Taxes: Taking a Bite out of Bitcoin Kerry K. Inger Mollie Mathis Auburn University

ABSTRACT: This tax research case introduces students to virtual currency taxation issues, which are increasingly important in the global economy. The setting provides an overarching story with three inter-related taxpayers and a variety of transactionsminer, short-term investor, and long-term investorthus, allowing instructors to assign individuals or groups to one or more scenarios. There is limited primary authority on virtual currency, leading students to relate the virtual currency transactions to existing primary authority. The case learning objectives are: (1) critical thinking, (2) technical knowledge, (3) tax research proficiency, and (4) written communication skills. Students identify relevant tax-related issues, conduct tax research, and prepare a research memorandum that summarizes their findings. Keywords: bitcoin; virtual currency; tax research; character of income; basis.

I. THE CASE

For this case, imagine that you are a tax professional who provides advice to clients. You will be assigned one of three taxpayers. Your partner has brought you in to conduct tax research regarding your respective clients unique tax issues involving Bitcoins. Below is a brief synopsis of each clients Bitcoin-related transactions.

Bitcoin Taxpayers

The Miner

Ms. Alicia Underhill started a Bitcoin mining business in January 2018. She invested in 50 AntMiner S9i Bitcoin mining machines at a cost of $668/machine, for a total investment of $33,400. The AntMiner S9i is currently the most powerful miner available on the market. Each machine is currently capable of mining 0.3603 Bitcoins per month at the current level of computational difficulty, which means that her 50 machines can create approximately 18 Bitcoins a month. The day the Bitcoins are mined is considered the day of receipt. Over the past year, the price of a Bitcoin in U.S. dollars (USD) has swung wildly, trading between $3,226 and $19,350, with a range between $6,000 and $10,000 for most of the past 6 months. In addition to the cost of the Bitcoin mining machines, Ms. Underhill has to rent space for her machines in a data center; this rent expense is $400 per month. The data center houses and cools the mining machines and provides electrical and networking services, which cost an additional $720 for each AntMiner S9i.

Once Ms. Underhills mining operations produce Bitcoins, she sells them to her business associate, Mr. Thomas Green. Ms. Underhill estimates that after accounting for all of her costs, she can generate $330 of gross profit a month from each AntMiner S9i. However, this is a soft number. Her revenue depends on the price of Bitcoins when she sells them to Mr. Green, and the amount of Bitcoins she is able to generate each month. The rate of Bitcoin generation depends on the amount of overall computational power on the network that is dedicated to Bitcoin mining; as more miners compete for Bitcoins, the rate of production declines. Her cost structure also varies based on the monthly data center costs (which vary with the price of electricity).

The Short-Term Investor

Mr. Thomas Green trades Bitcoins, buying at market prices from miners like Ms. Underhill and trying to time the market by selling when the price rises. He also trades other virtual currencies that can be traded in USD, including Ethereum as well as currencies that require Bitcoins as a conduit to convert to USD, including NXT. He does not have a set trading policy; sometimes he exchanges one virtual currency for another virtual currency, and other times he buys and sells virtual currency using cash. He has avoided virtual currencies that are sold to finance projects and instead has focused on virtual currencies that are a medium of exchange. He typically holds individual virtual currency holdings for less than a year; however, he also has some long-term holdings. He averages two or three trades a week and devotes a couple of hours a week to researching potential acquisitions and trades of virtual currency. While he enjoys trading virtual currency, he still works full time as a business manager for a professional sports team, which is his primary source of income and limits the time he can devote to trading virtual currency, as well as his ability to profit from short-term swings in the value of the currencies. Bitcoins have been a volatile asset over the past 12 months, which can be good and bad for traders like Mr. Green. Large swings in the price of Bitcoins create opportunities to generate large, realized gains; they can also result in large losses. Bitcoin prices were relatively stable until 2017, when virtual currencies entered the mainstream and a period of irrational exuberance ensued. Prices raced up from $2,000 to $19,350 before quickly trading down to $6,000$10,000. On August 1, 2017 Amaury Sechet and his team of developers decided to abandon Bitcoins SegWit2x protocol due to delays in transaction processing and to increase the block size limit.1 This resulted in a chain split (hard fork), a drastic change that required a split from the original Bitcoin network and the creation of a new virtual currency, Bitcoin Cash. After the split, everyone who held Bitcoins before the hard fork received the same amount of Bitcoin Cash, while still retaining the original Bitcoins. Mr. Green has not sold any of the Bitcoin Cash, but plans to sell his holding and focus on Bitcoins.

The Long-Term Investor

Mr. Wayne Arrington is a casual Bitcoin investor. On August 15, 2015, he purchased three Bitcoins for investment purposes when the price of one Bitcoin was $263.85. On November 25, 2017, when Bitcoins were priced at $8,795.50, he purchased $500 worth of goods for 0.0568472 Bitcoins at Overstock.com. He incurred a transaction fee of $8. He purchased an additional item for $140 from Overstock.com using Bitcoins on December 2, 2017, when Bitcoins were priced at $10,912.73 and again incurred an $8 transaction fee. Mr. Arrington is a supporter of education and donated one Bitcoin to his sons school (a qualified charitable organization under IRC 501(c)(3)) on December 22, 2017, when Bitcoins were priced at $13,664.97. Realizing he had not contributed to his IRA during the year, Mr. Arrington would like to contribute one Bitcoin to his IRA before year-end.

Assignment

1. Use your knowledge of the tax law to identify the tax issues faced by your assigned taxpayer related to their Bitcoin activities.

2. Prepare a technical research memo that summarizes your findings. The memo should include an analysis and conclusion about the proper tax treatment of each of the identified issues. Include primary authorities to support the suggested conclusion as well as any authorities that are contrary to this position. Note that Bitcoin is a new technological development that does not have specific primary authority. You will need to relate existing primary authority to a new setting. Include any tax-planning strategies that the taxpayer should be aware of in the future. You will need to use a tax research database to facilitate your research in addition to Notice 2014-21 from the Internal Revenue Service (2014).