Over the last several years, virtual currency has become increasingly popular. Bitcoin is the most widely recognized form of virtual currency, also commonly referred to as digital, electronic or crypto currency.

While most smaller businesses are not yet accepting bitcoin or other virtual currency payments from their customers, more and more larger businesses are. Businesses also can pay employees or independent contractors with virtual currency. But what are the tax consequences of these transactions?

Virtual Currency 101

Virtual currency has an equivalent value in real currency and can be digitally traded between users. It also can be purchased with real currencies or exchanged for real currencies and is most commonly obtained through virtual currency ATMs or online exchanges.

Goods or services can be paid for using “virtual currency wallet” software. When a purchase is made, the software digitally posts the transaction to a public ledger. This prevents the same unit of virtual currency from being used multiple times.

Tax impact

Questions about the tax impact of virtual currency abound and the IRS has yet to offer much guidance.

In 2014, the IRS ruled that bitcoin and other convertible virtual currency should be treated as property, not currency, for federal income tax purposes. This means that businesses accepting virtual currency payments for goods and services must report gross income based on the fair market value of the virtual currency when it was received, measured in equivalent U.S. dollars.

When a business uses virtual currency to pay wages, the wages are taxable to the employees to the extent any other wage payment would be. You must, for example, report such wages on your employees’ W-2 forms. They are subject to federal income tax withholding and payroll taxes, based on the fair market value of the virtual currency on the date received by the employee.

When a business uses virtual currency to pay independent contractors or other service providers, those payments are also taxable to the recipient. The self-employment tax rules generally apply, based on the fair market value of the virtual currency on the date received. Payers generally must issue 1099-MISC forms to recipients.

Finally, payments made with virtual currency are subject to information reporting to the same extent as any other payment made in property.

Deciding whether to go virtual

Accepting virtual currency can be beneficial because it may avoid transaction fees charged by credit card companies and online payment providers (such as PayPal or Venmo, in some cases) and attract customers who want to use virtual currency. It can also pose tax risks as guidance on the tax treatment or reporting requirements is limited.

It is important to research and contact your business adviser on the tax considerations when deciding whether your business should accept bitcoin or other virtual currencies.