IRS Issues Guidance on Taxation of Bitcoin Mining and Virtual Currency

On March 25, 2014, the IRS issued Notice 2014-21 (pdf) which contains guidance on tax principles applied to virtual currencies including Bitcoin. In an interview with Reuters, I told the reporter that this Notice was very unfair to miners, but the reporter did not elaborate on why I believe that the guidance is unfair to miners. Here is why.

In the Notice, the IRS states that it will treat virtual currency transactions as property transactions. The IRS then poses and answers 16 questions that are designed to provide guidance on how it will treat various transactions. 15 of these questions give standard property transaction taxation treatment to virtual currency transactions. However, question and answer 8 deviate from this treatment:

Q-8: Does a taxpayer who “mines” virtual currency (for example, uses computer 
resources to validate Bitcoin transactions and maintain the public Bitcoin 
transaction ledger) realize gross income upon receipt of the virtual currency 
resulting from those activities?

A-8: Yes, when a taxpayer successfully “mines” virtual currency, the fair market value
of the virtual currency as of the date of receipt is includible in gross income. See
Publication 525, Taxable and Nontaxable Income, for more information on taxable
income.

This means that the IRS has taken the position that a person who mines virtual currency is being paid in virtual currency for the service of mining virtual currency, rather than the person has produced virtual currency, a piece of property, through capital intensive number crunching. What is the process of virtual currency mining?

The way that I conceive of the process of virtual currency mining using the example of Bitcoin is that when a block is discovered a number of Bitcoins is created. The pool that discovers the block retains the Bitcoins, and the pool distributes the Bitcoins according to each members’ contributions to solving the block. So it’s not like you’re getting paid for providing services to someone else. It’s more like you’re creating property, Bitcoins, through capital intensive effort, solving math problems with expensive computers. Mining Bitcoins is similar to using alchemical processes to turn lead into gold, and you’d only be taxed on that once the gold is sold to someone else (and as a professional alchemist you’d be able to deduct your expenses for newt’s eye, cauldrons, and lead). Or, to use a more classic example: mining Bitcoins is like baking bread, and the baker is taxed when he sells the bread (the realization event), not when the bread is baked.

If the IRS says that they are going to tax virtual currency according to the principles of property taxation, then virtual currency miners should only be taxed when there is a realization event and not when they produce a unit of virtual currency.

The scope of this problem is immense. In the past year approximately 1.5 million Bitcoins have been mined. I’m going to estimate an average price per Bitcoin of $300 over the past year. If we assume that all Bitcoin miners are subject to US tax, then that represents $450 million in additional taxable income over the past year without any of the subsequent realization events. At a 25% tax rate, the Department of the Treasury has just raised $112.5 million in tax revenue from the production of something. The tax code doesn’t work this way. The taxation of copper or gold mining does not work this way. I cannot fathom why they decided to do this.

If you’re interested in the taxation of virtual currencies or if you have questions regarding your tax issues, give me a call at (408) 459-8427 or an email at will@lewistaxlaw.com.