On its face, it’s obviously great for Bitcoin if El Salvador adopts it as its legal tender. There are, however, nuances in the internal revenue code that make this news much bigger than most realize.

Most know that when trading foreign currencies gains must be reported and are taxed. But Section 988(e) carves out a de minimis exception for “personal transactions” where the gains do not exceed $200.

This is intended to allow travelers to transact in foreign currencies without all of the burdensome reporting requirements.

So far, Bitcoin has not qualified for this exception. Under IRS Notice 2014-21, the IRS opines that Bitcoin is “property” and not a “currency” because “it does not have legal tender status in any jurisdiction.” There is a good argument, though, that once Bitcoin is “legal tender” in El Salvador, it will qualify for US individuals as a “nonfunctional currency” (under Section 988), allowing individuals to forgo reporting gains on small, daily transactions—“personal transactions.”

In other words (tldr), if Bitcoin is legal tender in El Salvador, US citizens could possibly freely transact in Bitcoin, as a “nonfunctional currency,” without a need to report gains of less than $200.

That’s potentially huge news for retail US citizens, but there is also huge news for US Bitcoin businesses.

Most US businesses use the US dollar as their unit of account for bookkeeping and reporting. However, there are cases where businesses operating primarily in foreign jurisdictions use a foreign currency—the unit of account does not have to be USD. The unit of account used by the business is the “functional currency” of the business and, perhaps, even an individual (see Sec. 985 IRC). If a business’s “functional currency” is a foreign currency, it does not have to bother with gains/losses related to USD fluctuations.

Again, under Notice 2014-21, Bitcoin cannot qualify as a functional currency. And, again, this could change if El Salvador adopts Bitcoin as legal tender.

Final tldr If Bitcoin becomes legal tender in El Salvador, IRS Notice 2014-21 may become partially null, relieving US individuals and business of huge tax and reporting burdens, paving the way for Bitcoin to legally and easily be used as a currency in the US.

Disclaimer: I am not a tax lawyer. The discussion and analysis on this should be much more detailed before financial decisions are made. I’ve written this to be used as a starting point for discussion with a tax lawyer.

Edit: Many have pointed out that Japan recognized Bitcoin as “legal tender” in 2017. They did not. A lot of misinformed authors incorrectly wrote that, but there is a distinction between Japan’s legal recognition of Bitcoin as a form of payment and what the Code/Regs/precedent considers “legal tender.” I think (and hope) that El Salvador will truly recognize Bitcoin as legal tender.

Edit 2: A Decrypt article mentioning this thread and citing former IRS counsel to point out additional nuances. https://decrypt.co/73101/el-salvador-legal-tender-move-unlikely-to-change-us-tax-on-bitcoin-former-irs-counsel. FWIW, I agree with most of what’s written. Particularly, (1) if Bitcoin is currency, all gains over $200 would be treated as ordinary income rather than capital gains and (2) the IRS will likely need to be challenged before their is clarity on whether Bitcoin will qualify as a currency rather than “property.” I disagree that it will require “more and more” countries to recognize it as legal tender—one should be fine, but it is true that there will likely need to be evidence that Bitcoin is actually commonly used for personal transactions (not just a pretextual “legal tender”). With the lightning network quickly gaining momentum, I expect El Salvador’s move to be the catalyst that starts to convert Bitcoin’s usage from just a store of value to also a common medium of exchange (i.e., a currency).