Digital currency, or e-currency, is an electronic medium of exchange of which bitcoin has become the most widely circulated. Bitcoins use cryptography (mathematically created proofs to provide security, similar to online banking) to mitigate double-spending, a common problem for digital currencies. Individuals install a bitcoin virtual wallet on their computer or mobile device, thereby creating a unique bitcoin address. Bitcoins exist only as a numerical and alphabetical sequence. Wallets have both a public and a private address; the public address can be given to receive bitcoins in a wallet, while the private address, also known as the private key, is necessary to spend or transfer them from the wallet.

On March 25, the IRS issued Notice 2014-21 regarding "the tax consequences of virtual currencies," including bitcoins. According to the notice, such currencies are treated as property for federal tax purposes, for which taxpayers generally should apply tax principles of property transactions.

Taxpayers must recognize a gain or loss when virtual currency is exchanged for other property, in the amount of the difference between the fair market value (FMV) of the property received and the taxpayer's basis in the virtual currency. The character of the gain or loss depends on whether the virtual currency is a capital or ordinary asset in the hands of the taxpayer.

Taxpayers who receive virtual currency in exchange for goods and services are required to include in gross income the FMV of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. Taxpayers who mine bitcoins or other virtual currency also have gross income equal to the FMV of the virtual currency on the date of receipt. In either case, the taxpayers' basis in the virtual currency received is equal to the FMV in U.S. dollars as of the date of its receipt. Virtual currencies received in exchange for services or virtual currency mining may also be subject to self-employment taxes.

Taxpayers using virtual currencies to make payments are subject to the same information-reporting requirements as for any other form of payment. Therefore, employers paying wages in the form of virtual currency must appropriately report the value of the virtual currency at the time of payment on Form W-2. Furthermore, taxpayers using bitcoins to pay independent contractors and make other payments are subject to the Form 1099 reporting requirements.