Bitcoin, the IRS, and NSA

Author: Bob Eisenbeis, Post Date: March 27, 2014

Question: When is a virtual currency not a currency?

Answer: When the IRS says so

The IRS has determined that Bitcoins will be treated as property for tax and recordkeeping purposes, rather than as a currency. The rationale for treating virtual currencies as property despite their functioning in many cases as a medium of exchange is the fact that they are not “legal tender.” As has been widely reported, this means that Bitcoin transactions will be subject to short-term gains taxation and lower long-term capital gains taxes, and both holders and miners – and presumably exchanges as well – will be subject to extensive recordkeeping and other requirements. What follows is a brief summary provided by the IRS of the kinds of determinations it has made (even more detail can be found in the Q&A in IRS Notice 2014-21):

Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.

Payments using virtual currency made to independent contractors and other service providers are taxable, and self-employment tax rules generally apply. Normally, payers must issue Form 1099.

The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.

A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.

Whatever one may think about Bitcoin and other virtual currencies, the IRS ruling is a classic case of trying to fit a square peg into a round hole. Virtual currency enthusiasts are feeling that this ruling may provide some clarity as to the standing of virtual currencies in the US. But the reality is that the ruling will only serve to increase costs to law-abiding US taxpayers because of the extensive recordkeeping, disclosure, and reporting requirements that will make dealing in virtual currencies uneconomical for many potential users. The ruling also ignores the international and extraterritorial aspects of virtual currencies, and will simply drive miners and most users offshore, setting up a classic case of regulatory arbitrage. Finally, the new ruling will not deter unscrupulous users dealing in drugs, money laundering, terrorist financing, or child pornography, etc.; but it clearly will increase their risks, since US tax laws will now come into play as additional sources of risk. The ruling will not, however, turn them into honest citizens who will now dutifully report their illicit dealings.

Perhaps the most ironic aspect of the ruling is its failure to consider that one of the chief supposed benefits of virtual currency transactions in systems like Bitcoin is that dealings between buyers and sellers are anonymous. Indeed, the Canadian government in its February 2014 budget identified Bitcoin as a significant emerging risk to the government’s fight against money laundering and terrorism. If one doesn’t know who one is dealing with or where they are located, how can the required documentation and reporting be accomplished and enforced? For the most egregious cases, such as the highly publicized Silk Road case, which was shut down by the FBI, such Tor hidden services will be conducted offshore and out of reach of US authorities. They may even be used by US taxpayers, but the transactions will be virtually untraceable by design.

This raises the interesting question of who will actually be able to enforce the new IRS rulings. The ruling already sets up the potential for multiple and overlapping jurisdictions for enforcement between the IRS, FBI, and Secret Service (now part of Homeland Security). In light of the IRS’s new responsibilities for enforcing the income verification portion of the Affordable Care Act and its recent checkered history concerning the treatment of tax-exempt entities, the public has to be skeptical about any further expansion of the IRS’s reach. The Secret Service and FBI have certain capabilities, but it isn’t clear under what circumstances they will take over investigation and enforcement from the IRS. Moreover, in the case of the Secret Service, it has investigative capabilities, but prosecution authority tends to devolve to the states’ attorneys general. Given the electronic nature of virtual currencies, their anonymous nature, and international reach, perhaps the agency best positioned to monitor and track down delinquent virtual currency taxpayers is the NSA, but we probably won’t want to go there now either.

At Cumberland, we have not placed Bitcoins in any customer accounts, nor will we. The risks and uncertainties are too great, the volatility of Bitcoin valuations is unacceptably large, and the whole market has striking similarities to what was then called “wildcat banking,” in the 19th century.

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