Cryptocurrency Tax Reporting: What to Know About Bitcoin and Taxes

When you use cash to make a purchase in person, you hand over the dollar bills to the clerk. You give up the possession of the bill in exchange for the good or service you’re purchasing. You can no longer use this specific dollar bill for another purchase; it is in the possession of the business now. But you still have other dollar bills to use elsewhere.

With the advancement of technology came e-commerce. Online shopping is now a convenient way for consumers to purchase goods and services from the comfort of their own home or right off of their smartphone. Because of this, e-commerce relies on digital currency to make transactions. But unlike handing over a physical dollar bill, users had the opportunity to copy files containing digital currencies and use the same money multiple times.

Banks solved this problem by creating their own computerized ledgers to track transactions and balances of everyone’s accounts. However, many people have issues with a third-party central authority over their money. They wanted a secure and private way to control their money without an outside entity, thus sparking the development of cryptocurrency.

What is cryptocurrency? What is Bitcoin?

Cryptocurrency is a decentralized digital currency that is secured through encrypted codes to protect its users’ transactions and balances.

The most popular cryptocurrency is Bitcoin. It does not require a central authority to validate transactions between users. Instead, the transactions are verified through the massive network of Bitcoin users.

Before going further, one important distinction to make is the difference between “Bitcoin” and “bitcoin.” Bitcoin, with a capital B, is the name for the protocol and network as a whole, while bitcoin, with a lowercase B, is the name for the actual currency.

How Does Bitcoin Work?

Since Bitcoin is decentralized, every participant has a copy of the ledger, called blockchain, on his or her own computer. There is no sole person controlling it; no one can give him or herself more bitcoins because everyone’s ledger needs to match. The blockchain technology is transparent to all the users, so you can see all of the transactions and balances in place. While these actions are open and trackable, you can’t see who sends what to whom. User identities are kept anonymous.

You have a few options for how to get bitcoins. You’ll first have to create a Bitcoin wallet, after which you can find multiple ways to buy bitcoin. You can buy bitcoin using your bank account, purchase bitcoin from peer sellers, or withdraw from a Bitcoin ATM. Once you have bitcoin in your wallet, you can then find participating vendors and businesses to make a transaction.

Because it's all digital, one single bitcoin can be divided into very small fractions. So if your purchase is not worth an entire bitcoin, it can be cut in half or all the way down to 0.00000001 of its original whole.

You can choose to buy bitcoins, accept bitcoins as payment for a good or service, or earn bitcoins through a process called "mining," which is explained below.

How Bitcoin Mining Works

To maintain the blockchain, users can participate in what’s called “mining.” Bitcoin mining is the process of validating and updating the blockchain. This is done by using extremely powerful computers that race against one another to solve an equation by guessing a specific number.

The first “miner” to guess correctly gets to record the next batch of transactions to add to the blockchain. These newly written transaction confirmations are called “blocks.” Each block is sent to the other computers in the network to update the entire blockchain. On average, a new block is added every 10 minutes. In return, the original miner is rewarded with new bitcoins. The current reward per block is 12.5 bitcoins.

If you are interested in mining, you’ll need to upgrade to a highly powerful computer to be successful. Because these equations are extremely difficult, more advanced computers have been developed to make multiple guesses per second. Application specific integrated circuits (ASICs) are the current mining standard as they were manufactured solely for mining Bitcoin.

What is the Value of Bitcoin?

The value of bitcoin fluctuates every day. As of November 26, 2018, the value of 1 bitcoin is $3,632.30 U.S. dollars. In December 2017, 1 bitcoin was valued at almost $20,000 USD. But a few months later on March 31, 2018, the value of 1 bitcoin was $6,994.80 USD. So within the past twelve months, the exchange rate of bitcoin has dropped dramatically.

The Risks of Bitcoin

While the idea of a decentralized digital currency is appealing to some, there are a handful of risks associated with that.

  • The volatile value of one bitcoin can be enough to consider if getting involved is even worth it.
  • There is no formal protection for the individuals. Unlike your FDIC-insured bank account, nothing protects your wallet if the market goes south.
  • It’s not a formally accepted form of currency everywhere. While some businesses accept bitcoins for payment, many others keep a leery eye on it and prefer to accept legal tender currency.

How to Report Bitcoin Income and Pay Taxes on Cryptocurrency

While it’s not a legal tender currency, the IRS recognizes that many consumers use Bitcoin and other cryptocurrencies as a form of payment. In response, it released guidelines that clearly define the cryptocurrency tax laws.

  • When computing gross income, any taxpayer who accepts virtual currency as a form of payment for goods or services must include the fair market value of the virtual currency in USD as of the date that the virtual currency was received.
  • Employers paying with Bitcoin must report employee earnings to the IRS on W-2 Forms. The bitcoin value must be converted to the USD value as of the date each payment is made. Wages paid in virtual currency are subject to withholding to the same extent as dollar wages.
  • Employees paid in Bitcoin will need to convert their W-2 wages to USD and report as such.
  • Any Bitcoin held as a capital asset will be taxed as property. General tax principles applicable to property transactions also apply to transactions that use virtual currency. Any gain or loss from the sale or exchange of the asset is then taxed as a capital gain or loss.
  • Bitcoin miners must report any earnings as income. The bitcoins earned must be converted into the fair market value of the USD at the time of the earning.

In November 2018, Ohio became the first U.S. state, and one of the first governments in the entire world, to allow businesses to pay taxes using bitcoin. Businesses can register through and pay any of the 23 different types of state taxes with bitcoin. The website will then, through a third-party processor called BitPay, convert the bitcoin into USD to then deposit into the state's accounts. The hope is to eventually extend this option to individuals for the same purposes.

Get Help with Cryptocurrency Accounting, Preparing and Reporting

If you use Bitcoin or any other cryptocurrency, you’ll want to make special preparations for your tax return. Today’s tax laws are already tricky enough, and throwing in the considerations for cryptocurrencies only adds to the confusion.

Most taxpayers, whether they use Bitcoin or not, benefited from using a professional tax preparer. Call Watson CPA today for a free consultation to learn how to best prepare your tax return.

Photo by Viktor Forgacs on Unsplash

Income Tax Forms

IRS Red Flags that Trigger an Audit

What is an Audit by the IRS?

The IRS website defines an audit as “a review/examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amount of tax is correct.” The IRS conducts audits in an effort to minimize the tax gap — the difference between what the IRS is owed and what the IRS actually receives.

Selection for an audit doesn’t immediately mean there is a concern. The IRS chooses accounts based on random selection and computerized screening that compares your tax return to the “norms” of similar returns. The IRS may also choose to audit you if you do business with another taxpayer being audited.

What are some IRS Audit Red Flags?

When finalizing your taxes, you’ll want to have proper documentation for your valid deductions. Avoid these IRS red flags on your tax return that may increase your chances for an audit.

Unreported nonwage income

If you have a salary income but decide to pick up a freelance gig for a bit of extra pocket change, you will need to report your earnings on your Form 1099 along with your regular W-2. Failing to report part of your income is the one of the biggest red flags for an IRS audit.

Mathematical errors

Mistakes happen, but even a small mix-up within your calculations could merit an audit. Triple check your numbers before submitting your tax return. An unintentional mistake could lead to hefty fines. Worried about your math skills? Prepare your taxes with the help of an accountant.

Claiming too many charitable donations

The IRS can sense where your comfort level would be with charitable donations based on your salary. If your deductions are higher than average, the IRS will want to investigate further. Be sure to save your receipts and proof of charitable contributions to prove that you really are that generous.

Questionable business expenses

The IRS is strict about not mixing business expenses with personal expenses. A valid business expense must be both ordinary and necessary to your line of work. A chef could write off new utensils during a kitchen update. But a lawyer with an affinity for baking cupcakes couldn’t claim a stand mixer as a business expense.

Home office deduction

Writing off your home office can be a major pro to owning a business. But the IRS won't accept your kitchen table or living room couch as a home office. For a valid home office deduction, the office needs to be a space in your home solely dedicated to your business operation.

Hire a CPA during an IRS Tax Audit Representation

If you’ve received an audit notice from the IRS, don’t go through it alone. Having a CPA represent you is the best way to get tax audit help. The IRS will then communicate with the CPA, and the CPA will ensure that the audit is efficiently handled. Contact Watson CPA today for a free consultation and to accurately prepare your taxes.

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