Take-Away: With the cryptocurrency boom in the news these days, it is important to know the federal taxation associated with crypto-mining. A token awarded to a crypto-miner will be taxed as ordinary income, while the sale of that reward-token will be taxed as the miner’s sale of a capital asset.

Background: In the recent past few weeks missives have covered cryptocurrency, along with the struggles Treasury regulators have with the decentralized structure of all cryptocurrencies. This is just one more detail in that discussion to absorb.

Capital Asset: As was previously reported, any gains recognized from the sale of virtual currency investments are subject to capital gains taxes according to the IRS. Virtual currency is treated as property and not currency. [IRS Notice 2014-21.]

Crypto-Mining:  A crypto-miner plays an important role to secure a cryptocurrency network. Cryptocurrencies are powered by blockchain technology, a decentralized public ‘ledger’ of transactions that are grouped into ‘blocks’ that do not rely on any centralized authority to ‘police’ those virtual transactions. This absence of any centralized authority, or ‘middleman,’ can result in ‘double-spending’ problems, where cryptocurrency might be spent more than once. To prevent the risk of ‘double spending,’ cryptocurrency networks often rely on a consensus mechanism, known as proof-of-work. Under a proof-of-work consensus, miners compete to solve mathematical problems in order to validate and add a block of transactions to the blockchain ledger. In short, crypto-miners assure the integrity of the cryptocurrency’s virtual network in the absence of any ‘middleman’ or centralized regulator to ‘keep score.’

Mining Compensation:  A crypto-miner is usually compensated by a reward of cryptocurrency for the performance of their mining activities, which is leads to a taxable event. Under that same IRS Notice 2014-21,  a crypto-miner will recognize gross income upon the receipt of the reward-tokens in an amount equal to the fair market value of the ‘token-coins’ at the time of the receipt. In addition, if the miner’s activities constitute a ‘trade or business’, or the miner acts as an independent contractor, the reward-tokens, or virtual currency payments are deemed to be self-employment income and accordingly they are subject to self-employment taxes. If the miner performs their mining activities as an employee, the payments made in cryptocurrency are treated as wages that are subject to federal income tax and the withholding of Social Security/Medicare and unemployment taxes.

Example: Brooke mines Bitcoin. Brooke receives two Bitcoin tokens when the price per Bitcoin is $40,000. If Brooke’s mining services constitute a trade or business, or Brooke receives the Bitcoin tokens in her capacity as an independent contractor, the $80,000 ($40,000 per Bitcoin X 2 coins= $80,000) worth of Bitcoin that she receives will be treated as income, taxed at ordinary income tax rates. Brooke will also be subject to self-employment taxes and she will be required to remit estimated income tax payments on a quarterly basis. If Brooke had performed her mining services as an employee, the $80,000 that she receives will be subject to federal income tax withholding, with Brooke receiving a Form W-2 from her employer every year.

Mining Employers: If a miner’s employer pays more than $600 worth of virtual currency to the miner who is an independent contractor in exchange for their mining services, the employer will be required to prepare and file a Form 1099 with the IRS for each year that it uses miner-contractors for those services. If the employer formally employs the miner in the ordinary course of his or her trade or business, the employer will be subject to more tax compliance requirements in the form of federal withholding and will be obligated to issue to the miner a Form W-2 every tax year.

Sale of Reward Tokens: A miner will incur a second taxable event upon the sale of his or her reward-tokens, with the amount of gain (or loss) equaling the different between the sales price and the gross income recognized by the miner when he or she initially received the token-coins in exchange for performing their mining services.

Example: Following the first example, Brooke received two Bitcoins worth $40,000. If Brooke later sells those two Bitcoins three years later when the price per Bitcoin is $65,000, Brooke will recognize gain of $30,000 ($15,000 gain per Bitcoin  X 2 coins = $30,000.] Because Brooke held onto the Bitcoins for three years, her gain will be subject to long-term capital gains tax rates.

Conclusion: A miner of cryptocurrency thus faces two taxable events. First, when they are compensated for their services with the receipt of a cryptocurrency coin or reward-token, that will be taxed to the miner as ordinary income, at ordinary income tax rates, including possibly self-employment taxes. If the miner later sells their reward-token, that transaction will be treated as the sale of a capital asset, subject to either long-term capital gain rates, or short-term capital gains, i.e. ordinary income, if the reward-token is sold less than a year after its receipt. While I confess that I do not know any miners (nor would I come close to understanding what they do and how they go about doing it) I wonder if many miners operate on the ‘out of sight, out of mind’ principle when it comes to reporting their income.  Which may be why the IRS has recently announced that it is ‘beefing-up’ its scrutiny and enforcement of cryptocurrency mining activities.