!!!ALERT!!!
New IRS guidance on virtual currency (VC) released 3/25/14
http://www.irs.gov/uac/Newsroom/IRS-Virtual-Currency-Guidance

For most purposes, IRS requires a property approach (Schedule D gain/loss) not a foreign currency approach.

VC is taxable when mined by miners.  VC transactions are reportable.  See the IRS document for details and FAQ.  If you have been doing it differently, consult a tax professional. 

Regarding the scope of IRS rules, they only apply to US taxes.  Although the IRS might wish to be the top tax authority in the US they are not.   They are beneath the constitution, the revenue code (written by lawyers in congress and constantly changing), court case law, and the treasury department.  However in the absence of guidance from these other authorities, IRS rules should be followed.

Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions.

!!!ALERT!!!
New IRS guidance on virtual currency (VC) released 3/25/14
http://www.irs.gov/uac/Newsroom/IRS-Virtual-Currency-Guidance

For most purposes, IRS requires a property approach (Schedule D gain/loss) not a foreign currency approach.

VC is taxable when mined by miners.  VC transactions are reportable.  See the IRS document for details and FAQ.  If you have been doing it differently, consult a tax professional. 

Regarding the scope of IRS rules, they only apply to US taxes.  Although the IRS might wish to be the top tax authority in the US they are not.   They are beneath the constitution, the revenue code (written by lawyers in congress and constantly changing), court case law, and the treasury department.  However in the absence of guidance from these other authorities, IRS rules should be followed.

Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

Chris, I can't specifically bless tax returns or strategies I don't look at in specific detail, but what your paragraph sounds generally reasonable.  Among the other things I look at when advising clients include: operating loss carryforwards, eligibility for research credit, use of retirement plans (SEP IRA etc.), full use of self employment business deductions, use of rental income, use of living trusts, interfamily tax strategies, and charitable gifting of appreciated assets. 

Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

How is the 'reward' different from lottery winnings or a treasure trove (both taxable eg: Cesarini v. United States, 296 F.Supp. 3 (N.D. Ohio 1969)?  In particular, if a US based lottery pool were involved, with the pool as a counterparty, how would the counterparty record (and report) the transaction?

What are the holding periods and how much of a difference are you talking about?
There is a general cost-benefit principle in accounting that we should not spend $10 to accurately measure $1, and in tax enforcement in general the tax authorities spend $1 to collect $10, not the other way around.  Certainly reasonable estimation methods can be used to avoid individual measurement of micro amounts when exchange information is limited.  I encourage you to consult a licensed tax professional about the details of your situation.

I am a USA CPA licensed in CA and IL, and I can be found on LinkedIn or by Google.  Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

I've been asked (in private) for more technical support for the capital vs. ordinary treatment of bitcoin gain and loss.  I will share my research on this with you all.  Beware, it is somewhat technical.

A) "Is bitcoin a capital asset? ... I don't mind doing some reading "
It depends.  This is a grey area raising a lot of issues depending on the details of the situation.  I don't have a general answer at this time.

If we believe Bitcoin is currency then, since an individual taxpayer's functional currency is the US dollar,  the foreign currency rules IRC988 apply:"Code Sec. 988. Treatment of certain foreign currency transactions
(a) General rule
Notwithstanding any other provision of this chapter -
(1) Treatment as ordinary income or loss
(A) In general. Except as otherwise provided in this section, any foreign currency gain or loss attributable to a section 988 transaction shall be computed separately and treated as ordinary income or loss (as the case may be)."

This is powerful language and "notwithstanding other provisions of this chapter" means that it potentially trumps the IRC1221 rules on capital assets and capital loss.  Section 988 goes on to say:
"(C) Special rules for disposition of nonfunctional currency
(i) In general. In the case of any disposition of any nonfunctional currency -
(I) such disposition shall be treated as a section 988 transaction, and
(II) any gain or loss from such transaction shall be treated as foreign currency gain or loss (as the case may be).
(ii) Nonfunctional currency. For purposes of this section, the term "nonfunctional currency" includes coin or currency, and nonfunctional currency denominated demand or time deposits or similar instruments issued by a bank or other financial institution."

However, see Rev. Rul. 74-7 where traveler foreign currency reconversion gain/loss not associated with a trade or business was determined to be capital gain/loss.

See also (1985) National Standard Company v. Commissioner: Will the Real Character of Foreign Currency Exchange Gains and Losses Connected with the Disposition of Foreign Debt Please Stand Up? John F. Lyons
http://digitalcommons.pace.edu/cgi/viewcontent.cgi?article=1580&context=plr

Section 1221 defines the term "capital asset" as property held by the taxpayer, regardless of whether it is connected with the taxpayer's trade or business, unless the property meets one of eight listed exceptions: (1) inventory; (2) property of a character which is subject to the allowance for depreciation provided in section 167, or real property used in a trade or business; (3) certain intangible property; (4) accounts receivable acquired in the ordinary course of a trade or business; (5) certain publications of the United States Government; (6) certain commodities financial derivatives; (7) certain hedging transactions; and ( 8 ) supplies of a type regularly consumed by the taxpayer in the ordinary course of a trade or business of the taxpayer.

(0) Is bitcoin property?  Perhaps.  "Foreign currency is recognized as "property" as that term is used in the internal revenue laws. Such property meets the literal definition of a capital asset as set forth in section 1221.2" (International Flavors & Fragrances Inc.; 62 T.C. 232 (1974))  

(1) Is bitcoin inventory?   Probably not. "In the manufacturing context, goods subject to inventory are tangible, movable objects." -  Cf. Jim Turin & Sons, Inc. v. Comm’r , 219 F.3d 1103, 1107 (9th Cir. 2000), (although the IRS commissioner has broad power, in the future to require inventory accounting in designated industries; eg see IRS Letter Ruling 9523001 and 9527003).  Also note that property cannot be classified as inventory unless it is held by the taxpayer primarily for sale to customers in the ordinary course of his or her trade or business (Van Suetendael v. Comm'r, 152 F.2d 654 (2d Cir. 1945))

(3) Is bitcoin certain intangible property?  Copyrights, a literary, musical, or artistic compositions, and similar property.  Probably not.

(7) Is bitcoin certain hedging transactions in the course of trade or business.  This is a complex grey area, as hedging in the course of a trade or business is not well defined.   See Lyons cit. above.  However transactions entered into for speculative purposes will not qualify as hedging transactions. See S. Rep. No. 201, 106th Cong., 1st Sess. 24 (1999).

B) Redacted.
C) " prefer to do things right"
I assume that most of us want to do the right thing, not just to avoid penalties and to sleep well at night, but to set a good example to others and to have a functioning society and government that relies on trust not just on enforcement.  Call me an idealist.    As you can see Bitcoin is a grey area in the tax law, and we are best served by not preparing the tax return ourselves, but hiring a (another) licensed professional who will research the specific situation efficiently and accurately and perhaps with less bias than the taxpayer doing it themself.  

When we (tax professionals like me) make mistakes it is perhaps from error or miscommunication vs. from deliberate deceit/fraud, whereas with a self-prepared return the taxpayer is more likely to be considered 100% responsible and perhaps the taxpayer intent is more likely to be questioned.  Having a respected preparer signature on the return is also particularly important if the tax return is to be credible documentation of income for loan or loan refinance.

Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions.  

You are likely better off paying capital gain tax as an individual, rather than income+payroll tax, particularly if the holding period might be over a year and the capital gain is long term.  In general corporations are like lobster traps, it is easy to put stuff in but expect to pay tax when taking it out. 

Try to find a licensed tax advisor in your state (each state has its own tax rules and licensing peculiarities) who is up to speed on virtual currency issues.  I am taking qualified California bitcoin clients this 2013 tax season and am even accepting payment in Bitcoin.  I can be found through google or linkedin.

Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

In general, the approach you describe sounds reasonable to me.  I do not think the problem of tracking is quite so "huge".  Eventually when you sell or exchange the coin you will have paid tax on 100% of your realized amount, so the amount recognized at the mining date is just a matter of timing.  Adopt a method that is reasonable and simple to apply and be consistent.  For example you trade primarily on one exchange during a period you might use published trades from that exchange if available to value mined coins in that period (last, w. avg, (high+low)/2 - any would probably be considered reasonable).  Whichever method and periods are appropriate for your situation and volume, write it down and be consistent.  By paying some tax at time of mining you are demonstrating good faith effort to comply in a grey area of tax law.  Where people get in trouble is when they exhibit the attitudes like "I will pay zero tax" or "I will arbitrarily change my methods from day to day or using hindsight to pay the absolutely least amount of tax possible".  Don't do that.  These are the people tax authorities tend to select for enforcement and to set precedents. 

I am a USA CPA licensed in CA and IL, and I can be found on LinkedIn or by Google.  Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

Agreed, it is income at the time of mining.  I am not convinced that BTC mining is like creating artwork for several reasons.  Artwork does not have active markets that can be used to determine price at the date of creation.  While art involves assembling supplies previously owned by the artist, bitcoin mining involves a point in time when the miner has control over something they did not previously possess.  And, perhaps most telling is the matching principle in accounting that income and related expenses should be recognized together.  So I doubt that deducting electric and equipment expenses now, while deferring recognition of revenue will be considered to be consistent.  Then there is IRC83 which requires that deferred compensation (such as stock and options) be recognized at the fair market value when title transfers to the taxpayer, not when the investment is sold.  And IRC988 requires income to be recognized when foreign currency is received for goods or services.

Regarding depreciation, in general for federal taxes, most miner expenses get deducted immediately not depreciated, because the business sets a $2,500 capitalization threshold, expensing anything below this threshold, and then accelerating depreciation of expenses over $2,500 up to IRC179 limits (often $500K).  For state taxes it is possible that some expenses may need to be capitalized and depreciated.  Don't forget to deduct telecomm expenses, training, reasonable business travel and home office expenses.

I am a USA CPA licensed in CA and IL, and I can be found on LinkedIn or by Google. Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

While the IRS has not given specific guidance on BTC as of today, they likely will do so in the next 6 years, and there may be significant advances in forensic technology in this period.  If a taxpayer gets an audit notice 6 years from now, and has a tax position that is overly aggressive there can be substantial interest and penalties, even exceeding the disputed amount.

I am not convinced that BTC mining is like creating artwork for several reasons.  Artwork does not have active markets that can be used to determine price at the date of creation.  While art involves assembling supplies previously owned by the artist, bitcoin mining involves a point in time when the miner has control over something they did not previously possess.  And, perhaps most telling, there is a matching principle in accounting that income and related expenses should be recognized together.  So I doubt that deducting electric and equipment expenses now while deferring recognition of revenue will be considered to be consistent.  Then there is IRC83 which requires that deferred compensation (such as stock and options) be recognized at the fair market value when title transfers, not when the investment is sold.  And IRC988 requires income to be recognized when foreign currency is received for goods or services. 

Regarding fair market value, I think revenue ruling 59-60 allows consideration of exchanges other than MtGox, as long as the exchange is active, the valuation method is used consistently and satisfies all other applicable rules.

I am a USA CPA licensed in CA and IL, and I can be found on LinkedIn or by Google. Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

Regarding mining, there is a matching principle in accounting that suggests that income should be recognized at roughly the same time as related expenses.  So deducting expenses when incurred or paid, but capitalizing the value of mined coins and not recognizing income until the coins are sold would, in my opinion, not likely be upheld in tax audit or litigation.  By far the safest position is to recognize income at the FMV when mined.  Determining FMV is not completely clear cut, given as much as 10% spread in dollar values between exchanges.  Whatever valuation method is used should be used consistently, and it is probably worth seeking valuation advice if the mining revenues are large.  The income recognized becomes the tax basis and then additional gain or loss is recognized based on the change from basis when the coins are sold.  Several methods including LIFO and specific identification may be used to decide which coins were sold.  Whichever method is chosen should be used consistently.

I am a USA CPA licensed in CA and IL, and a certified valuation analyst, and I can be found on LinkedIn or by Google. Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

Folks, at this time the distinction between currency and investment is a grey area to me and both approaches have some support in tax law.  I'm repeating the court case citations I am aware of that lend some support to either approach.  There is no right and wrong here yet until the lawyers in congress, or the lawyers who are now judges give us stronger guidance on what to do with coins that are not associated with countries.  As described in my earlier post each approach has advantages and disadvantages.  Pick one or be consistent with previous years.  Consider seeking advice from a tax expert before changing approaches.

Supporting the currency approach:  In SEC vs. Trendon T. Shavers and BTCST  Judge Mazzant writes “It is clear that Bitcoin can be used as money,”  “It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses.”  Also see IRC 988(c )(1)(C )(ii) “Nonfunctional currency. For purposes of this section, the term "nonfunctional currency" includes coin or currency, and nonfunctional currency denominated demand or time deposits or similar instruments issued by a bank or other financial institution.”

Supporting the investment approach: In California Bankers Assn. v. Shulttz “‘Currency’ is defined in the Secretary’s regulations as the coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued.”  Some other jurisdictions may be taking this investment approach.

I am a USA CPA licensed in CA and IL, and I can be found on LinkedIn or by Google.
Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

Reversing the scenario does make a difference.  Although losses are only deductible in one of those three categories, all gains, including those outside these categories are usually taxable.  In your case above however, IRC988(e)( 2 )(B) sets a $200 threshold below which the currency exchange gain on personal transactions are ignored.  From a practical standpoint, a taxpayer is unlikely to get audited over the taxes on a single $50 unreported gain. Common things that do cause taxpayers to get audited are tips from ex-wives and ex-employees. 

This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

The000Dustin, unfortunately the situation described above sounds similar to the example in IRS Rev. Ruling 74-276 where exchange loss of an overseas employee was not deductible because it was not "(1) losses incurred in a trade or business, (2) losses incurred in a transaction entered into for profit, though not connected with a trade or business. and (3) certain casualty and theft losses."  (see also IRC165( c ) and Treas Reg 1.165-1(e)( 2 ) )

Business expenses ideally are reimbursed by the employer who deducts them on their business return, or as an unreimbursed employee expense on Sch A.  Unincorporated nonemployee businesses deduct exchange loss on Schedule C or E or F of the owner. "Losses incurred in any transaction entered into for profit, though not connected with a trade or business;" I would report as a negative component on 1040 line 21 OTHER INCOME.  And of course investment losses go on Sch D.  Be careful with travel related exchange losses however, as other travel specific limitations may apply.

I hope these comments were helpful.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

"It's strange to start out the comment with "the rules seem pretty clear," because I was thinking just the opposite. "  - Yes, agreed, it is still murky.

Why file anything at all?  Because it starts the clock on the statute of limitations, limiting the ability of tax authorities, in the indefinite future, from targeting you with future forensic technologies, for many years worth of compound interest and penalties, or taking even stronger measures against you.  And because it is the right thing to do. IRC 6501(c)( 1) False return. In the case of a false or fraudulent return with the intent to evade tax, the tax may be assessed, or a proceeding in court for collection of such tax may be begun without assessment, at any time.  See also 6501(c)( 2) Willful attempt to evade tax ; and 6501(c)( 8 ) Failure to notify Secretary of certain foreign transfers.   

"And then there's the question to file anything on a schedule D in the first place.
One approach may be to just file it under "other income" and pay income rates. "
Given the lack of standards for presentation of bitcoin income, I would be much more concerned that numbers are reasonably accurate than to presentation.

The investment approach has the advantages of lower long term capital gain rates and perhaps deferred realization of gains in some exchanges, but losses are capital losses which are harder to utilize.  In contrast the currency approach more readily realizes gains at ordinary income rates, but any losses are ordinary and easier to realize and carryforward as NOL. 

If the dollar difference between the two approaches is large, the taxpayer (or their advisor) may want to pay to obtain a private letter ruling from the IRS on this issue.  I have searched but am not aware of any such rulings to date.  I would not recommend changing between methods without consulting a CPA or tax attorney, and I also recommend professional advice when choosing between LIFO, specific identification, or other methods of timing trading.

Supporting the currency approach:  In SEC vs. Trendon T. Shavers and BTCST  Judge Mazzant writes “It is clear that Bitcoin can be used as money,”  “It can be used to purchase goods or services, and as Shavers stated, used to pay for individual living expenses.”  Also see IRC 988(c )(1)(C )(ii) “Nonfunctional currency. For purposes of this section, the term "nonfunctional currency" includes coin or currency, and nonfunctional currency denominated demand or time deposits or similar instruments issued by a bank or other financial institution.”

Supporting the investment approach: In California Bankers Assn. v. Shulttz “‘Currency’ is defined in the Secretary’s regulations as the coin and currency of the United States or of any other country, which circulate in and are customarily used and accepted as money in the country in which issued.”  Some other jurisdictions may be taking this investment approach.

So far I have been writing about BTC for individuals, not for businesses.  If you have a Bitcoin based mining or trading business then your tax basis may not be cash and your functional currency may not be the dollar, and your situation becomes MUCH more complicated.

There are several other compliance reporting issues US taxpayers with bitcoins should be aware of, particularly if you transact bitcoins outside a brokered exchange:  FATCA, FBAR, Forms 8300 and 1042-S.

I am a USA CPA licensed in CA and IL, and I can be found on LinkedIn or by Google.
Here is my circular 230 disclaimer.  This post is intended to provide generalized tax and valuation information that is only appropriate in certain situations. It is believed accurate at this time, but these rules, alas, are constantly changing.  It is not intended or written to be used, and it cannot be used by the recipient, for the purpose of avoiding tax penalties that may be imposed on any taxpayer. These contents should not be acted upon without specific professional guidance. Our liability, under any circumstances, is limited to the amount paid for our services.  Please contact us if you have questions. 

Hmm, I tried posting two days ago and now I don't see my post.  Am trying again here and now.