Real Taxes on Virtual Currencies: What Does the IRS Say?
39 Pages Posted: 5 Feb 2015
Date Written: May 1, 2014
This paper discusses the recent Internal Revenue Service (Service) guidelines on tax reporting for virtual currencies, such as Bitcoin, and argues that the Service should define convertible virtual currencies more narrowly to remove pure game experiences from the regulation. The author suggests that a more sensible definition can be developed based on the Government Accountability Office’s proposed classification of virtual currency systems.
The three criteria that should be used to distinguish various types of virtual currency systems are: (1) virtual currency can be used to purchase both virtual and real goods and services, (2) virtual currency is freely exchangeable to U.S. dollars, and (3) trading virtual currency for real currency is expressly authorized by end user license agreements. The third criterion provides an easily administrable solution to distinguish pure game currencies from hybrid and open-flow currencies. Virtual currencies with express prohibition on exchanges to real currencies and ability to pay for only in-game goods and services should be classified as closed-flow. Currencies on the other end of the spectrum that do not have any restrictions on exchange to real currencies and can be used to pay directly for real world goods and services should be classified as open-flow. Bitcoin is a good example of an open-flow currency. Hybrid currencies are those that do not have legal restrictions on exchanges to real currencies, but are not yet accepted as payment for real goods and services.
In contrast to the proposed in Notice 2014-21 uniform treatment of all convertible virtual currencies as property, the author suggests that virtual currencies in open-flow systems such as Bitcoin should be treated as foreign currency, those in hybrid systems such as Second Life or other game worlds permitting real money transactions should be treated as property, and the Service should decline to tax transactions in closed-flow systems such as World of Warcraft. The proposed options for tax treatment of different types of virtual currency systems deal with issues of equity and efficiency both for taxpayers and the Service. Taxpayers get to benefit from the proposed simplified procedures for handling hybrid and open-flow transactions while taking into consideration ability to pay and possibility of tax evasion arguments.
Note: This is a preliminary version of the article. The final version will be available in the spring 2015.
Keywords: Bitcoin, virtual currency, virtual worlds, tax, tax policy, cryptocurrency, IRS Notice 2014-21
JEL Classification: E62, H2, H21
Suggested Citation: Suggested Citation