Friday, October 3, 2014

The CFO's Guide to Bitcoin, Part 1 & 2: Basics / Taxes and Accounting

Adam Bluemner for FindAccountingSoftware.com writes: The Basics: 80,000 businesses already accept bitcoin. And to echo a recent Entrepreneur article, “Why not yours?”
It’s no longer an idle question.
If the bitcoin question hasn’t landed on your doorstep, it will soon. The Wall Street Journal op-eds are already here. So are eyebrow-raising headlines announcing things like PayPal’s embrace of bitcoin.
Customers will want to know. Business partners will mention it. Soon, the boss will ask. And, accountants and financial executives will be among the first required to weigh in.
The business case for bitcoin
Should your business accept bitcoin?
It’s a complicated question.
After all, even former U.S. Treasury Secretary Tim Geithner says he doesn’t quite understand Bitcoin.
The bitcoin decision may not have an obvious answer. In fact, we won’t have real data on bitcoin’s long-term acceptance, price stability, and potential viability versus cryptocurrency competition for years.
But a couple things are sure to happen before those results get tallied. Consumers are going to continue to spend bitcoins. And, someone’s going to ask for your opinion on whether your company should accept them.
Time to get up to speed!

How does bitcoin work?

There are many great articles that go into depth on the nitty-gritty of the bitcoin protocol. This is not one of those articles. There’s just too much to get to from the bitcoin business and accounting angle.
But if you want to understand how the techy stuff works, I won’t leave you hanging, either. If you don’t know bitcoin from bitly, check out:
To start thinking about the bitcoin business case, though, there’s just a few basics you need to know about the bitcoin technology:
  • Bitcoin is a peer-to-peer system for the exchange of digital cash.
  • It is a protocol, a network, and a currency.
  • It’s both anonymous and transparent. All transactions are public, you just don’t know whose they are.
  • The currency is not backed by any government or commodity.
  • There can only ever be 21 million bitcoins. But they are divisible into one hundred millionths.
  • The bitcoin system derives its integrity from mathematics and cryptography. “Miners” create bitcoins by solving complex computations. Each solution proves the spender of a bitcoin is its owner.

How can bitcoin reduce the cost of doing business?

Or, to translate the question into accounting-ese, “Why should I care?”
Bitcoin enables a number of cost-savings opportunities. None are more significant than minimizing credit card processing fees.
A 3% credit card processing rate is common. Processing $1,000,000 in credit card transactions at that rate, therefore yields fees of $30,000. Using bitcoins for a similar transaction volume would likely cost somewhere between $0 and $10,000.
Infographic: How Bitcoin Activity Stacks Up Against Other Payment Networks
SOURCE: STATISTA
Sometimes it’s misreported that bitcoin is totally free. But the bitcoin network does require a fee in certain circumstances. It’s a small, variable amount. The technical details of each transaction determine the sum. And, yes, in some cases, there is no fee at all. Bitcoin merchant software provider Coinbase estimates the cost of this feeat between .0001 and .0005 BTC. (This is under $.20 based on current Bitcoin exchange values.)
Remember, bitcoin is peer-to-peer. So you don’t need to work with a 3rd party to receive bitcoin payments. But many companies offer to handle these nominal fees as part of their standard service pricing. (The aforementioned Coinbase doesn’t charge on transaction processing, but charges 1% to cash out bitcoins to dollars.)

Are there any other potential cost-savings?

Using a digital currency like bitcoin enables some other cost-saving drivers as well.
Bitcoin transactions are non-repudiable. There is no such thing as a chargeback. There are no overdrawn accounts and bounced checks. Consumer chargebacks cost retailers up to $11.8B annually. But the distributed consensus system bitcoin relies on disallows the possibility of chargebacks by verifying bitcoin ownership before making the transfer. (Want to know more about how bitcoin prevents chargebacks? There’s a great article at BTCTheory.com on the subject worth checking out.)
The news cycle has also been loaded with instances of high profile credit card data breaches. The recent Home Depot breach alone compromised some 56 million credit cards. And the December 2013 Target breach reportedly cost the company $100M. (VentureBeat.com) When customers pay with bitcoins, however, they are not turning over any sensitive data. As such, there is no cost related to stewarding confidential info. And, consequently, there is no liability for its compromise.
There’s also another burgeoning opportunity for cost savings on the buy-side. Think back to the difference in processing fees for credit card and bitcoin transactions. That delta gives retailers and suppliers a strong reason to incentivize bitcoin spending. And, some are doing just that. Computer giant Dell recently ran a pilot promotion discounting computers for consumers purchasing with bitcoins.

Are there other business benefits?

There’s a popular vision of the accounting department as organizational naysayer. You know, the same stereotype where the CFO is the red-pen wielding curmudgeon.
I’m not naive enough to say that model is totally passe. But it’s also too limiting a viewpoint of the role of most modern financial executives. A more expansive view is coming into focus. Deloitte’s “Four Faces of the CFO” description put it this way: “CFO’s take a seat at the strategy planning table… They are vital in providing financial leadership and aligning business and finance strategy to grow the business.”
Bitcoin acceptance offers not only tactical cost-cutting, but additional revenue-generating opportunities.
What kind of revenue opportunity does bitcoin acceptance present for strategic growth? The market capitalization of all bitcoins based on current market exchange rates is $5.5B in USD. (Blockchain.info) Sure, that pales in comparison to the $1.2T of US currency currently in circulation. (NewYorkFed.org) But it would have placed bitcoin ahead of the market capitalization of all but 24 nations’ M0 (cash) currency supplies as of 2007. (MarketOracle.co.uk)
The bottomline is that there’s a lot of bitcoin out there. It has value. And, people want to spend it. For many companies, that will smell an awful lot like opportunity.
From the customer-satisfaction perspective: It’s a win to tell your bitcoin toting customer that you (and not your competitor) can accommodate their spending preference.
Over on the marketing side: There’s no shortage of news organizations and bitcoin evangelists hunting down early adopter stories to share with their audience.

What are the risks?

Bitcoin offers some unique business opportunities. But it doesn’t come without risk.
There are three main areas of risk to consider: long term viability/valuation concerns, security threats, and ongoing operation costs.
The $64,000 questions are: Will bitcoins hold their value? And, is the currency here to stay?
It’s not hard to understand why the questions persist. In October 2013 a bitcoin had a value of around $125 USD. In December of the same year rose to over $1,100. Currently, a bitcoin is worth about $400. 10% daily fluctuations in value are not uncommon.
Bitcoin market value September 2013 to September 2014
SOURCE: BLOCKCHAIN.INFO
It’s a level of volatility that could make any financial executive queasy. Depending on the timing of a transaction relative to the moment of accounting, a given transaction action could easily go from nice profit to failing to cover costs. Or, the profitability could double or triple.
Barry Silbert, the founder of Bitcoin Investment Trust summed it up this way: “It is pretty much the highest-risk, highest return investment that you can possibly make.”
But it is possible to do business in bitcoin without taking on the investment risk. It’s an important fact that many business leaders may not yet realize. The two leading providers of bitcoin merchant solutions, BitPay and Coinbase, both offer instantaneous conversion of transactions into USD. Eliminating bitcoin holding time negates the possibility for unfavorable exchanges.
The security threat is tougher to parse. The Consumer Financial Protection Bureau released the following warning earlier this year:
Virtual currencies may have potential benefits, but consumers need to be cautious and they need to be asking the right questions. Virtual currencies are not backed by any government or central bank, and at this point consumers are stepping into the Wild West when they engage in the market.
Thefts, fraud, and scandals related to bitcoin companies have been in the news frequently, of course. An article in Wired estimated the amount of the loss on the infamous Mt. Gox debacle at over $460M. (A forum entry at BitcoinTalk.org maintains an updated list of bitcoin heists worth checking out.)
An important distinction should be made though when it comes to bitcoin andbitcoin companies. All bitcoin thefts so far have involved the transfer of end-users’ private encryption keys to 3rd party bad actors. The bitcoin wiki maintains:
In the history of bitcoin, there has never been an attack on the block chain that resulted in stolen money from a confirmed output. Neither has there ever been a reported theft resulting directly from a vulnerability in the original bitcoin client, or a vulnerability in the protocol. Bitcoin is secured by standard cryptographic functions. These functions have been peer reviewed by cryptography experts and are considered unlikely to be breakable in the foreseeable future.
The final major risk to consider in terms of business bitcoin adoption involves supporting costs. While bitcoin payment acceptance opens a revenue channel and offers efficiencies, there are program costs. Key decision makers will need to spend time analyzing which service providers (if any) should be chosen. There are accounting and taxation ramifications tied to bitcoin acceptance that require special attention. And, employees will require training to execute transactions.


“In this world nothing can be said to be certain, except death and taxes.”

No doubt, many aspects of the bitcoin phenomenon would astound Benjamin Franklin if he were alive today. (Though perhaps not as many as you might expect. He did help architect the new republic’s original alternative cash, Continental Currency.) But the inability of bitcoin to escape tax liability clearly wouldn’t have surprised the founding father a bit!
Anyone inquiring into the prospect of accepting bitcoin payments will also find the taxation issue inescapable. Two questions are inevitable:
  1. What are the tax ramifications of taking bitcoin payments? And,
  2. How will that affect accounting?
The business case for bitcoin
These questions don’t always seem to have easy answers. But recent government announcements have shed light on bitcoin’s tax status.
And, bitcoin fans aren’t always excited about what they’re seeing.
single CNN article described the tax rules governing bitcoin as “a headache,” “an accounting nightmare,” and “a shot across the bow.”
But the same article also speculated that a solution could come in the form of “a killer bitcoin app.” “Something that tracks your basis [bitcoin value] and records gains and losses against market value, daily.”
Where are we at now with bitcoin from a financial management perspective? Government regulations are in place. Technologies are emerging from the bitcoin development community that help ease accounting difficulties. And, standardized bitcoin business accounting is starting to take shape.
Let’s take a closer look.

How are bitcoins taxed?

On March 25th, 2014, the IRS ended one of the great mysteries surrounding bitcoin when it released Notice 2014-21. The notice declared:
For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.
The announcement signified that revenues realized from the sale or exchange of bitcoins would count as capital gains. According to the IRS:
A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer.
CNBC contributor Gina Sanches observed, “What this says is every time you make a transaction, you basically have to keep track of your capital gains.”
For many bitcoin advocates the hope had been that bitcoin would be treated the same as any foreign currency. The hope wasn’t entirely unfounded, either. A March of 2013 announcement from the Treasury Department’s Financial Crimes Enforcement Network (FinCen) did consider bitcoins to be money, rather than assets. FinCen stated that anyone operating a virtual currency exchange would be considered to be “running a money transmitting business.” (NYTimes.com)
But for daily business purposes, the IRS decision settled the tax status issue. In the eyes of the tax collection agency, Bitcoins are indeed property and capital gains taxes are be due on revenues from their sale or exchange.


Multi y-axis line chart detailing bitcoin count and market cap (usd) in 2014
BITCOIN MARKET CAPITALIZATION HAS DROPPED FROM $7.3B TO $5.0B USD BASED ON A DECREASE IN THE EXCHANGE RATE SINCE THE IRS ANNOUNCEMENT. HOWEVER, THE NUMBER OF BITCOINS IN CIRCULATION CONTINUES TO RISE. SOURCE: BLOCKCHAIN.INFO

How do I calculate capital gains on bitcoin?

Bitcoin capital gains use the same formula as any other asset might.
Sale price - purchase price (including fees) = capital gains.
As with other assets, the length of the asset’s holding period determines long term or short term gains status for tax rate assignment purposes. The Turbo Tax website identifies that short-term capital gains rates ranged from “10 percent to 39.6 percent” in 2013, with long-term capital gains rates at “0, 15, and 20 percent for most taxpayers.”
For more on general capital gains calculation, check out the IRS literature governing the “Disposition of Business Property.”


Map of USA detail top marginal tax rate on capital gains by state
SOURCE: TAX FOUNDATION

What are the unique challenges of bitcoin tax calculation?

Calculating gains on bitcoin assets is different than with many other assets, though, for a few reasons:
  1. Bitcoins are virtual.
  2. Bitcoins are divisible.
  3. Bitcoins are relatively liquid (at least at SMB volumes).
These differences present a challenge related to establishing initial bitcoin purchase prices. It’s a challenge that’s easy to accommodate when accounting for just a few transactions. But it gets harder when transaction counts rises to the hundreds or thousands.
So how do you determine cost basis (purchase price) on bitcoin transactions for capital gains calculation? A recent Investopedia article discussed the topic:
Since Bitcoin is now taxed as personal property, like shares of stock, investors theoretically have the option to sell their assets on a first-in-first-out (FIFO) basis, a last-in-first-out (LIFO) basis, or to sell those specific tax lots that are most efficient under the “specific share identification” method used for stocks. [However…] In real life, “specific identification” sub-accounting may be out of [your] hands or outright impossible. Even the industry’s leading exchanges and hosted wallets currently lack the accounting software needed to ensure trades are executed in a tax-optimizing fashion.


MethodFIFOLIFOSpecific ID
Lots sold10/2013: Sell 60 BTC11/2013: Sell 20 BTC
09/2013: Sell 40 BTC
11/2013: Sell 20 BTC
10/2013: Sell 40 BTC
Tax Result10/2013: Long term gain
(60% × $74,000 × 15%)
09/2013: Short term gain
11/2013: Short term gain
($30,000 × 25% - $1,500 × 25%)
10/2012: Long term gain
11/2013: Short term gain
(50% × $74,000 × 15% - $1,500 × 25%)
Taxes Due$6,660$5,250$3,690
A SAMPLE CAPITAL GAINS TAX CALCULATION FROM INVESTOPEDIA SHOWS HOW THE TAX BURDEN CAN VARY BASED ON THE TIMING OF THE SALE AND THE SELECTED VALUATION METHOD. (ALL EXAMPLES ASSUME THE SAME PURCHASE DATE AND ACQUISITION PRICE.)

Not everyone shares the conclusion that LIFO, FIFO, and specific share identification are all permissible asset valuation methods, though. A tax attorney posting on the bitcoin subreddit warned against using methods other than FIFO:
Once a bitcoin is purchased, it becomes indistinguishable from the other bitcoins stored in the same wallet or account. In a subsequent sale or exchange, there is no way to trace the cost or acquisition date of the bitcoin being transferred out. There are some other methods available, such as LIFO (“Last In, First Out”) and Average Cost Basis, but it’s not clear if bitcoins are eligible for these alternatives. So, I would caution against using any system other than FIFO without guidance from a tax advisor or instructions from the IRS.
At this point, the IRS has not officially stated which asset valuation methods are permissible. However, financial executives should know that the IRS has already shown that it is willing to rule retroactively. IRS Notice 2014-21 did more than simply declare digital currency to be assets. It also said taxpayers who treated virtual currency “in a manner that is inconsistent with this notice prior to March 25, 2014” could be “subject to penalties for failure to comply with tax laws.”
The capital gains calculation issue is significant. It threatens the very practicality of accepting bitcoin payments. In fact, that’s a main reason why the IRS decision to consider bitcoins as property disappointed many bitcoin advocates. Andreas Antonopolous, Chief Security Officer at Blockchain.info, described it as “an untenable burden.”
-ANDREAS ANTONOPOLOUS COMMENTS ON THE TAXATION RULES RELATED TO BITCOIN.
But the bitcoin development community is already offering some solutions to the capital gains calculation dilemma.
Both BitCoinTaxes.info and Libratax.com provide online tools to calculate capital gains tax. Each service integrates with various bitcoin exchanges and digital wallets. Users also can select between FIFO, LIFO, and average costing methods. And, for the moment at least, both services are free. (Though each offers premium tax preparation related services for a fee.)

Is there a way to avoid the whole capital gains tax issue?

It’s not hard to imagine that accounting departments might prefer to avoid the bitcoin capital gains headaches.
But it’s not necessary to give up bitcoin to do so.
By leveraging bitcoin merchant payment processing services, bitcoin can be kept as a supported payment method without incurring capital gains (or losses).
Many bitcoin payment processors will accept bitcoin payment on your behalf and pay you in cash. Since you never have possession of the bitcoins, you bear none of the responsibility related the risk of fluctuations in the bitcoin value. This prevents the possibility for capital gains (and losses).
The typical bitcoin payment processing services arrangement allows you to maintain an account with the merchant processing provider, from which you can withdraw funds. The subscription model for most services often involves a small fee to be paid when you “cash out.”
Popular bitcoin payment processors include:

How are bitcoins handled from an accounting perspective?

For better or worse, IRS Notice 2014-21 did clarify how to manage bitcoin accounting.
Since the IRS considers bitcoins to be property, they need to be treated as such for accounting purposes. Consequently, company owned bitcoin holdings should be recorded to non-cash asset accounts in the general ledger.
Like other non-cash asset accounts, valuation changes in bitcoin accounts can be tracked as appreciation/depreciation. Bitcoins do not require the complex depreciation scheduling that fixed assets do, though. Fair market value can be more easily ascertained from active bitcoin exchanges.
Tracking bitcoin accounts as foreign currency accounts would seem to present another possibility. Aside from the IRS declaration that bitcoin is not a currency (despite behaving like on in many ways), there’s a more mundane reason this often isn’t feasible. Bitcoins are divisible up to 8 decimal points. Most accounting software solutions stop at the traditional 2. So natively tracking bitcoin balances within most accounting solutions doesn’t work. Tracking the converted cash value of bitcoin asset accounts avoids this issue. It also conforms with the IRS guidance on the topic.
What’s leftover from an accounting perspective is mainly the issue of transactional reporting. For instance, what happens when an accounts receivable entry is paid via bitcoin?
The Bitcoin Wiki answered the question this way:
In practice, Bitcoin is likely no different than accepting payment in other forms, such as cash, or gold, or scrip, or gift cards or foreign currency. What would you ask your accountant if you decided that you wanted to accept Berkshire Bucks or 1-ounce gold coins as payment?
As noted in a recent Bitcoin Magazine article titled “Using Bitcoin with QuickBooks,” there are “several possible ways to record Bitcoin sales.” But the method outlined specifically by the author provides a practical approach. It both satisfies the accounting matching principle and allows for the creation of an account dedicated to tracking capital gains for tax purposes.
About the author:  is a Project Specialist Manager at Find Accounting Software. He's been helping software buyers make informed investments in business software for over a decade.



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