Why would the IRS care about cryptocurrency? For two reasons:
Trading cryptocurrency is a taxable event; and converting cash into a virtual currency could be a way to launder money.
I was the tax consultant for the largest fund of cryptocurrency a few years ago before it disbanded. The way this fund made money was by converting U.S. dollars or euros into bitcoin. Then the bitcoin was converted to another cryptocurrency, and then another, and so it went. All of these transactions were tracked and made public using blockchain, which is a digital ledger in which transactions made in bitcoin or other cryptocurrencies are recorded chronologically and publicly. Each conversion is a taxable transaction.
It is easiest to think of cryptocurrency as a commodity, such as gold and platinum. Let's say an investor buys an ounce of gold and then converts the gold to platinum. That would be a taxable event. Gold has a dollar value and platinum has a dollar value, with the difference being taxable. Just like any currency or commodity, the cost of one unit of any cryptocurrency changes by the second.
Miners, traders, or investors access their virtual currencies through a wallet, which is the bitcoin equivalent of a bank account. The wallet enables virtual currency owners to receive the virtual currency, provides storage for them, and enables the owner to send them to other wallets. There are two main types of wallet. The first is a software wallet, which virtual currency owners install on their computer or electronic device. This type of wallet gives the owner total control, yet it can be challenging to download and maintain. The second type, the web wallet (or hosted wallet), is hosted by a third party, and while it is easier to use, a certain trust must be placed in the provider to ensure the coins are protected.
Once a wallet is set up, the virtual currency owner then has an address that looks something like this: 1BvBMSEYstWetqTFn5Au4m4GFg7xJaNVN2.
After the wallet's owner chooses a password, by the way, there is no way to change it, which makes it imperative that the owner write down the password and secure it in a safe location. A client of the author lost $250,000 because the safe where he kept his wallet address and password was sent to an incinerator. A wallet's owner has no way to access the wallet without the string of letters and numbers and the password.
IRS takes notice
In response to concern over virtual currencies and their perceived potential for evading taxes, the IRS issued Notice 2014-21 in March 2014. This notice gave guidance on everything from paying employees with cryptocurrency to how the various trades between different currencies are treated.
But in a 31-page report from the Treasury Inspector General for Tax Administration, released Sept. 21, 2016, the IRS basically admitted that though a Virtual Currency Issue Team had been created, guidelines for compliance had not been developed. The recommendations from this report included developing a coordinated virtual currency strategy, providing updated guidance for requirements and tax treatments, and revising third-party reporting requirements and documents.
Another problem that the IRS has had with virtual currencies is that the transactions by miners, traders, or other investors are not currently reported on any tax forms. For instance, investors who trade foreign currency on the Forex (a foreign exchange site) are sent tax forms for all of the trades made on the platform. However, cryptocurrency exchanges do not currently issue Forms 1099 for transactions within the platforms.