Federal Strategy for Regulation of Bitcoins Revealed in IRS Guidance

The IRS’s March 25, 2014 declaration that bitcoins are property, not currency, is the final piece of the carefully-crafted federal approach to bitcoin regulation which greatly differs from the approach of other sovereign nations.  In doing so, the IRS, by fiat, has cut through the Gordian knot, the problem of defining the nature of bitcoins.

On March 25, 2014, the IRS issued Notice 2014-21, its guidance on the tax consequences of bitcoin dealings. The Notice is the last shoe to drop regarding the federal approach to bitcoin regulation following new guidance from the Financial Crimes Enforcement Network of the Treasury Department (FinCEN) and a round of bitcoin prosecutions by the Justice Department.

The Bitcoin System

Bitcoin regulation turns on the unique characteristics of this virtual currency.
With no central authority, the bitcoin system uses peer-to-peer technology to operate. Transactions are carried out collectively by the network and are recorded only in an electronic log of transactions called the blockchain. Nodes, or individual computing centers, compete to create the blockchain. This “mining” process is a distributed consensus system that is used to confirm waiting transactions by including them in the blockchain. “Miners” are motivated to create units of convertible virtual currency because they are issued 25 bitcoins for successful validation of the blockchain.

Bitcoin transactions are anonymous, decentralized, and resistant to forensic exploration. A particular transaction traces bitcoins identified with digital signatures, verified by miners and authenticated by the blockchain. A bitcoin has no inherent value, does not have a physical existence, and is utilized by persons who are intimately aware of its nature.

FinCEN Regulation of Bitcoins

On March 18, 2013 the Financial Crimes Enforcement Network of the Treasury Department (FinCEN) issued guidance on the application of its regulations to bitcoins (See “The Federalization of Bitcoins,” e-Commerce Law & Strategy (6/2013), http://www.lawjournalnewsletters.com/issues/ljn_ecommerce/30_2/news/The-Federalization-of-Bitcoins158235-1.html/).

FinCEN’s bitcoin jurisdiction is based on the regulation of money services businesses. Such businesses, including those deemed money transmitters, are subject to reporting requirements, such as reports on currency transactions, including suspicious activities related to such transactions. 31 C.F.R. section 103.20. Criminal and civil penalties apply to non-registered and non-reporting money services businesses. 31 C.F.R. section 103.41(e).

FinCEN relies on the facts and circumstances of the provided services to determine whether the broker or dealer is acting as a money services business. Therefore, the creation and transmission of bitcoins is germane to FinCEN’s decision to deem certain bitcoin transactions as performed by money services businesses.

The possibility of the use of bitcoins for criminal Internet transactions is obvious, but the inclusion of miners and third-party dealers as regulated entities, coupled with money laundering and contraband prohibitions, imply that FinCEN and Department of Justice prosecution will achieve some measure of control over bitcoin commerce (See “Hysteria Grips Bitcoin Market As Apple Removes Bitcoin Wallet App from Its Store,” e-Commerce Law & Strategy (3/2014), http://www.lawjournalnewsletters.com/ issues/ljn_ecommerce/30_11/news/hysteria_grips_bitcoin_market_as_apple_removes_bitcoin_wallet_app_from_its159285-1.html).

Justice Department Prosecution of Silk Road

The current drive to prosecute bitcoin malfeasance with general criminal statutes is illustrated by the Silk Road prosecution in the Southern District of New York, US v. Albrecht, No. 14 Cr. 68 (KFB).

On February 4, Ross Ulbricht was indicted for operating Silk Road, an internet site used for illicit transactions, from 2011 through 2013. Silk Road was the most sophisticated and extensive criminal marketplace on the Internet and was used by several thousand drug dealers and other unlawful vendors to distribute hundreds of kilograms of illegal drugs and other unlawful goods and services to well over a hundred thousand buyers, and to launder hundreds of millions of dollars deriving from these unlawful transactions. Silk Road profited from commissions it collected on each transaction.

Silk Road was anonymized through operation on the “Tor” network, a special network of computers on the Internet, distributed around the world and designed to conceal the true IP addresses of the computers on the network and the identities of the networks’ users. Moreover, Silk Road used a Bitcoin-based payment system to facilitate the illegal commerce conducted on the site, including by concealing the identities and locations of the users transmitting and receiving funds through the site.

In addition to illegal narcotics, other illicit goods and services such as computer hacking, malicious software and forged documents were openly bought and sold on Silk Road.
Approximately 173,991 Bitcoins worth over $150 million have been seized in the course of the investigation, including approximately 29,655 Bitcoins recovered from servers used to run the Silk Road website, and approximately 144,336 Bitcoins recovered from computer hardware belonging to Ulbricht seized upon his arrest.

Ulbricht is charged with narcotics conspiracy, engaging in a continuing criminal enterprise, conspiracy to commit a continuing criminal enterprise, conspiracy to commit computer hacking and money laundering conspiracy.

An interesting sidelight of this prosecution is Ulbricht’s contention in a March 29 motion that he couldn’t have engaged in money laundering because bitcoins aren’t a “monetary instrument.”

However much publicity Ulbricht created by arguing that there was no “money” in his money laundering, he makes a fundamental error in analysis by assuming that he is charged with a financial transaction involving monetary instruments, which are defined as “coin or currency of the United States or of any ther country, travelers’ checks, personal checks, bank checks, and money orders.”

While the FinCEN and IRS guidance that bitcoins are not “coin or currency” is relevant to this category of money laundering involving monetary instruments, the rationale of the case may be that he is prosecutable because he engaged in a financial transaction which involved the movement of funds, the proceeds of illegal activity, by wire or other means, an entirely different category of “financial transaction” which does not turn on the definition of money.
The introduction of a possibly specious argument into a bitcoin criminal prosecution illustrates the evolving nature of the federal regulation of bitcoins and the complex interaction of agency definitions of bitcoins.

IRS Notice 2014-14

The IRS, in issuing the Notice, is the third federal agency to acquire a formative role in regulating bitcoins. However, unlike the FinCEN approach, which centers on requiring defined third parties to identify themselves and report transactions, or the Department of Justice’s use of traditional racket-busting crimes such as money laundering and conspiracy statues, to capture those who engage in off-the-grid transactions, the IRS has, in the Notice, addressed existential questions about bitcoins for those who are legitimately engaged in bitcoin activity.

The Notice begins with the premise that bitcoins are virtual currency which have various economic uses that emulate real currency. However, despite the fact that bitcoins are a medium of exchange, no national jurisdiction has recognized bitcoins as legal tender.
However, bitcoins have value in legal tender units that can be determined by any of the index sites on the internet. As a virtual currency convertible to legal tender, the IRS has determined that there are clearly defined federal tax consequences of transactions in bitcoins.

The first and foremost principle underlying these tax consequences is that, for federal tax purposes, virtual currency is treated as property and all general tax rules applicable to property transactions apply to transactions virtual currency. Thus, because bitcoins have an easily-referenced value in legal tender currencies, a taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency. For the IRS’s purposes, the taxpayer must report the value of the utilized bitcoins at the relevant point in time, the time of the taxable event.

Here, the IRS by fiat has cut through the Gordian knot, the problem of defining the nature of bitcoins. No sophisticated or deep questions about the nature of money form the basis of the discussion. Bitcoins are not legal tender and therefore they must be property.

This makes a whole series of reporting requirements mandatory for those who report at all.
The gain or loss from a bitcoin transaction may be of a capital asset, i.e. stocks, bonds, and other investment property. For example, assuming that bitcoins may be held as investment property, they may be exchanged for stock equities or sold on a bitcoin exchange for dollars. As always, ordinary gain or loss results when the bitcoins are not capital assets.

Mining bitcoins, the generation of bitcoins via computer processes, creates gross income. Miners and the self-employed paid with bitcoins are subject to self-employment taxes.
Those employees paid with bitcoins must determine the fair market value of the bitcoins and that amount is subject to federal income tax withholding, FICA and FUTA taxes, with W-2 reporting.

The IRS also requires reporting of a bitcoin payment to a person with a value of $600 or more to a U.S. non-exempt recipient if made within the course of a trade or business. Such payments include rent, salaries, wages, premiums, annuities, and compensation.
A bitcoin payment to an independent contractor for services is also reportable.

The Notice, first and foremost, means that the IRS has regularized bitcoins for the legitimate community of reporting taxpayers and provided them with the joys of long-term capital gains treatment.

Another control measure is implicit in the reporting requirements. The nominal value of bitcoins at any given time is crucial to tax reporting, much as the relevent value of gold or silver is that of market prices of these commodities is when traded or given away. However, bitcoins are not simply fungible lots. Bitcoins are uniquely identifiable by their computer-generated code and because the code is unique and unalterable, they are as readily recognizable as paper money with a serial number or a car with a VIN number.

Not all property is identifiable, but bitcoins are identifiable property. Thus, the IRS may demand the identification of the specific bitcoins involved in a taxable transaction. Such a demand would be well within the IRS’s administrative power to verify reported transactions.
The bottom line is that possible supervisory power over bitcoin transactions and transfers may be created in the IRS through normal tax reporting. This creates a new source of information for civil and criminal enforcement actions by FinCEN and the Department of Justice.

Conclusion

Command economies often resort to command solutions. Thus, China appears to be moving to abolish the use of bitcoins within its banking community and has such control of its Internet that it is undoubtedly actively monitoring bitcoin transactions.

The comparison to legalization of marijuana in the US is apt. Transactions in marijuana are regulated and taxed in jurisdictions which permit legal sales. Those states that maintain marijuana as illegal lose the transparency of the trade, not to mention the tax revenues.
China, on the other hand, for many complex social and political reasons, would never allow legal marijuana despite the boost to tax revenues implicit in its legitimization. China’s conservative leaders, with their ability to institute reforms by decree, will continue to criminalize marijuana as they may abolish transactional use of bitcoins.

However, nothing in capitalist doctrine demands curtailing of bitcoin use in view of the legitimate expansion of the economy through appropriate bitcoin usage. The US, has clearly decided that abolition of bitcoin transactions is not practical as it has decided that marijuana may be legal and that regulation of either is more appropriate.

More by | James Ching James Ching , Law.com Contributor
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