Bitcoin is a cryptocurrency or as described by the IRS “virtual” currency. Bitcoin can be used to pay for goods and services, it can also be held as an investment, and as such it is considered a taxable asset. This means it’s tax treatment is different than that of legal tender (dollars). It is subject to tax in the same way the receipt of property is subject to federal tax.
According to the IRS, “Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency. Bitcoin is one example of a convertible virtual currency…”
If a taxpayer receives Bitcoin as payment for goods and services, they must compute the fair market value of the virtual currency and add it into their income. Per the IRS, “General tax principles applicable to property transactions apply to transactions using virtual currency.”
Here are two examples where the use of Bitcoin as a payment must be reported to the IRS:
If someone hires an independent contractor and pays them in Bitcoin instead of dollars, the contractor must report that as income. The independent contractor will also be subject to self-employment taxes on this transaction.
If an employer decides to pay wages to employees (oversees or domestic) with Bitcoin, those wages must be reported on a Form W-2 and will have federal income tax withheld as well as payroll taxes.
If the individual receiving the Bitcoin plans to hold it for some period of time, it is worth noting that gains from the sale or exchange of Bitcoin may also be taxable since Bitcoin that is held can also be considered a capital asset. A simple explanation of capital assets is – investments that are expected to generate value over a period of time. Here are some helpful facts to help you understand the Schedule D you must file with your 1040 if you are reporting the sale or exchange of capital assets: https://www.e-file.com/help/schedule-d.php
For more help with Bitcoin and the potential taxes, there is an expansion of information about virtual currency on the IRS.gov website. Here you can find Notice 2014-21 that the IRS has published with information including many frequently asked questions as well as the IRS answers. This is made available via a downloadable pdf that provides US taxpayers with additional information pertaining to Bitcoin and other virtual currencies.