Bryan C. Skarlatos & Jay R. Nanavati quoted in "Is Bitcoin Going Out Of Style?", Tax Notes

“That’s hot.”

This column does not give investment advice, but readers need look no further for a market top in cryptocurrencies than the fact that Paris Hilton is touting — or rather tweeting — an initial coin offering. Yup, the socialite and perfume entrepreneur who once tried to trademark the phrase “that’s hot” tweeted that she is looking forward to participating in LydianCoin’s initial coin offering (ICO).

LydianCoin is going to be a digital marketing platform sponsored by Gravity4, which is looking to raise $100 million. Lydian calls itself the first big artificial intelligence marketing cloud for blockchain. The platform is supposed to produce AI driven marketing — presumably a more advanced version of the way social networks scoop up user information, analyze it, and then target ads back to those users. Those who miss out on Hilton’s investment picks might want to invest with their dentists — Dentacoin, a blockchain dental insurance platform, will have an ICO in October (Business Insider, Sept. 5, 2017).

We’ve got your fall fashion coming, readers, but this couldn’t wait. Are cryptocurrencies going out of style? Is demand for them created not just by speculation but also by criminality? Criminals are believed to be backing away from cryptocurrencies.

This article looks at the issue raised by taxpayers using Bitcoin to conceal their assets, income, and financial transactions. It uses Bitcoin as a shorthand for cryptocurrencies created by distributed ledger systems. There are hundreds of other such cryptocurrencies, the largest of which is Ethereum.

As is usual for similar problems, money laundering, drug dealing, and other criminal cases precede pure tax cases. Tax charges may be add-ons. So it may be many years before anyone sees a pure tax case involving cryptocurrency. This article looks at the issues and the trajectory of cases.

Bitcoin Background

Bitcoin is not money. It is property for tax purposes (Notice 2014-21, 2014-16 IRB 938). Laws governing money handling come into play when Bitcoin users exchange money for Bitcoin and vice versa. As we shall see, all roads lead to government-issued currencies. The point of mining Bitcoin or trading Bitcoin is to get currency, like U.S. dollars.

Tax law defines a currency as issued by a sovereign and designated as legal tender. Many things are accepted in private transactions, but that does not make them legal tender good for all transactions. A privately issued medium of exchange is not a currency for purposes of tax and money laundering rules.

Treasury’s Financial Crimes Enforcement Network said that Bitcoin exchanges have to register as money service businesses (MSBs). FinCEN specifically stated that Bitcoin isn’t money but that when it is exchanged for money, the exchanger has to comply with money laundering rules, which include reporting of large transactions (FIN-2013-G001). Some cryptocurrency exchanges have registered. Many have not.

Bitcoin mining is pyramid scheme. Ostensibly, no more than 21 million Bitcoin units will ever be created. But there are already smaller denominations — milliBitcoin, microBitcoin, and satoshi — and the Bitcoin split created duplicates. Most Bitcoin is owned by the originators — that is, miners. Bitcoin is becoming more valuable in terms of government-issued currencies. Bitcoin’s market capitalization is estimated to be $44 billion.

And there are a lot of outright Bitcoin Ponzi schemes around. Many ICOs are frauds. Some scams, like OneCoin and Swisscoin, had no blockchain. They just took people’s money. Swisscoin ran a pyramid scheme in which holders were rewarded for recruiting others.

The SEC charged an individual with running a Bitcoin Ponzi scheme three years ago (SEC v. Shavers, Civil Action No. 4:13-CV-416 (E.D. Texas Sept. 18, 2014)). Shavers promised investors a return of 7 percent per week based on Bitcoin arbitrage. Silly as this sounded, Shavers managed to raise $4.5 million before the SEC caught up with him, but he only kept $165,000 because of the need to use new investor funds to pay off old investors. When the federal district court entered judgment against Shavers, the 700,000 Bitcoin he raised was worth 10 times as much, so he was ordered to disgorge $40 million (SEC Litigation Release 23090, Sept. 22, 2014).

Bitcoin is not a security. But Bitcoin ICOs are securities because they are investment contracts. The SEC had to treat Bitcoin as money for this purpose. The SEC’s recent action on ICOs may discourage some such schemes at the margin (SEC Investor Bulletin, July 25, 2017). Recent regulatory actions will have the salutary effect of discouraging the use of ICOs to launder money.

ICOs accept cryptocurrencies in exchange for marketable tokens which are themselves cryptocurrencies. An ICO is a coin swap. The proceeds can be used to fund other projects, buy other cryptocurrencies, or track real securities like Apple shares. The legal structures of ICOs are not straightforward. ICOs are popular with cryptocurrency holders wanting to monetize their holdings without converting them to legal tender and triggering banking and money laundering rules. ICOs have raised nearly $2 billion — overtaking venture capital as start-up financing (Business Insider Australia, Sept. 5, 2017).

ICO issuers maintained that their investors had become owners of a software platform and that they were not investment contracts because they don’t accept legal tender — to no avail with the SEC. Most use the Ethereum platform, which is simpler than Bitcoin. The tokens are themselves securities, even if they trade as cryptocurrencies. For this reason, some ICOs do not sell to U.S. investors.

Obviously wary of stepping on a popular fad, the SEC said it will not bring enforcement actions against ICO issuers, instead merely warning investors that ICOs could be securities. DAO, a $150 million ICO that the SEC’s distributed ledger technology working group studied, did not qualify for the crowdfunding exemption to securities registration (SEC Release No. 81207, July 25, 2017). Before it invested its ICO proceeds in promised projects, DAO suffered a hack that took a third of its funds.

The SEC is dithering about authorizing a Bitcoin exchange-traded fund until there is a regulated market in Bitcoin futures. The Commodity Futures Trading Commission ruled favorably on Google’s cryptocurrency trading platform, LedgerX, which will be both a derivatives clearing organization and a swap execution facility, allowed to clear options and swaps (CFTC letter no. 17-35, July 24, 2017).

Chinese securities regulators took a harder line. The People’s Bank of China declared ICOs illegal, prohibited them from monetizing cryptocurrencies, promised to punish ICO issuers, and demanded that they return investor funds. This action is so broadly worded that some observers think it makes all cryptocurrency trading illegal. The regulator said that cryptocurrencies do not have legal status as money and therefore should not be circulated as such. Moreover, ICO platforms are not allowed to exchange legal tender for cryptocurrency or provide pricing and intermediation — in short, no one can operate an exchange (Business Insider, Sept. 4, 2017).

Not Anonymous

Bitcoin is not anonymous. If it truly were, no one could keep track of who owned what. But there are operators who promise anonymity to criminals. And there are above-board exchanges that don’t post transactions they process on the blockchain. Ross Ulbricht’s now-defunct Silk Road used the dark website Tor to shield user identities and operated an internal Bitcoin-based payments system. (Prior coverage: State Tax Notes, July 17, 2017, p. 277.)

Indeed, blockchain technology — which creates a time-stamped, immutable, append-only ledger — creates the ultimate audit trail. Bitcoin is actually more traceable than cash. A Bitcoin verification shows the entire transfer history of the Bitcoin being transferred. Indeed, the Bitcoin Foundation reassured FinCEN that it could trace where any Bitcoin had been — up to a point.

Every Bitcoin is traceable all the way back to the point of its creation. But the identity of the holder is not revealed on the blockchain, which shows only the date, time, and amount of a transaction and the associated wallet’s unique alphanumeric identifier. The blockchain does not reveal the beneficial ownership of the wallet. Even for transactions posted on the blockchain, wallet identifying information can be obscured in networks like Tor, transactions can be bundled for posting, or private blockchains can be used for less common cryptocurrencies.

Moreover, many transactions are now settled off the blockchain and never recorded there. The exchange that processed the transactions would have the only records. From an investigatory standpoint, the blockchain’s limitations and the widespread practice of off-chain clearing combine to make the blockchain more like the Depository Trust Company, which holds publicly traded shares on behalf of brokers, who control information about beneficial owners. To find the owner, it is necessary to sue the intermediary in each case.

“The irony is that the users of Bitcoin desperately want a clear record of who owns the coin to protect their ownership. On the other hand, many of them use Bitcoin because they want there to be complete confusion or opacity on the part of the government about who owns the coin,” said Jay Nanavati of Kostelantz & Fink.

“The Bitcoin network is vulnerable to blockchain analysis which can connect the dots to real world identities in the long run. This implies Bitcoin itself isn’t half as useful for criminal enterprise as first perceived,” wrote Izabella Kaminska, a keen observer of cryptocurrency development, at FT Alphaville. “It’s just a matter of time before the Feds catch up, which may undermine Bitcoin’s primary utility from now on” (FT Alphaville, July 27, 2017).

The blockchain is incorruptible because of the distributed nature and public exposure. Participants monitor each other’s transaction records and in so doing keep each other honest. Group confirmation of transactions ensures that the same funds are not spent twice. But because Bitcoin is lodged in software, it is vulnerable to hacking, denial of service attacks, and ordinary bugs. Because it is decentralized, no one is ultimately responsible for problems, as the internal war over the split demonstrated.

Blockchain technology has other uses. Walmart, the largest U.S. grocer, wants to use it to create an audit trail for food safety. Several business sectors are studying blockchain technology for regular business use. Fifty banks are members of the private R3 consortium studying blockchain technology. Goldman Sachs filed a patent application for a private blockchain for foreign exchange trading. Blockchain can also be used for smart contracts and insurance, like Dentacoin. Ethereum’s systems host hundreds of non-monetary blockchain applications.

The IRS CI division has been studying blockchain technology for a long time. It has a contract with Chainalysis that will allow it to track Bitcoin transactions through the blockchain. The analysis can be followed by a subpoena. Chainalysis guarantees that its tracker technology produces evidence that will hold up in court. (Prior coverage: Tax Notes, Aug. 28, 2017, p. 1066.)

Kathryn Keneally of Jones Day became familiar with blockchain technology when she was assistant attorney general at the Justice Department Tax Division. “Blockchain creates a trail cheaply and efficiently,” she said. “It creates a chain of ownership, and allows different people to come into the same ledger. It can move title, keep track of goods, and track where things are, so there could be no more bills of lading or validation necessary.” But the challenge for government is getting access to information.

Criminals

If Bitcoin is so traceable, are the world’s financial criminals just dumb? Nope, they’re catching on and moving on from Bitcoin.

“The issues will be the ones we’ve always seen. Fraud is fraud. It’s the same playbook as beforehand,” said Keneally. “What makes Bitcoin interesting is the concept that it is a place to store secret wealth, now that we’ve made foreign bank accounts difficult, and cash somewhat difficult.”

“Criminality has created a natural demand point for Bitcoin,” wrote Kaminska. She observed that if Bitcoin has to obey all the rules that other financial institutions obey, it wouldn’t be useful for criminals, demand would dry up, and it would no longer have cost advantages over regular currency (FT Alphaville, July 27, 2017).

There is evidence of that prediction coming true. As regulators and the IRS close in on Bitcoin and its brethren, criminals are heading for the exits. Blockchain Intelligence Group thinks that criminal activity is now 20 percent of cryptocurrency volume, a reduction from its previous share of half. Hansa, AlphaBay, and BTC-e have been shut down. Criminals may have moved on to cryptocurrencies Ethereum and Monero, which offer better customer privacy. Monero promises to scramble user identities using stealth addresses and ring signatures.

It was a watershed moment when the government shut down Bitcoin exchange BTC-e and arrested its Russian chief Alexander Vinnik (United States v. BTC-e and Vinnik, No. CR 16-000227 SI (N. D. Calif Jan. 17, 2017)). Vinnik was charged with money laundering, conspiracy to commit money laundering, and operation of an unlicensed money transfer service (18 USC sections 1955(a)(1), 1956(h), 1957, and 1960). The government sought criminal forfeiture of all property and cash used in those crimes (18 USC section 982(a)(1)).

The superseding indictment of BTC-e and Vinnik accused BTC-e of using Bitcoin to launder billions of dollars, rubles, and euros for the world’s criminals, particularly cybercriminals who demand ransom in Bitcoin form. Tax refund fraud and identity theft were thrown into the mix of crimes for which BTC-e was alleged to have received proceeds.

BTC-e maintained U.S. servers and is believed to have accepted U.S. business. BTC-e customers were not required to provide any identifying information and could use anonymous codes to facilitate withdrawals. BTC-e avoided collecting customer information by using offshore companies to receive funds and Bitcoin exchanges to process withdrawals. Fees were charged every step of the way.

The government believed that BTC-e was the world’s preeminent cyber money laundry. Worldwide, BTC-e served 700,000 customers and transacted in 9 million Bitcoin. BTC-e was alleged to have received proceeds from the Mt. Gox hack and the CryptoWall ransomware scheme. BTC-e itself used Liberty Reserve, a Bitcoin exchange that the government shut down in 2013, accusing it of laundering $6 billion in criminal proceeds. BTC-e grew in the wake of the Mt. Gox implosion and Liberty Reserve shutdown.

What Customers?

Most Bitcoin holders are investors who purchased Bitcoin from an exchange or exchanger (an individual operating as an exchange). The preeminent Bitcoin exchange Coinbase Inc. estimated that more than half of its customers held for investment. Large investors, called Bitcoin whales, include miners, private equity firms, and hedge funds.

Many investors are legitimately trying to learn about applicable tax law and comply with it. Investors believe that the supply of Bitcoin really is limited to 21 million, so that it is an inflation-proof currency that will appreciate perpetually. Some 16 million Bitcoin units have been issued. But the Bitcoin split, discussed below, created many new millions of Bitcoin units, causing Goldman Sachs to predict that the shine would wear off and the price would fall.

A substantial subset of customers, however, see Bitcoin as a magic tool to avoid government and legal constraints generally. Chinese customers love cryptocurrency as a way around exchange controls. U.S. customers may see it as an escape from the tax system. The IRS posited this kind of customer in the affidavits from IRS senior revenue agent David Utzke in support of its summons to Coinbase.

Coinbase exchanges Bitcoin for dollars. It stores Bitcoin in customer wallets using secure vault technology. It processes Bitcoin transactions for merchants using a proprietary interface. It issues a Bitcoin-denominated debit card, the VISA Shift card. Coinbase is registered with FinCEN as a money transmitter, has licenses in 36 states, and follows anti-money-laundering rules. It has 10 million customers who maintain millions of Bitcoin wallets (there can be more than one per customer). Called “the McDonald’s of Bitcoin banking,” Coinbase does not permit short sales or limit orders.

The Justice Department issued a John Doe summons to Coinbase for not just transaction records but also user profiles, account instructions, due diligence, statements, correspondence, and security settings (In the matter of John Does, No. 3:16-cv-06658-JSC (N.D.Calif.)). The summons seeks information about investors who sold Bitcoin for dollars — a taxable transaction in property. It also seeks Coinbase’s know-your-customer and due diligence records for these customers.

Several months later, after some public griping, including by congressional leaders, the summons was narrowed to focus on transactions involving $20,000 or more per year. Bitcoin holders who bought and held or got a Form 1099-K from Coinbase were excluded. A summons need only identify an ascertainable class of persons (section 7609(f)). The summons excluded transactions for which Coinbase operated as a merchant payments processor — that is, people buying things with Bitcoin.

A summons also requires a reasonable basis to believe there has been noncompliance. That means the IRS need only show that the transaction in question is susceptible to non-reporting, like barter exchanges. The government argued that the lack of withholding and use of peer-to-peer systems instead of licensed financial intermediaries allows cryptocurrencies to “replace traditional abusive tax arrangements as the preferred method for tax evaders.” The government noted a public perception that Bitcoin is a way out of taxes. (Prior coverage: Tax Notes, Nov. 28, 2016, p. 1129.)

A summons requires that the information sought be not readily available. A court may rely on the government’s petition and affidavits (section 7609(h)(2)). The petition explained that the blockchain does not contain wallet or account information. The blockchain does not present the ownership of the wallet.

The government’s description of Coinbase procedures implies that the transactions it seeks information about were posted on the blockchain. A Coinbase account gives the customer a standard wallet. A customer can have a vault account in addition. As the name indicates, a vault account is one for which the customer lacks immediate access to the funds. Regardless which kind of account is used, Coinbase automatically generates a new wallet address for every transaction, which sticks to the customer’s account. Coinbase customers have access to the complete list of their transaction-based wallet addresses.

As usual, the need for access to undisclosed funds trips up the would-be tax cheat. In his affidavit accompanying the original petition, Utzke described a customer who had undisclosed offshore accounts but was attracted to Bitcoin because offshore banking was inconvenient, even though he had an ATM card. This customer used Bitcoin to repatriate his offshore funds without disclosure. His offshore bank transferred his funds to a domestic bank that got him an account with a Bitcoin exchange. He did not convert the Bitcoin into dollars but instead used it as currency.

Utzke also examined a pair of domestic corporations that bought and sold Bitcoin without reporting the gains. They buried their acquisitions as deductions for technology expenses on their returns. Their gambit was revealed when IRS examiners wanted substantiation of those claimed expenses. Both companies maintained wallet accounts at Coinbase.

Of course, as Utzke pointed out, criminal money launderers are not in the habit of reporting their Bitcoin gains. There is no information reporting of Bitcoin transactions. The IRS sought transactions for the years 2013-2015 — a period that was punctuated by the publication of Notice 2014-21. Fewer than 1,000 people reported Bitcoin transactions on Form 8949 during the that period, despite evidence that many more are trading in it.

Coinbase fought the narrowed version of the summons, arguing that the IRS failed to give guidance to taxpayers (United States v. Coinbase Inc., No. 3:17-cv-01431 (N.D. Cal. 2017)). The narrowed summons would still require nearly 9 million records pertaining to 14,000 customers, according to Coinbase. The exchange complained that it would cost nearly $100,000 to sort and retrieve information to comply, arguing that a lot of the information would be useless to the IRS. Coinbase asked for an evidentiary hearing.

Some customers sought to intervene in the original summons, and the government responded that they lack standing. The federal district court for the Northern District of California granted leave for a substitute Coinbase customer to intervene, citing the breadth of the summons. The court criticized the IRS for not describing how it would legitimately use millions of customer records. The intervenors asked for discovery and an evidentiary hearing about the IRS’s good faith. (Prior coverage: Tax Notes, July 24, 2017, p. 404.) The government responded that the intervenors had not met the burden for an evidentiary hearing.

The Digital Currency and Ledger Defense Coalition sought to intervene to apprise the court of the wonders of blockchain technology and to convince it that “these innovations should be fostered and properly sheltered from actions that will discourage their development.” But given the fees that Bitcoin exchanges charge, the idea that Bitcoin would transform retail banking for the unbanked is out the window.

What other kinds of cases are being brought? The case posited by Utzke, a U.S. person offshore account holder who happens to hold cryptocurrency, appears to be common but not picked up by the IRS until the taxpayer voluntarily discloses. So the taxpayer’s capital gains on the appreciated cryptocurrency would be rolled into voluntary compliance and amended returns to report undeclared accounts and undeclared income.

Some lawyers represent exchangers. Individuals operating their own little unregistered homebrew exchanges have larger problems than not paying tax on their own personal cryptocurrency gains. They are money transmitters. They may be accused of being money launderers. Money laundering requires actual knowledge but is frequently tried on circumstantial evidence and willful blindness on the part of the launderer. Proving these things to a jury is difficult. With all these felonies on the table, willful failure to pay tax could be a tagalong charge, but it could also be easy to prove.

Practitioners believe that the narrower Coinbase summons will be enforced. But in getting the summons narrowed, the exchange effectively raised the intractable frequent flier problem, which could damage IRS credibility its in pursuit of large-scale tax cheats using Bitcoin as an investment asset.

The Frequent Flier Problem

What can you buy with Bitcoin? Many merchants now accept it. Amazon takes it. Overstock.com takes it. Home Depot takes it. PayPal takes it. Dell takes it. You can buy coffee and snacks in San Francisco. You can even pay some lawyers with it. Coinbase processes transactions for many merchants in-house using its proprietary software because the Bitcoin blockchain is too slow (more about that elsewhere in this article).

Don’t mess with little people’s perks. Don’t mess with their personal myths about the nature of their transactions. Let’s revisit frequent flier miles in the early ’80s — when there were no cosseted million-mile fliers like George Clooney’s character in Up in the Air and no vendors offering to cash out loyalty rewards.

From a tax law standpoint, frequent flier miles were a slam dunk. Employers paid for most of the holders’ flights. Holders were beleaguered business travelers who earned their miles the hard way — flying coach on frequent domestic flights on sales visits to unglamorous places where Olive Garden was the best restaurant in town and Starbucks was a mirage in the desert. (Snobbery aside, those franchises are a blessing for road warriors.)

An airline currency earned on employer-provided flights was clearly compensation. It was taxable income, perhaps as a taxable fringe benefit (section 132). This magazine said so at the time. (Prior coverage: Tax Notes, Feb. 25, 1985, p. 742.) The IRS agreed a decade later, ruling that reimbursement plan rules were not met (section 62(c) (TAM 9547001). It caused a firestorm.

The big, mean, onerous IRS wanted to take away perks that brought joy to miserable middle-class work travel. The agency wanted to tax airline currency that brightened holders’ lives, allowing them to fly free to some other unglamorous location to visit relatives. Again, Clooney’s character did not exist yet. Airlines did not send chauffeured cars to pick up valuable customers, guarantee them first class seats, or offer to buy back miles for cash. On the other hand, frequent flier miles expire, deleteriously affecting their present value.

In a craven press release, Treasury said that the IRS would not enforce the law and that there must have been a misunderstanding. Thus it effectively gave away the right to tax frequent flier miles and their employer-paid kissing cousins in other loyalty programs in their entirety. In 2002 the IRS formally announced a policy stating that receipt of employer-paid frequent flier miles would not be taxed but conversion to cash might be (Ann. 2002-18, 2002-1 C.B. 621).

Coinbase’s successful resistance to the breadth of the initial summons indicates the inchoate frequent flier problem with taxing Bitcoin. Even though most Bitcoin holders are investors who don’t buy anything with their Bitcoin, there are users who believe Bitcoin is a currency. They think it’s cool. They have faith in technology. They don’t care about anonymity. They don’t trust banks because a bank foreclosed on Dad’s house. They may be penniless millennials with low incomes. But they trot up to the coffee shop and merrily pay for their brew with Bitcoin and feel hip and secure doing so.

Technically, that little coffee purchase is a taxable exchange of property for property. It is a barter transaction. Say our millennial paid for a $6 fancy coffee drink with caramel syrup using Bitcoin in which he had a basis of $4.50 — entirely possible given the recent appreciation of Bitcoin. Our millennial realized a $1.50 gain on that exchange. He had no idea.

Our millennial files a Form 1040EZ and gets back a couple thousand dollars that his employer over-withheld from his paycheck according to IRS withholding instructions. There is no Schedule D attached for his Bitcoin-enabled coffee purchases. He probably doesn’t even know his basis in his Bitcoin. In real life, no one knows the basis of anything unless it is subject to broker reporting. But the tax law has no minimums.

The IRS would look like an ogre if it set up our millennial for his Bitcoin gain on his $240 of annual coffee treats. The IRS should excuse small consumer transactions made in cryptocurrencies or loyalty points or other devices that ordinary consumers think of as currencies. The question is how to do it without letting an investor with millions of dollars of cryptocurrency gains escape taxation. Their transactions should be made subject to broker reporting, which may or may not require a statutory change (sections 6045(g)(3)(B)(iv), 6045B). Bitcoin whales make elite frequent fliers look like pikers.

Penalties?

Let’s revisit Notice 2014-21. The IRS acknowledged that in some environments, Bitcoin functions like a real currency despite its lack of status as legal tender. The notice was expressly limited to transactions in convertible cryptocurrency, with no inference intended for nonconvertible cryptocurrency.

The IRS explained that recipients of Bitcoin in exchange for goods and services have to include the fair market value of the Bitcoin. A Bitcoin investor who purchases interest in an ICO has a taxable transaction and probably a Bitcoin gain. Taxpayers have to figure out the FMV of Bitcoin at the time of the transaction for tax reporting purposes. The IRS made it clear that the exchange of Bitcoin for services or property results in taxable gain or loss, the character of which depends on whether it is a capital asset or inventory.

Payments made in Bitcoin are subject to information reporting rules, for which there is a $600 threshold for trade or business payments to taxable recipients (section 6041(a)). Settlement organizations, like Coinbase, have reporting requirements if the total transactions they process exceed fairly low thresholds. TIGTA told the IRS that Form 1099 instructions should be fixed (TIGTA 2016-30-083).

Bitcoin miners, who have collectively earned $2 billion since Bitcoin’s introduction in 2009, are subject to income and self-employment taxes, as the notice makes clear. This liability may be theoretical because most of them labor at Bitcoin server farms in China, the largest of which is Antpool. Individual Bitcoin miners favored currency treatment of Bitcoin when polled, while mining organizations agreed with the IRS’s property characterization.

The notice warns about penalties for failure to report Bitcoin transactions before it was issued. But lawyers representing Bitcoin customers and exchangers do not believe that penalties would be sustained for periods before the IRS announced its view that Bitcoin is property. The IRS mentioned reasonable cause, and it may be that taxpayers have a reasonable cause argument that they believe that Bitcoin is currency. The IRS seems to be missing the point that people wouldn’t have a clue what they were dealing with.

“Even before you get to reasonable cause, there are good arguments that there is no basis for penalties in the first place,” said Bryan Skarlatos of Kostelanetz & Fink LLP, who explained that the two most common penalties would be negligence and substantial understatement. “For taxable years preceding the notice, a strong argument could be made that it was not unreasonable to believe that Bitcoin could be currency, so no negligence penalty.”

“It may be more difficult but still entirely possible that there would be substantial authority for the position that Bitcoin is currency, so no substantial understatement. If you did have a penalty and can show that you tried to figure it out but the law was ambiguous, you may have reasonable cause,” said Skarlatos.

Few lawyers doubt the correctness of the IRS view that Bitcoin is property and not currency. But this logical conclusion becomes problematic for tax administration and more importantly for IRS credibility on matters that touch ordinary consumers. Public comments on the notice showed that people were flummoxed about accounting for transactions and tracking basis for Bitcoin regardless of how it was used. TIGTA recommended that the IRS give better instruction.

“Logically it is property. But we’ve created a nightmare of tracking value and reporting,” said Keneally. “It’s barter, but that’s not what the parties think they’re doing.”

Nearly a decade ago, the IRS National Taxpayer Advocate’s report anticipated the problem of the agency coping with popular expectations of nontaxation, referring to currencies created in virtual world games:

[M]any Internet users and virtual world operators believe that in-world transactions are not and should not be subject to tax, in part because of the administrative difficulties that taxation would present. Thus, a taxpayer may conclude that when the IRS gets around to providing guidance on the taxation of in-world transactions, it will likely reach the same conclusion, especially since it has not issued any guidance to the contrary even though the tax issues presented by virtual worlds have received significant publicity.

The IRS might want to handle the situation the way the Australians did. ATO ruled that cryptocurrencies are property for purposes of capital gains taxation (TD 2014/26). Australian law already excused capital gains on personal assets when the basis was AUD 10,000 or less — in contrast to there being no minimums in U.S. law. Cryptocurrency can be inventory (TD 2014/27).

ATO ruled that cryptocurrency isn’t foreign currency (TD 2014/25). When cryptocurrencies are used in consumer transactions, there are no income tax ramifications as long as the user is not in the trade or business of selling goods or services. The Australian government also plans to remove cryptocurrencies from the GST, effectively treating them as legal tender. (Prior coverage: Tax Notes Int’l, July 3, 2017, p. 24.)

Facts and circumstances determine the purpose of holding cryptocurrencies. “The inherent nature of Bitcoin means that it is generally either used as a means of exchanging if for something of value, or it is kept as a speculative investment. Whether or not Bitcoin is used or kept mainly for personal use or enjoyment will depend on the particular facts and circumstances of each case,” ATO stated.

The Bitcoin Split

Bitcoin could not go into wide use because merchants can’t spend it and transactions could not be cleared quickly enough by miners. Bitcoin payments were taking as long as an hour to clear on the blockchain, and there was a big backlog.

In addition to creating Bitcoin, Bitcoin miners process Bitcoin payment transactions on the blockchain — the public, distributed ledger. Not only is the proof-of-work verification process slow, but miners have to be interested in the transaction fees relative to planned decreasing mining rewards. Even though it is public and distributed, the blockchain is not a nonprofit utility. So Bitcoin is not low cost for those who want to use it for transactions.

It got so bad that more sophisticated users and Bitcoin exchanges now process many of their own transactions outside the Bitcoin blockchain. Outfits like Coinbase clear their own transactions and those of merchants. When our millennial buys coffee, Coinbase or another exchange probably does the clearing in-house, outside the blockchain. Coinbase processes its own transactions and passes on charges for transactions processed in the blockchain. It advertises to merchants that Bitcoin can be instantly converted to legal tender.

When a Bitcoin transaction is settled off the blockchain, it is never posted on that public ledger. Exchanges are not decentralized and usually control each customer’s cryptocurrency by taking custody of their private keys. Again, the Coinbase summons petition noted that the information sought resided solely with the exchanges and other intermediaries. Coinbase does advertise instant conversion to legal tender for account holders.

The Bitcoin split was preceded by years of arguments and an attempt to make the blockchain more efficient. In August, the Bitcoin blockchain was split into Bitcoin and Bitcoin Cash. This event was called the hard fork. Bitcoin technically incurs soft forks all the time, when miners compete for blocks. The winner’s block survives and the other block dies. In the recent hard fork, both tines survived. Some miners will continue to mine and process Bitcoin, while others will mine and process Bitcoin Cash.

While the hard fork was being processed, Bitcoin exchanges froze customer accounts and wrote unintentionally hilarious Dear John letters to customers stating that they couldn’t access their money for a while. Again, exchanges usually control customer accounts and their private keys. (Given that transfers are irreversible, hacking an exchange can be very lucrative.)

The point of the split was to allow Bitcoin transactions to be processed more quickly by processing them in larger batches at Bitcoin Cash. As of August 1, there are now two versions of Bitcoin and two blockchains. The hope was that the more efficient Bitcoin Cash protocol would take over and the old Bitcoin protocol would be abandoned. Instead customers and exchanges seem to be clinging to the old protocol.

This is not like the conversion from national currencies to the euro — there is no central authority able to mandate an expiration date for the old Bitcoin protocol. Some Bitcoin exchanges, including Coinbase, did not support Bitcoin Cash, leaving their users with Bitcoin, where most of the mining capacity still resides. Bitcoin Cash has a market value of around one-tenth of Bitcoin. It’s not clear that Bitcoin Cash is even safe to hold.

Bitcoin Cash retained the history of the Bitcoin blockchain. So Bitcoin Cash has the same number of tokens, but new currency can be created under the Bitcoin Cash rubric and entered into the Bitcoin Cash blockchain. Bitcoin holders were given equal amounts of both versions — essentially increasing the legal currency value of what they own. Bitcoin exchange Kraken credited each Bitcoin customer’s account with an equal amount of Bitcoin Cash (The Wall Street Journal, July 31, 2017).

Did the Bitcoin split cause a realization event? Yes, because existing holders of Bitcoin were given a new valuable cryptocurrency product to the extent their exchange supported it. Because the split produced an equal number of Bitcoin Cash units, the amount realized may well be the full FMV of those units. Roughly $5 billion of Bitcoin Cash units were created. The realization event probably took place this year, but the amount realized is not clear (The Wall Street Journal, Aug. 25, 2017).

Every Bitcoin holder whose exchange supported Bitcoin Cash was affected by the split and has tax ramifications — even penniless millennial caffeine fiends. The income realization is highlighted by the fact that not all Bitcoin holders benefited. Only those whose exchanges decided to support Bitcoin Cash got Bitcoin Cash. Holders who keep their Bitcoin on their own hard drives can also process transactions on either Bitcoin blockchain.

The realization event could be analogized to an in-kind dividend on shares that did not produce an accretion to wealth (Eisner v. Macomber, 252 U.S. 189 (1920)). Treatment as an in-kind dividend might defer but not eliminate recognition until Bitcoin Cash is exchanged for currency or used for purchases.

What’s the endgame? What happens to the chips when the casino goes bust? The ICOs indicate that the dumb money is piling in. The money launderers are being caught and the money laundering problem may be overstated. Criminals might decide they’d rather be chatting with Caribbean lawyers about getting their ill-gotten gains to real banks in London and Zurich. When the values of cryptocurrencies collapse and the fad is over, holders may well come into the tax system wanting relief for their capital losses. 

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