Mining Virtual Convertible Currencies (Cryptocurrencies)
Recent enforcement action and "John Doe" record demands issued by the Internal Revenue Service have placed a focus on tax compliance in the cryptocurrency community which has not existed until recently. The US Income Tax questions a virtual convertible currency miner has are similar in scope to traders (such as tax rules related to sale and exchange rules), and different as it refers to earning block rewards for mining cryptocurrency. The guidance provided by the Internal Revenue Service on March 25, 2014, in Internal Revenue Notice IR-2014-36 provided guidelines on tax treatment for activities related to mining cryptocurrency.
For purposes of this article, the terms virtual convertible currency, cryptocurrency and crypto will be used interchangeably.
Let’s take a look at the issues related to mining cryptocurrencies…
But First, the Required Legalese…
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
Earning the Block Reward is a Taxable Event
According to the Internal Revenue Service guidance issued on March 25, 2014 (Internal Revenue Notice IR-2014-36 IRS Virtual Currency Guidance), when a taxpayer earns a block reward of virtual convertible currency (Bitcoin, Ethereum, STEEM, etc.) for successfully mining a new block on the Blockchain, the taxpayer has earned taxable income. The taxable income earned is the determinable fair market value (in USD) of the virtual convertible currency earned from the block reward.
Imagine we decide to set up a cryptocurrency mining rig in our basement to mine some STEEM (or another cryptocurrency). Also, consider our mining rig has successfully generated block rewards which earn 100 STEEM on the first day of operation, and the USD value of STEEM at the close of trading on our preferred cryptocurrency exchange values STEEM at $0.20 per token. Based upon the guidance issued by the IRS, we would have (100 STEEM x $0.20 per STEEM token) = $20 of taxable income to report.
Now suppose on the second day of mining for blocks, our mining rig successfully generates block rewards which earn 50 STEEM, and the USD value of STEEM at the close of trading was closer to $0.30 per token. Calculating our cumulative taxable income would be:
- Day 1: (100 STEEM x $0.20 per STEEM token) = $20.00
- Day 2: (50 STEEM x $0.30 per STEEM token) = $15.00
Our total taxable income to report would be $35.00.
An earlier installment in the US Tax Considerations series (US Tax Considerations When Blogging for Magic Internet Money (Part I) touched on the topic of how to value cryptocurrencies earned for Author Rewards and Curation Rewards on Steemit. Those same valuation techniques are applied in valuing block rewards earned for mining.
Selling the Virtual Convertible Currency is a Taxable Event
Internal Revenue Notice IR-2014-36 IRS Virtual Currency Guidance set forth virtual convertible currencies are treated as property for US Federal Income Tax purposes, and cryptocurrency transactions are governed by the same general tax principles associated with property transactions. As a result, all sales and exchanges of cryptocurrency have realized capital gains/losses which must be reported for US tax purposes.
If we continue to expand upon the example from the section above, imagine we decide to sell off the tokens earned from the first day of operation (100 STEEM valued at $0.20 per STEEM token) and suppose we sell them for a $0.30 per STEEM token.
- Basis of STEEM tokens (Original Value): $0.20 per STEEM token
- Sale Price of STEEM Tokens: $0.30 per STEEM token
(Sale Price of STEEM token – Basis of STEEM Token) = Reportable Capital Gain/(Loss)
$0.30 - $0.20 = $0.10 Capital Gain per STEEM token
Capital gains realized from the sale or exchange of STEEM tokens held longer than one year and one day are taxed at potentially favorable Long Term Capital Gain rates. An earlier installment of the US Tax Considerations series (US Tax Considerations When Blogging for Magic Internet Money (Part II)) touches on this topic in greater detail.
What to Report
Based upon the guidance issued by the Internal Revenue Service in Internal Revenue Notice IR-2014-36 IRS Virtual Currency Guidance, and for purposes of the example in the above sections, we would have two taxable events to report:
The first taxable event is $35 of taxable income earned in block rewards related to mining. The tax treatment of this first event is to tax the rewards earned as ordinary income.
The second taxable event is $10 of capital gain realized from the sale or exchange of STEEM tokens. The tax treatment of this second event is to tax the capital gain from the sale of STEEM as a capital gain.
Mining Virtual Convertible Currency as a Trade or Business
While a business created for the purpose of mining virtual convertible currency is beyond the scope of this article, a brief discussion on this point will be covered.
It is possible a taxpayer could decide to form an entity engaged in the trade or business of mining virtual convertible currency, where the entity (rather than the taxpayer) engages in the mining activity as a for-profit activity. In this scenario, it is feasible the tax treatment of the mining and sale of virtual convertible currencies would be different, and all profits generated would be taxed as ordinary income and subject to self-employment tax. The primary questions to determine this would be are you engaged in a trade or business as defined by the Title 26 The Internal Revenue Code, and should your virtual convertible currency be treated as inventory instead of property?
Should you find yourself in this scenario, contact a tax professional for more guidance related to for-profit businesses engaged in cryptocurrency mining activity.
Wrapping it up
Based upon guidance issued by the Internal Revenue Service on March 25, 2014, earning block rewards related to mining a virtual convertible currency is a taxable event which must be reported for income tax purposes. Generally speaking, sales and exchanges of cryptocurrency earned from block rewards related to mining are subject to a second taxable event from the realized capital gain/loss at the time of the exchange or sale. With the most recent enforcement actions aimed at Coinbase, every cryptocurrency miner should focus on the quality of their record keeping and income tax reporting to remain in compliance and avoid costly penalties.
Have a tax question? Please feel free leave a question in the comment section below, and I may feature it in a future blog post.
