Bitcoin Mining Tax Implications

The IRS has not provided a large amount of guidance regarding the taxation of crypto-asset mining. The main source of discussion is found in Notice 2014-21.

The required timing of the recognition of income for virtual mining differs from physical mining. The IRS claims that physical mining results in inventoried costs and that recognition of income does not occur until the disposition of the commodity in an exchange. With virtual mining, however, the IRS requires immediate recognition of income, even though the miner may not have yet converted it to traditional currency.

The IRS does not explain how it determines that the reward for successfully verifying a block is immediately taxable. Section. 1.61-1, in part, says that gross income includes income realized in any form, whether in money, property, or services. The key question in this instance is the timing of the taxation.

The IRS’s position on taxing virtual currency mining can conceivably be supported with an analysis of Sec. 83. Under Sec. 83, which deals with property transferred in connection with performance of services, property does not have to be transferred as direct compensation, but just in connection with the performance of the services. The property transferred in exchange for services is immediately taxable at the time the property is transferable or there is not a substantial risk of forfeiture. In the virtual currency mining context, this would occur when the crypto-asset reward is credited and available for transfer to the miner.

Another way to analyze how crypto-asset mining should be taxed is to consider financial accounting principles. Sec. 446 requires taxpayers to use the same book and tax accounting methods except if the method does not clearly reflect income. At this time, there is no set financial accounting treatment for mining of crypto-assets. The financial accounting treatment is arguably consistent with either the IRS-mandated approach or with the gold mining analogy approach.

IFRS 15 requires both a customer and a contract in order for there to be revenue recognition. There is not a specific contract between a customer and a miner for the block reward. An argument can be made that all the participants in the block chain have an implied contract regarding the block award, making all the participants in the black chain a customer. Therefore, the new crypto-asset can be considered revenue. However, it can also be argued that there can be no contract for purposes of IFRS 15 because such an implied contract could not be enforced against any one individual.

Another view is that the receipt of the block award is an accession to wealth because the miner has an increase in assets. Thus, the receipt of the award should be reported as other income. Characterizing the award as revenue or other income is consistent with the IRS’s assessment of block chain mining as immediate income.

A contrary view is that crypto-asset mining produces an internally generated intangible asset. The miner is inputting computing power, electricity, and staff costs to build, or mine, an internally generated intangible asset, that being the crypto-asset. No revenue or gain is recognized until the resulting intangible asset, the crypto-asset, is subsequently sold.

This approach is closer in application to that of gold mining. The block reward is categorized as a self-created intangible asset, and revenue is not recognized until the bitcoin is sold to a third party. Similar to the exploration and development stage of mining, success regarding efforts to create a block are not assured, so costs would be immediately expensed.

One other notable feature of crypto-asset mining that is relevant to taxation involves mining pools. Individuals or companies that want to make a profit through crypto-asset mining have the choice to either go solo with their own dedicated devices or to join a mining pool where multiple miners and their devices combine to enhance the hashing output. The bigger a pool, the steadier and more predictable a member’s earnings. The reward amount that miners participating in a pool receive is usually based on the proportion of hashing power they are contributing to the aggregate of the pool.

Whether a miner directly participates in crypto-asset mining or as part of an overall pool, the income recognition issues are the same. The question is whether the reward is for provision of services (generating immediate taxable income) or, on the other hand, for participating in the creation of an intangible asset (with taxation analogous to the mining and processing of gold). The outcome could also potentially depend upon whether the miner is a publicly traded corporation subject to GAAP principles or operates on a much smaller scale, such as an individual.

The incentive structure of crypto-asset mining with multiple participants reinforcing block chain security and other attributes through competition raises a question of the substance of the work. Arguably, the miners are providing services to the system whether intended or not. In addition, just like certain levels of placer mining activity, individuals can participate in crypto-asset mining as a hobby. For individuals participating without a realistic potentials for profit, this activity likely falls under Sec. 183 limitations.

The evolution in scale in mining activities could resemble the development of many new processes and innovations with implications for the resulting taxation. The future may bring increasing questions as to how a new process or industry interacts with existing tax rules as it evolves in adoption, participation, and scope.

Source: Craig White, Ph.D. “Gold and bitcoin: Tax implications of physical and virtual mining.” The Tax Adviser, August 2020, pp. 516-521.

Gold Mining Tax Implications

Physical materials have provisions regarding natural resource mining that are organized around the life cycle of a mining operation. The mining cycle operates in four phases:

  1. Exploration
  2. Development
  3. Operations
  4. Decommissioning and post-closure.

In the context of mining for physical minerals, the Code allows for immediate deduction of expenses through the exploration and development stages. Development involves activities after the existence of ores or minerals in commercially marketable quantities has been disclosed, and can include expenses incurred during the development and production stage.

Once in the production stage, inventories are required to be established.

In summary, the IRS does not immediately impose tax when gold is produced. The tax treatment of production follows the general rule of capitalization of costs associated with the production of gold and current deduction of period expenses.

The top five mining corporations are responsible for roughly 20% of annual projection. Therefore, a significant portion of U.S. gold production is subject to the corporate income tax.

Individuals engaged in gold mining are subject to provisions that limit their use of losses to reduce taxable income. The IRS stresses Sec. 183’s rules on hobby activities to individual placer mining. IRC section 183 states that a miner must be in a trade or business or engaged in an activity for the production of income with the objective of making a profit in order to claim mining related expenses such as those for exploration and development.

Thus, a smaller-scale operation is less likely to result in a profitable operation and more likely to fall within Sec. 183’s rules on hobby activities.

Source: Craig White, Ph.D. “Gold and bitcoin: Tax implications of physical and virtual mining.” The Tax Adviser, August 2020, pp. 516-521.