Image Credit: Zach Copley

Ahh Bitcoin. Some say its a currency. Some say its not. Some say its property. Some say its closer to tulips. Some even say that its a platform that could be as revolutionary as the Internet itself. 

And its in these murky waters that the Internal Revenue Service has for once shone through as a beacon of clarity, kind of. To the IRS, its irrelevant how you define Bitcoin. You've still got to pay taxes on it. 

How big of a check will you be cutting come April 15?
On Tuesday, the IRS released Notice 2014-21 (gotta love the way bureaucracy labels press releases), its guidance for "Virtual Currency". In the release, and particularly in the Q&A section, the IRS details exactly how it will treat bitcoin transactions from a tax standpoint. Here is what you need to know.

1. You are paid by an employer in Bitcoin
In this case, your employer will report your income on a W-2 just as though you were being paid in dollars. These earnings are subject to federal withholding and payroll taxes.

2. You are paid as a contractor in Bitcoin
If you're a contractor, your income must be reported still, typically on form 1099. The normal tax rules for self employed individuals still apply. 

3. Buying and selling Bitcoin (miners, exchanges, or speculators) fall under existing capital gains tax laws
If you're in the Bitcoin business as a speculator, miner, or holder of the currency, your gains will be taxed at the capital gains tax rates for short term or long term holdings. So just like day trading stocks, your short term gains will largely be split with the government.

In all of these cases, the IRS requires you to calculate the fair market value of the Bitcoin in dollar terms at the time of the transaction. The government does not recognize Bitcoin as legal tender, and therefore it must be converted into dollars.

In essence, the IRS is saying that you can pay or be paid with Bitcoin (facilitating a transaction, kind of like a currency...), but if you trade Bitcoin or exchange it for other property you must pay on gains above your cost basis (like property). With no comparable invention existing in the tax code, the IRS has jammed a square peg into a round hole.

Confused? It only gets worse. Enforcing these rules may be futile
For the serious Bitcoin players -- the miners, rich enthusiasts, and Silk Road varieties -- the tax implications of dealing with Bitcoin will likely just mean a relocation to offshore tax havens.

For the rest of us, this notice just codifies the need for painstaking and expensive record keeping -- you will have to document the number of Bitcoins and their value relative to the dollar at the specific point and time. The exchange rate changes constantly -- just thinking about documenting all these transactions makes my head hurt. For the law abiding this is definitely annoying, and probably also a headwind for wide adoption of the currency. 

Alphonse Capone, the world's most famous tax evader?

The story for the "bad guys" is a little different. Bitcoin is anonymous, and with encryption technologies like Tor, it can be nearly impossible to trace. Even further complicating the enforcement matter is that Bitcoin is a truly international currency. There are 7 billion people populating 196 countries in the world. From Russia to China to Pakistan to Venezula, Brazil, Liberia, and beyond--the task of tracking down a criminal running an encrypted browser and using an anonymous currency is daunting at best and impossible at worst. 

So for the drug and gun dealers, the child pornographers, the terrorists, and the money launderers, this IRS guidance will not change their Bitcoin dealings in any meaningful way. It does increase their risks though, which is a move in the right direction for the government. Don't forget, Al Capone went down for tax evasion, not murder or running a criminal empire.

I'm sticking to what I understand
I do not own any Bitcoin, and I personally do not plan to get into the virtual currency game anytime soon. The risks are too uncertain and the volatility is far, far too great. I find Bitcoin a very intriguing invention, but my money will stay invested in businesses that I know and understand, in real estate, and in diversified index funds. With these investments, I can sleep well at night (and I'm sure my accountant appreciates it too).