necessary that more time be devoted to business than to entertainment. For an entertainment activity that is associated with business, the business discussion can directly precede or follow the entertainment activity. For a discussion to be directly before or after the activity, it generally must be on the same day as the activity. However, facts and circumstances may allow the entertainment and the discussion to be on consecutive days, for example if the customer is from out of town. 4

5 How do I Write Off Baseball Season Tickets to my Business? (continued) Season tickets The special rules for facilities do not apply to season tickets. Instead, the taxpayer must allocate the cost of the season tickets to each separate entertainment event. The amount deductible is limited to the face value of the ticket. For a "skybox" or other area leased and used exclusively by the taxpayer and guests, the amount deductible is limited to the face value of non-luxury seats for the area covered by the lease. Under these rules, it appears that the deductible costs of baseball season tickets must be determined separately for each baseball game. Attendance at a baseball game would involve a "distracting" activity that is not conducive to a business discussion, so the cost of the game would not be directly related to the conduct of the trade or business. However, attendance at a game before or after the conduct of a substantial business discussion could qualify as being associated with the business; in these circumstances, the cost of the event would be deductible. If the taxpayer provided food to the customer at the baseball game, the cost of the food would be deductible as part of the cost of the event. Some "luxury" seats include food provided by the baseball team to the ticket user. It appears that the taxpayer would have to determine the fair market value of the ticket and the food separately, although the costs of food actually provided to the customer may still be deductible. For more information about this article, please contact our tax professionals at [email protected] or toll free at 844.4WINDES ( ). The IRS Issued Final Regulations for Additional Trust/Estate Expenses that are Not Subject to the 2% Adjusted Gross Income Floor Final regulations were issued to clarify which costs incurred by estates and non-grantor trusts (trusts) are subject to 2% floor for miscellaneous itemized deductions under Internal Revenue Code (IRC) Section 67(a). While the final regulations largely follow the proposed regulations, the final regulations contain several changes and additions to the proposed regulations including the following: Ownership costs. The proposed regulations provided that "ownership costs" are costs that are chargeable to or incurred by an owner of property simply by reason of being the owner of the property. They also set out that such costs are customarily or commonly incurred by all property owners, including individual owners. The final regulations do not change the proposed regulations, but, after listing examples of ownership costs that are customarily or commonly incurred by all property owners, they note that other expenses incurred merely by reason of the ownership of property may be fully deductible. 5

6 The IRS Issued Final Regulations for Additional Trust/Estate Expenses...(continued) Tax preparation fees. The proposed regulations set out a list of tax returns the costs relating to which are not subject to the 2% floor. Those returns are estate and generation-skipping transfer tax returns, fiduciary income tax returns, and the decedent's final individual income tax returns. The final regulations clarify that the above list is an exclusive list; the costs of preparing all other tax returns are subject to the 2% floor. Investment advisory fees. The proposed regulations provide that fees for investment advice (including any related services that would be provided to any individual investor as part of an investment advisory fee) are subject to the 2% floor. They also provide that, to the extent that a portion (if any) of an investment advisory fee exceeds the fee generally charged to an individual investor, and that excess is attributable to an unusual investment objective, that excess is not subject to the 2% floor. Appraisal fees. Unlike the proposed regulations, the final regulations address appraisal fees. The final regulations provide that appraisal fees incurred by an estate or a trust to determine the fair market value of assets as of the decedent's date of death (or the alternate valuation date), to determine value for purposes of making distributions, or as otherwise required to properly prepare the estate's or trust's tax returns, or a generation-skipping transfer tax return, are not subject to the 2% floor. The costs of appraisals for other purposes (for example, appraisals to determine the proper amount of insurance needed on property) are subject to the 2% floor. Other fiduciary expenses. Unlike the proposed regulations, the final regulations address other fiduciary expenses. The final regulations provide that certain other fiduciary expenses are not subject to the 2% floor. Such expenses include, without limitation: probate court fees and costs, fiduciary bond premiums, legal publication costs of notices to creditors or heirs, the cost of certified copies of the decedent's death certificate, and costs related to fiduciary accounts. Bundled fees. Under the proposed regulations, if an estate or trust pays a bundled fee (as defined above), that fee must be allocated, for purposes of computing the adjusted gross income of the estate or trust, between the costs that are subject to the 2% floor and those that are not. The proposed regulations provided an exception to this rule for certain bundled fees. They also provided that any reasonable method may be used to allocate the bundled fee between the two types of costs. The final regulations make no changes to the proposed regulations, but they add the following: The IRS creates the possibility of additional exceptions to the bundling rule by adding "except to the extent provided otherwise by guidance published in the Internal Revenue Bulletin." Facts that may be considered in determining whether an allocation is reasonable include, but are not limited to, the percentage of the value of the corpus subject to investment advice, whether a third party advisor would have charged a comparable fee for similar advisory services, and the amount of the fiduciary's attention to the trust or estate that is devoted to investment advice as compared to dealings with beneficiaries and distribution decisions and other fiduciary functions. For more information about this article, please contact our tax professionals at [email protected] or toll free at 844.4WINDES ( ). 6

7 Helpful Tax Tips if You Are Moving this Summer If you make a work-related move this summer, you may be able to deduct the costs of the move. This may apply if you move to start a new job or to work at the same job in a new job location. In order to deduct moving expenses, you must meet these three requirements: 1. Your move closely relates to the start of work. Generally, you can consider moving expenses within one year of the date you first report to work at a new job location. Additional rules apply to this requirement. 2. You meet the distance test. Your new main job location must be at least 50 miles farther from your former home than your previous main job location was. For example, if your old main job location was three miles from your former home, your new main job location must be at least 53 miles from that former home. 3. You meet the time test. After you move, you must work full time at your new job location for at least 39 weeks during the first year. Self-employed individuals must meet this test and also work full time for a total of at least 78 weeks during the first 24 months upon arriving in the general area of their new job location. If your income tax return is due before you have satisfied this requirement, you can still deduct your allowable moving expenses if you expect to meet the time test. If you determine that you can claim this deduction, here are a few more tips: 1. Travel. You can deduct transportation and lodging expenses for yourself and household members while moving from your former home to your new home. You cannot deduct the cost of meals during the travel. 2. Household goods. You can deduct the cost of packing, crating and transporting your household goods and personal property. You may be able to include the cost of storing and insuring these items while in transit. 3. Utilities. You can deduct the costs of connecting or disconnecting utilities. 4. Nondeductible expenses. You cannot deduct as moving expenses any part of the purchase price of your new home, the costs of buying or selling a home, or the cost of entering into or breaking a lease. 5. Reimbursed expenses. If your employer reimburses you for the costs of a move for which you took a deduction, you may have to include the reimbursement as income on your tax return. 6. Update your address. When you move, be sure to update your address with the IRS and the U.S. Postal Service to ensure you receive mail from the IRS. For more information about this article, please contact our tax professionals at [email protected] or toll free at 844.4WINDES ( ). 7

8 California Franchise Tax Board Releases List of Most Common Audit Issues This article is reproduced with permission from Spidell Publishing, Inc. In the Tax News, the FTB listed the most common audit issues found on individual and business entity returns. Here are the listed issues, separated by taxpayer type. Personal income taxpayers Like-kind exchanges Other state tax credits Head of household filing status Expired credits Employee business expenses Pass-through entities Shareholder/Partner/Owner s basis in a pass-through entity Partnership/LLC property dispositions Termination of partnership/llc Transfer of partnership interest S corporation liquidations Charitable deductions for trusts Charitable remainder trusts Apportionment of trust income Corporations Cost of performance and sourcing of intangible sales Sales factor and gross receipts Abusive tax shelters Credits For more information about this article, please contact our tax professionals at [email protected] or toll free at 844.4WINDES ( ). 8

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