Tag: bitcoin

IRS

Taxation of cryptocurrency forks and airdrops

In Revenue Ruling 2019-24 the IRS considered what are the tax consequences of crptocurrency forks and airdrops.  Those of us who hold, or held, cryptocurrency during widely-followed forks, such as Bitcoin’s 2018 fork into Bitcoin and Bitcoin Cash, know the drill.  The development community can’t agree on fundamental issues about the particular cryptocurrency, such as the amount of data each “block” should carry and how often such blocks should be validated on the blockchain.  Rather than compromising, one faction or the other generates a new code base using the existing coin and adds (or subtracts) their modifications, later releasing the new code into the world as a new coin or token.  Voila, the “fork” (as in a fork in the road) has birthed a new cryptocurrency on its very own blockchain, to thrive or survive alongside its “parent” coin.  Sometimes (as has been the case with Bitcoin Cash), that new coin thrives quite handsomely, resulting in increased wealth in the hands of the HODLer.  Money for nothing?  According to the IRS, actually, no.

The Revenue Ruling’s definitions of cryptocurrency and the mechanics of forking and airdrops is, to the credit of the IRS, spot on.  Someone has been doing their homework into what exactly they are looking at, which is important, since bad inputs make for bad outputs.  In summary, the Ruling notes that the end result of the fork is one of two scenarios:  (i) the taxpayer receives the new cryptocurrency, which is credited to his account or otherwise received by him (via “airdrop”, in the terms of the opinion); or (ii) the taxpayer does not receive the new crypto for any number of reasons, the one cited being where the exchange on which the taxpayer had her pre-fork crypto does not support the new coin, and that crypto-holder’s rights vanish into thin air.

The first conclusion the IRS comes to, which is that there is gross income to the taxpayer where he or she receives the forked coin is, in my view, correct.  Under classic income tax laws there is a clear “accession to wealth”, that is, you have more money in your pocket (perhaps a lot more) post-fork than pre-fork.

Not all income, however, is created equal in the eyes of the tax law.  Once you determine you have income you must then consider the character of that income, that is, capital, ordinary, or something else.  There are books written about these distinctions.  For our purposes, “ordinary” income includes things like a salary or proceeds from the sale of your business’ inventory.  Capital gain (or loss for that matter), in contrast, relates to purchases and sales of “capital assets”.  Capital assets are, for most people, their investments, perhaps including real estate, stocks and bonds, and cryptocurrency.  This distinction is critical, since different types of income are subject to different income tax rates.

The timing matters too – ordinary income is recognized the minute you either receive it (for cash basis taxpayers) or when “all events” have occurred (for accrual basis taxpayers) that result in the taxpayer having dominion and control over the assets.  For capital assets there is a taxable event where the property is “sold or exchanged”, that is, in some cases, mere receipt of a capital asset will not always trigger tax consequences.  Rather, the law keeps a kind of “tally” of the amount of tax you will have to pay (at some point) in what’s called the “basis” of the asset.  The “basis”, in plain language, is the amount of your investment in an asset.  If the price at sale is above your basis, voila, capital gain.  If the price is below it, capital loss.

Let’s take stock splits as an example.  Let’s say you bought 1 share of Apple (AAPL) at $300.00 (everyone seems to like using Apple as an example). Assume for purposes of this example that you are not a dealer in securities or a professional trader.  What do we know about AAPL in your hands?  (1) That is is (in all likelihood) a “capital asset” (an investment outside of your ordinary trade or business); and (2) Your “cost basis” is $300.00.  As of this evening AAPL is trading at around $317.00.  What do we know now?  We know that, given your basis of $300.00, you now have $17.00 of profit.  If you sold AAPL at $317.00, you would have $17.00 of capital gain.

Fine.  Now assume that AAPL splits two for one, that is, all shareholders of AAPL will receive double the number of their shares, so now you have two shares of AAPL.  Here’s the trick:  your basis in each of the shares is also cut in half.  Therefore, you now have two shares of AAPL.  What’s the price of each?  $158.50.  What’s your basis in each?  $150.00.  What if you sold your two post-split shares of AAPL?  What would your gain be?  Still…$17.00.  See?  Your basis “account” adjusted to reflect the economic reality of the transaction, and spread your initial $300.00 investment across the two shares.

Now imagine that instead of splitting, AAPL pays you a cash dividend of $1.00 per share every quarter (it’s actually around $0.77, but let’s use round numbers).  Dividends are, unlike shares received in a stock split, ordinary income (unless “qualified”, which we won’t get into here).  OK, so why don’t we just treat the dividend like a capital asset, and adjust the basis without having a taxable event?  Well, because the law says so, and perhaps in part because dividends are paid in cash.

The question then is, did the IRS get the second part right, that is, the character of the income that you receive when you receive airdropped tokens from a hard fork.  In my opinion, no.

Forked tokens can feel like “manna from heaven” as the saying goes, but in my opinion they much more closely resemble stock splits than dividends.  My opinion is based on what the IRS has told us for many years – that cryptocurrency is property, not money.  Property held as a capital asset that produces more property (like a stock split) should be treated in the same manner as a stock split, and not as if the forked coins are the same as cash, which they most certainly are not.

For starters, the recipient of the forked coin has extreme price risk from the get-go.  It is not uncommon for a forked coin to spike wildly upon receipt (which, according to the opinion, is then its taxable value) only to collapse violently thereafter.  The token holder may not stand a chance – if you’re not in front of your computer ready, willing and able to sell at the precise moment the coin is received – you may end up with a big tax bill AND an asset that has declined significantly in value.  This is neither consistent nor fair.  A true dividend does not have this inherent risk.  True, currencies are always fluctuating in value against other currencies (and gold), but in the short term, your $1.00 AAPL cash dividend is going to buy the same amount of coffee (perhaps half a cup) whether you’re at your computer when its paid or not.

Second, the IRS has further confounded and complicated cryptocurrency accounting for everyone.  It is bad enough that technically, you have to report either gain or loss for the use (that is, “sale or exchange”, remember?) of crypto for anything, including our proverbial cup of coffee.  Now, you must track the basis of assets with different characters.  This will be a huge challenge for developers of crypto accounting and recordkeeping software, thereby making the neat and clean records the IRS wants taxpayers to keep all the more elusive, and often inaccurate.

In essence, the IRS is looking to have it all ways – cryptocurrency is property subject to the reporting and accounting for capital gain and loss, except when it’s not.  And by the way, if you DO decide to hang on to your airdropped coins, only to sell them later if the price goes way up, you may also have capital gain to pay later, on the very same asset that gave rise to ordinary income upon receipt, even though that asset was really capital in nature all along.

So, brush off your spreadsheets.  Between cold storage wallets, intra-exchange transfers, and now, airdropped, forked coins, it will continue to be a challenge to stay in compliance in the crypto world.

(c) 2020 Good Attorneys At Law, PA

Money

Cryptocurrencies and Money Transmitter Laws

Arrow both ways
Wherefore Bitcoin?

Evaluating the rules behind whether you, as a Bitcoin buyer or seller, are functioning as a money transmitter under state law can be baffling.  Cryptocurrencies and money transmitter laws coexist in mostly uncharted waters here at the dawn of 2020.  The following is a note examining both both the broad concepts and the specific provisions of money transmitter statutes as they pertain to cryptocurrencies (particularly Bitcoin) in New York, New Jersey, California, Florida and Wyoming.

Each of the United States has its own regulatory regime when it comes to money services businesses, particularly money transmitters.  While money transmission at the federal level is almost exclusively concerned with money laundering, the state laws’ greater complexity is derived in part from additional concerns on the part of state lawmakers, such as consumer protection.  For this reason, as I will describe below, there are a host of net worth, bonding and reporting requirements that make state law money transmission licensing and ongoing compliance daunting.

It is helpful to group the states conceptually into three different categories in order to evaluate how they treat cryptocurrencies.  The first group consists of the “silent” states, that is, those that have not specifically regulated or incorporated the unique characteristics of cryptocurrency into their statutory schemes.  That a state is “silent” could be considered “good” from one perspective if its silence means that that particular state was not inclined to regulate cryptocurrency (the minority view), but might be considered to be “bad” if the absence of regulation means uncertainty and the risk of being accused of operating an unlicensed money transmission business, which in most states is a criminal offense.  This latter point of view is, unfortunately, how I view the majority of the states we consider herein.

Apart from the silent states we have the “regulated” states, that is, those states that in one form or another have spoken definitively about how cryptocurrency fits into, or is excluded from, their existing money transmitter laws.  Among the regulated states we have two types, those in which regulation has, from most objective perspectives, advanced the ability to do business with cryptocurrency in that state (Wyoming), and those whose regulatory scheme has added next-to-impenetrable barriers for smaller firms looking to comply in good faith with state law (New York).  The third, somewhat more opaque category consists of states that have issued some form of guidance, in the form of pronouncements by public bodies, court cases, and the like, but have not adopted a single, uniform approach to regulating (or not regulating) cryptocurrency.  This latter category could be grouped with the “silent” states mentioned above, from the standpoint that these half measures, while perhaps a start, have introduced further uncertainly into the state regulatory landscape.

These laws are forever changing and evolving, and the difficult and stifling state of state laws is the source of much scholarly compliant.  It is absolutely worth knowing the contours of state money transmitter law, too, in order to cherry pick favorable jurisdictions that are likely to improve first.  Further, there are encouraging developments, particularly in Wyoming, with that state’s creation of a new type of federally chartered financial institution that may pave the way for more open banking relationships and more sane compliance regimes.

As we look through each state’s laws, despite the differences in the specifics of compliance there are nevertheless a number of unifying concepts that makes understanding easier.  Aside from being an interesting philosophical question in the cryptocurrency community, what constitutes “money” under state law is fundamental to understanding the states’ money transmitter statutes.  A central consideration is whether the state considers “money” as only including only that which is backed by a sovereign authority, or whether the statutory definition is more broadly concerned with value.  California, for example, does not include virtual currencies within its definition of what is “money”:  “’Money’ means a medium of exchange that is authorized or adopted by the United States or a foreign government.”  The term includes a monetary unit of account established by an intergovernmental organization or by agreement between two or more governments.   Wyoming, in contrast, does not define “money” per se, but rather includes “money or monetary value” within the scope of its definition of “money transmission”.

Next are the common regulatory characteristics.  Based on my research, in no state is acquiring a money transmitter license a matter of right, but rather a matter of “privilege”, which must be applied for.  In other words, each state ultimately exercises discretion in whether or not to grant the license, even one follows the application procedures perfectly.  Second, there is a sometimes-substantial application fee.  Third are net worth requirements (that is, applicants must show a minimum net worth in order to qualify to apply, ostensibly to protect consumers from thinly capitalized businesses more likely to disappear with their money).  Fourth are ongoing reporting obligations to the state, sometimes requiring submitting reports to the state as frequently as quarterly.  Fifth are ongoing “examinations”, which, at a minimum, may be conducted at the discretion of the state, and which the examined party is expected to pay for (!)  Sixth are the penalty provisions, which in some states makes unlicensed money transmission a criminal offense.  Some states have what we might term “add-on” provisions, such as the requirement to maintain anti-money laundering programs as part of state compliance, as is the case in Florida.

For each of our selected states, therefore, we follow the following order of analysis: (1) how does the state define “virtual currency” (the term most often used at the state level), “money” and “money transmission”, and does cryptocurrency fall within those definitions?; (2) if cryptocurrency is considered money, what types of activities constitute “money transmission”, requiring a money transmitter license?

New York State
New York

New York

As many are aware, in an effort to regulate cryptocurrency related businesses the Superintendent of The New York State Banking Department created the “BitLicense” by regulation.  These regulations pertain to “virtual currency business activity” taking place within the state.  The BitLicense regime exists on top of and in addition to New York’s money transmitter law.

We consider the BitLicense provisions first.  The definitions section provides the following relevant definitions:

(g) New York means the State of New York;

(h) New York resident means any person that resides, is located, has a place of business, or is conducting business in New York;

(p) virtual currency means any type of digital unit that is used as a medium of exchange or a form of digitally stored value.  Virtual currency shall be broadly construed to include digital units of exchange that: have a centralized repository or administrator; are decentralized and have no centralized repository or administrator; or may be created or obtained by computing or manufacturing effort. Virtual currency shall not be construed to include any of the following:

  • digital units that:

(i) are used solely within online gaming platforms;

(ii) have no market or application outside of those gaming platforms;

(iii) cannot be converted into, or redeemed for, fiat currency or virtual currency; and

(iv) may or may not be redeemable for real-world goods, services, discounts, or purchases;

(2) digital units that can be redeemed for goods, services, discounts, or purchases as part of a customer affinity or rewards program with the issuer and/or other designated merchants or can be redeemed for digital units in another customer affinity or rewards program, but cannot be converted into, or redeemed for, fiat currency or virtual currency; or

(3) digital units used as part of prepaid cards;

(q) virtual currency business activity means the conduct of any one of the following types of activities involving New York or a New York resident:

(1) receiving virtual currency for transmission or transmitting virtual currency, except where the transaction is undertaken for non-financial purposes and does not involve the transfer of more than a nominal amount of virtual currency;

(2) storing, holding, or maintaining custody or control of virtual currency on behalf of others;

(3) buying and selling virtual currency as a customer business;

(4) performing exchange services as a customer business; or

(5) controlling, administering, or issuing a virtual currency.

23 CRR-NY 200.3(a) then provides us with the fundamental requirement that:  “No person shall, without a license obtained from the superintendent as provided in this Part, engage in any virtual currency business activity…”

From the statutory language above we can conclude the following:  (1) Bitcoin is almost certainly a “virtual currency”; (2) a wide range of activities qualify as a “virtual currency business activity … involving New York or a New York resident”, most specifically, “transmitting virtual currency”, “storing, holding, or maintaining custody or control on behalf of others”, and “buying and selling virtual currency as a customer business.”  This may be the case notwithstanding that the Bitcoin one receives is mostly from sources outside of New York, if the remission of fiat currency is to a New York resident.

The BitLicense application and compliance processes are onerous.  The application fee is $5,000.00.  The capital requirements are determined by the Superintendent and set in an arbitrary amount “sufficient to ensure the financial integrity of the licensee and its ongoing operations based on an assessment of the specific risks applicable to each licensee.”  Such amount could range from tens to hundreds of thousands of dollars.  The checklist for the documents and information to be submitted with the application runs ten pages and includes everything from credit reports of the company principals to flow-charts and diagrams of one’s exact business processes.  The applicant must have a number of existing processes already established, including anti-fraud, anti-money laundering, cyber security, privacy and information security policies.  The applicant must post a bond and agree to a host of supervisory and oversight provisions on the part of the state, including seeking government approval of any change of control of the company and submitting to an examination by the Department “not less than once every two years”.  Quarterly and annual financial statements are required.

Even if the BitLicense requirement did not apply, we must consider next what types of business activities would fall within the scope of New York’s Money Transmission Statute.  Curiously, New York’s money transmitter statute defines neither “money” nor “money transmission” in the definitions section of the Transmitters of Money part of the New York Banking Code, although “money transmission” is defined elsewhere:  “(a)  The term money transmission shall include all instruments sold or issued including travelers checks, money orders, checks, drafts, orders, wire or electronic transfers, facsimile transfers and shipments by courier for the transmission or payment of money.”

This definition neither expressly includes nor excludes virtual currency, however, that may be a moot point as it pertains to any part of a business that handles fiat currency.  So, for example, the remission of fiat funds to a Bitcoin seller, whether directly or indirectly, could constitute (or is) a wire, or an “electronic transfer” within the meaning of the money transmission statute, giving rise to the need to get a Money Transmitter’s License in New York.

New Jersey
New Jersey

New Jersey

New Jersey falls within the bounds of a mostly “silent” state when it comes to whether cryptocurrency trading falls within its money transmitter statutes.  As set forth in the definitions section of its money transmitter statute:

“Money” means a medium of exchange authorized or adopted by the United States or a

foreign government as a part of its currency and that is customarily used and accepted as a

medium of exchange in the country of issuance.

“Money transmitter” means a person who engages in this State in the business of:

(1) the sale or issuance of payment instruments for a fee, commission or other benefit;

(2) the receipt of money for transmission or transmitting money within the United States or to locations abroad by any and all means, including but not limited to payment instrument, wire,facsimile, electronic transfer, or otherwise for a fee, commission or other benefit; or

(3) the receipt of money for obligors for the purpose of paying obligors’ bills, invoices or

accounts for a fee, commission or other benefit paid by the obligor.

Section C.17:15C-4 sets forth the requirement that money transmitters need to be licensed:

  1. a. No person, other than a person exempt from the provisions of this act pursuant to

section 3, shall engage in the business of money transmission without a license as provided in

this act.

In New Jersey (like many states), “money” is restricted to media of exchange that are created, authorized and adopted by sovereign powers.  In these states cryptocurrencies are arguably not “money” and therefore could be argued to fall outside of those statutes regulating money transmitters.

California Map
California

California

Despite being a global hub for technology companies, California is perhaps behind the times when it comes to adopting a crypto-friendly legislative scheme.  As with the other states we start with what defines “money” and/or “money transmission”.  The California Code pertaining to Money Transmitters is found at the 2018 California Financial Code, Division 1.2, Sec. 2000 et seq.:

(k) “In California” or “in this state” means physically located in California, or with, to, or from persons located in California.

(o) “Monetary value” means a medium of exchange, whether or not redeemable in money.

(p) “Money” means a medium of exchange that is authorized or adopted by the United States or a foreign government. The term includes a monetary unit of account established by an intergovernmental organization or by agreement between two or more governments.

(q) “Money transmission” means any of the following:

(1) Selling or issuing payment instruments.

(2) Selling or issuing stored value.

(3) Receiving money for transmission.

(u) “Receiving money for transmission” or “money received for transmission” means receiving money or monetary value in the United States for transmission within or outside the United States by electronic or other means. The term does not include sale or issuance of payment instruments and stored value.

California provides that:

  • A person shall not engage in the business of money transmission in this state, or advertise, solicit, or hold itself out as providing money transmission in this state, unless the person is licensed or exempt from licensure under this chapter or is an agent of a person licensed or exempt from licensure under this chapter.

Under this statutory scheme it is likely that the receipt and transmission of either Bitcoin OR fiat money could fall within the money transmitter statute.  Here, “monetary value” includes any “medium of exchange” (including, it would appear, Bitcoin), and “money received for transmission” includes “monetary value”.  Further, the definition of “in this state” precludes unlicensed money transmission, or the advertising thereof, even if one does not have a physical or permanent presence in California.

Florida map
Florida

Florida

Florida falls within the category of states that, while technically “silent”, may include cryptocurrency not within the definition of a “currency”, but rather in the context of whether “receiving … monetary value … for the purpose of transmitting the same” within the definition of money transmission.  The significance of this is that receiving either fiat or Bitcoin for the purpose of transmitting it in Florida probably falls within the money transmitter statue, requiring a license.

As set forth in the Florida Statutes:

560.103 Definitions.—As used in this chapter, the term:

(11) “Currency” means the coin and paper money of the United States or of any other country which is designated as legal tender and which circulates and is customarily used and accepted as a medium of exchange in the country of issuance. Currency includes United States silver certificates, United States notes, and Federal Reserve notes. Currency also includes official foreign bank notes that are customarily used and accepted as a medium of exchange in a foreign country.

(17) “Foreign currency exchanger” means a person who exchanges, for compensation, currency of the United States or a foreign government to currency of another government.

(21) “Monetary value” means a medium of exchange, whether or not redeemable in currency.

(22) “Money services business” means any person located in or doing business in this state, from this state, or into this state from locations outside this state or country who acts as a payment instrument seller, foreign currency exchanger, check casher, or money transmitter.

(23) “Money transmitter” means a corporation, limited liability company, limited liability partnership, or foreign entity qualified to do business in this state which receives currency, monetary value, or payment instruments for the purpose of transmitting the same by any means, including transmission by wire, facsimile, electronic transfer, courier, the Internet, or through bill payment services or other businesses that facilitate such transfer within this country, or to or from this country.

(emphasis supplied).

Florida Statutes Sec. 560.204(1) provides that “[u]nless exempted, a person may not engage in, or in any manner advertise that they engage in, the selling or issuing of payment instruments or in the activity of a money transmitter, for compensation, without first obtaining a license under this part.”

Wyoming flag
Wyoming

Wyoming

Wyoming stands out as the single most cryptocurrency-friendly state in the US.  A package of recent legislation reflects a climate of forward-thinking legislators that listened to experts in the field in creating these new laws.  The following statutory provisions govern money transmission in Wyoming:

(xii) “Monetary value” means a medium of exchange whether or not redeemable in money;

(xiii) “Money transmission” means to engage in business to sell or issue payment instruments, stored value or receive money or monetary value for transmission to a location within or outside the United States by any and all means, including but not limited to wire, facsimile or electronic transfer;

(xxii) “Virtual currency” means any type of digital representation of value that:

(A) Is used as a medium of exchange, unit of account or store of value; and

(B) Is not recognized as legal tender by the United States government.

40-22-103. License required.

  • … no person shall engage in the business of money transmission without a license. The division shall regulate money transmitters and carry out the provisions of this act.
  • A person is engaged in the business of money transmission if the person advertises, offers or provides services to Wyoming residents, for personal, family or household use, through any medium including, but not limited to, internet or other electronic means.

40-22-104. Exemptions.

(a)          This act shall not apply to:

(vi) Buying, selling, issuing, or taking custody of payment instruments or stored value in the form of virtual currency or receiving virtual currency for transmission to a location within or outside the United States by any means;

Under this statutory scheme two things are clear:  (1) the general rule is that the transmission of “money or monetary value” still requires a money transmitters’ license, however (2) the receipt and transmission of virtual currency is expressly excluded from the entire money transmitter statute.  To the extent that one receives and then subsequently transfers Bitcoin, one may do so freely in Wyoming without a license.

The package of legislation as a whole is indeed encouraging from a “business climate” standpoint.  In addition to the above provision (among others that, for example, make clear that one can have property rights in one’s digital currency under UCC law), a provision that creates a new type of Special Purpose Depository Institutions intended to handle crypto-related business and assets should be very interesting in the upcoming years.  These institutions are intended to bridge the gap between the traditional financial system (including connection to the federal reserve) and the crypto world.  Further, Wyoming has created a regulatory “sandbox” not unlike what Switzerland and Canada have done to avoid quashing FinTech developments and new ideas.

(c) 2020 Good Attorneys At Law, PA – All rights reserved

Bitcoin

Bitcoins Are Property, Sayeth The IRS

Bitcoin
IRS says Bitcoins are property

IRS States Bitcoins Are Property

So the IRS has issued a Notice on the virtual currency known as Bitcoin:  It’s not a currency, it’s property. Jolly good, you say, so what? Well, that decision has some major tax implications for the future of what adherents will insist is a virtual currency, or “cryptocurrency”.  That has a number of important tax considerations, but for the uninitiated let’s start with the basics, that is, what the heck is Bitcoin?

For these purposes let’s ignore the IRS and grant Bitcoin respect as a “virtual currency”, that is, a medium of exchange, something intangible asset that people can trade for other goods or services (or, other Bitcoins). It owes its existence to computer programmer Satoshi Nakamoto, who created the algorithms related to Bitcoin in and around 2009.  It has no tangible existence – one cannot carry a Bitcoin in one’s wallet – but rather depends upon two types of technology for its existence:  “peer to peer networking” and “public key encryption”.  If you find the technical stuff boring, skip down to “Bitcoins Are Property” below.

Bitcoin Technology

Peer to peer communication is, put simply, stuff that lots and lots of different people on lots and lots of computers do in a “distributed” or decentralized manner, that is, there is no single computer or person that controls what goes on.  Napster was one of the first and best known peer to peer networks for sharing music.  Millions of different people had songs on their computers.  These people used Napster’s software, which you could download onto your computer for free, to share the files over the internet with anyone else also running Napster.

No one was in charge – you simple stood up to be recognized as a “node” on the Napster network, sort of like establishing your own bus stop along a busy route.  Then you shared what you had in the same way as you might conduct a pot luck dinner at your local church.  The church opens its doors, provides the meeting space (and perhaps one of those big silver coffee makers), and everyone brings their own dishes to share.  There are rules:  clean up after yourself, don’t show up empty handed, but otherwise no one is in charge of the event.  Simple.

Then there’s part two – public key encryption. The deep specifics of this system are beyond the scope of this article (and my comprehension), but in simplest terms PKI is a system by which people can share information securely using a “public” key, an external reference that functions a bit like a PO Box, combined with each user’s “private” key, like the key to that box. You send someone a private letter by referencing their PO Box (which is public), but only the owner can open (or “decrypt”, in the computer world) the letter by using their private key.

These technologies are critical to Bitcoin in that its creators needed a system that allowed them to be traded and exchanged using a decentralized (peer-to-peer) secure (PKI-based) system. When Mr. Nakamoto created his alogrithm he set a finite limit on the number of Bitcoins that will ever exist: 21 million. There are currently around 12 million in circulation, with about 9 million more to be discovered. They are created just as virtually as they are traded: anyone so inclined, and with the computer resources and knowledge to do it, can “mine” Bitcoins by verifying existing Bitcoin transactions. The miners get a commission, in essence, for adding value to the entire virtual monetary world.  So, whether you bought your Bitcoins, received them in exchange for goods or services, or mined them you have created or received something of value.

Bretton Woods participants
Tea time at Bretton Woods

What is Currency?

In addition to technology what makes up a currency is, put simply, that people think its a currency, or a “medium of exchange”.  If I give you a dollar for a lollipop there’s an immediate understanding that what I am giving you has some intrinsic, quantifiable value (that is, a dollar is worth, surprisingly, $1), that the dollar has an equivalent value in goods or services (lollipops), and that the recipient of my dollar can reuse it to exchange for something else that he might want (say, balloons).  This latter part is important.  Part of what makes a currency a currency is not only what the original two transacting parties think (our agreement to exchange dollar for lollipop), but that everyone else understands that what both of the parties got has some measurable value.  In monetary terms the dollar is therefore not only our “medium of exchange”, but is also recognized as “legal tender” for the transaction.  Who decides what is “legal tender”?  The simple answer is the government, in part because of the United States Constitution and in part under policies that have evolved over the years.   For a fascinating history on what makes money what is it (and who gets to decide that) read up on the exceptional Heritage website.

IRS Rules Bitcoins Are Property

As the use (and trading) of Bitcoins has grown so has the government’s interest in them.  Part of why the IRS would care involves whether someone has “acceded to wealth” when they create, sell or exchange a Bitcoin.  In other words, has someone to the transaction gotten richer by dealing in Bitcoins rather than a “true” currency?  It is a longstanding principle of tax law that such accessions to wealth are “income” which might be taxable to the recipient.  I have acceded to wealth, for example, if someone gives me a dollar (for nothing in return), a share of stock or a piece of real estate

Having looked at the issue the IRS came down to the conclusion that Bitcoins are property, not a “currency”.  In so doing the US government made using Bitcoin as a medium of exchange much more complicated.  This is because, put simply, you, the Bitcoin user, must now keep track of what you paid for your Bitcoin, where it came from, and whether you have tax consequences when you use it to purchase something.  This is a whole host of worries you never have to deal with when you use a “true” currency.

The Tax Consequences of Using Bitcoins

So what exactly do you have to track and bother with?  The answer, in short, is your “basis”.  Basis is just a word.  It means “what is my investment in this thing”.  If  you paid $10 for a share of stock, that is your basis in it (more technically, your “cost basis”).  If that stock appreciates to $15 and you sell it, you have “acceded to wealth” by $5, on which you pay tax.  So, when it comes to Bitcoins, according to the IRS, go forth and buy, sell and exchange it however you like, however, be sure you track your basis and report your gain (or loss) each time you do it.

This is a huge pain, perhaps by design.  Tracking one’s basis in readily exchangeable, intangible things like stock, or now Bitcoins, is extremely complicated.  Stock brokers use highly sophisticated software that tracks stock transactions, accounting for all of the Byzantine and upside down rules that govern these transactions.  Few, if any, Bitcoin users are prepared for this level of reporting.  Figuring out your gain or loss also assumes that you are able to trace exactly which Bitcoin you purchased to use for your cup of coffee.  This is similarly difficult given that Bitcoins are “tumbled” into “blocks”, that is, virtually sliced and diced so that it is unclear which Bitcoin you got, or who created or received it.  This serves to protect Bitcoin users’ privacy, something the government is viewing with increasing hostility.

Philosophically I am disappointed, though hardly surprised, with this decision.  Our entire banking system, really, the entire global economy is in large part based on the dollar as a medium of exchange.  That serves an important purpose in that it lends predictability to how oil, carrots or lollipops are priced.  There are many “data points”, that is, places to compare, contrast and get an idea of what something should cost.  The downside, however, is that it preserves a government’s monopoly on how you do business.  Again, this is desirable in many ways, but has a dark side:  the government, not you, decides what the currency is worth.  The more currency the government prints, the less it can buy or earn in the form of interest.  You, the buyer, might not see that the dollar you had yesterday is not the dollar you have today, but those who are exchanging their oil, carrots and lollipops do.  Words you hear a lot like “purchasing power” and “inflation” can be tricky to grasp, but are very important to how people live.

What Now?

The matter is not entirely settled.  Changing how things work depends on how good the idea is, how strong are the forces against it and who has more patience.  Congress, not the IRS, has the ultimate constitutional authority to determine what is considered a “true” currency, and in time this may be the case.  Further, the IRS may have done recent Bitcoin purchasers a service.  Where you have gains you can also have losses.  Just as you accede to wealth through appreciated Bitcoins, you can claim a loss when you didn’t buy so well.  As a practical matter, the IRS is entirely unprepared to enforce its new position regarding Bitcoins, as it is unlikely that more than a tiny fraction of this bureaucracy understand them.  So, time will tell.

I want to hear from you!  Should Bitcoin be considered “currency”?  Does the confidentiality of Bitcoin transactions outweigh the risk that they could be used for illicit purposes?  Leave a comment, or contact me for a stimulating discussion over a cup of coffee.