The Challenges of Bitcoin: What Has the IRS Done, and What Else Can It Do?

By:
Carnet A. Brown, CPA
Published Date:
Jul 1, 2015

“Developments in the virtual currency world occur so rapidly, I was concerned that anything I wrote would be overtaken by events before I got here.” –Remarks from Under Secretary of Terrorism and Financial Intelligence David S. Cohen

There can be no growth or development unless there is change—either positive or negative. The former is welcomed and supported; the latter must be managed with the hope of mitigating its effects. Without change, the monetary system that currently exists would not have evolved from the practice of subsistent farming: the lack of variety in subsistent farming led to the bartering system, and the ineffectiveness of the bartering system lead to money/legal tender as a medium of exchange. Now the system has transformed again to include Bitcoin and other virtual currencies.

Background

In the United States, both U.S. notes and Federal Reserve notes are part of the national currency, and both are legal tender. U.S. notes, characterized by a red seal and serial number, were the first national currency, authorized by the Legal Tender Act of 1862, and began circulation during the Civil War. The Federal Reserve Act of 1913 authorized the production and circulation of Federal Reserve notes. Although the Bureau of Engraving and Print prints these notes, they move into circulation through the Federal Reserve System. On the Federal Reserve Notes, the seal and serial numbers appear in green.

As for virtual currencies, Bitcoin is probably seen as the most popular, complex, and promising, compared to other digital currencies that have existed, such as Liberty Reserve. According to the U.S. Department of Treasury, Liberty Reserve was a web-based money transfer system, or “virtual currency.” It was registered in Costa Rica and started operating in 2001. In order for this process to work effectively, a system of internal accounts and a network of third-party intermediaries, or “exchangers,” are needed. Liberty Reserve maintained accounts for registered users, funded through exchangers. These registered users typically sent a bank or nonbank wire transfer to an exchanger, who then transferred the corresponding value of the Liberty Reserve virtual currency from the exchanger’s account to the user’s account.

Once an account was established, transfers can be made from one account to another instantly and anonymously. To withdraw funds, a user would instruct Liberty Reserve to send transfer value from the user’s account to that of an exchanger, who would transfer the value in U.S. dollars or another currency as a bank or nonbank wire transfer to the user or other recipients. Exchangers operated as independent money service businesses globally, charging a commission on each transfer of funds into or out of the Liberty Reserve currency.

Bitcoin, which started in 2009, is a decentralized virtual currency that can be acquired by anyone. It is stored in a “wallet” made up of multiple bitcoin addresses. Each bitcoin address is indexed by a unique public ID—an alphanumeric identifier that corresponds to the public key (discussed below). There are many Bitcoin wallets to choose from, with various levels of security, convenience, and complexity, according to Weusecoins.com. Wallet types include the web, software, and mobile phone. Web wallets are maintained on the Internet; though this makes them less secure, they are the most convenient and easiest to use. Software wallets are maintained on the user’s computer and are considered more secure than a web wallet because there is no need for a third-party service. Mobile phone wallets come in the form of downloadable apps (Breadwallet for the iPhone and Andreas Bitcoin Wallet for Android phones). Bitcions can be bought or sold through currency exchanges for U.S. dollars or other major foreign currencies. On January 1, 2011, Bitcoin traded for about $0.30, and it ended 2014 at $325.

The Complexities Behind Bitcoin

Anton Badev and Matthew Chen stated that Bitcoin is a scheme designed to facilitate the transfer of value between parties. Unlike traditional payment systems, which typically involve the transfer of value denominated in sovereign currencies, Bitcoin has its own metric for value, called a bitcoin. A bitcoin is an electronic token without reference to any underlying commodity or sovereign currency and is not a liability on any balance sheet. Bitcoin is a complex scheme, and its implementation involves a combination of cryptography, distributed algorithms, and incentive-driven behavior.

Badev and Chen state that Bitcoin relies on two cryptographic schemes: digital signatures and cryptographic hash functions (cryptography refers to the coding and decoding of secret messages). Briefly, the former enables the exchange of accurate (payment) instructions between the parties of a transaction, and the latter is used to enforce discipline in writing transaction records in the public ledger. The implementation of digital signatures involves public key encryption, where a pair of keys (public and private) is generated with certain desirable properties. A cryptographic hash function takes as input a string of arbitrary length and returns a string with predetermined length. The function is deterministic, meaning that the same input m will always give the same output h. The input is message m and the output is hash h. A desirable property of the hash function is that even small changes in message m are likely to change hash h significantly.

Bitcoins are held for two main reasons. One is for investment purposes to benefit from the appreciation in value of the bitcoins; the other is for transaction purposes, which is really to make payments using bitcoins. For a user to send bitcoins to another user using the Bitcoin network, both users must have Bitcoin addresses. The person sending would sign the transaction message using his or her private key and broadcast it, then all the members on the Bitcoin network could verify that this transaction came from the sender and that it has not been tampered with. The Bitcoin protocol would verify that there are sufficient funds in the sender address to ensure that the transaction could be completed and that only the owner of the private key for the address could have signed the message. After this is completed, the transaction would be recorded in the public ledger.

Each transaction is chronologically recorded in a public ledger, called the blockchain, by participants in the network, according to Badev and Chen. There is a reward for recording transactions in the blockchain, and the participants in the Bitcoin system compete by solving a computationally intensive cryptographic problem to make records. A well-defined process, which guarantees consensus, elects the winning participant, and the blockchain is updated. Importantly, each participant keeps a copy of the ledger, and the consensus of the incremental changes guarantees that these copies are identical.

IRS Actions

On April 14, 2014, the IRS issued Internal Revenue Bulletin (IRB) 2014-16: IRS Virtual Currency Guidance. It describes how general tax principles apply to transactions involving virtual currency; defines virtual currency; and states that Bitcoin is one example of convertible virtual currency, meaning that it can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies. The fair market value of a virtual currency is the U.S. dollar equivalent of the virtual currency at the date of payment or the date of receipt for a transaction involving virtual currency. For example, a taxpayer who receives virtual currency as payment for goods or services must include in gross income the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received.

Perhaps the most important measure to combat the challenges for virtual currency is the requirement of information reporting. In The Tax Gap – Widening or Narrowing?, published in the December 2013 issue of the TaxStringer, it is stated that income subject to reporting had a lower case of misreporting compared to income subjected to little or no informational reporting. The IRB states the following about informational reporting relating to virtual currencies, including Bitcoin:

  1. A person who in the course of a trade or business makes a payment of fixed and determinable income using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee. Fixed and determinable income includes rent, salaries, wages, premiums, annuities and compensation.
  2.  Generally, a person who in the course of a trade or business makes a payment of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment to the IRS and to the payee on Form 1099-MISC.
  3. Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property. Therefore, payers making reportable payments using virtual currency must solicit a taxpayer identification number (TIN) from the payee. The payer must backup withholding from the payment if a TIN is not obtained prior to payment or it the payer receives notification from the IRS that backup withholding is required.
  4. If certain requirements are met, in general, a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third party settlement organization (TPSO). A TPSO is required to report payments made to a merchant on a form 1099-K.

What’s Next for the IRS?

With changes in the virtual currency world occurring rapidly, the IRS will need to make investments into specialized computer equipment and its human capital. As the use of Bitcoin increases and more and more people see it as a preferred choice to make payments, the need for these investments will be greater if the IRS intends to prevent the tax gap from widening. Given the complexity of the Bitcoin system, the IRS will need to ensure that its employees are educated and trained on the nature of this type of currency. This will assist its employees in identifying where transactions may have been omitted, as well as in auditing taxpayers with Bitcoin transactions.

The IRS could also require taxpayers who use bitcoins to make certain disclosures to the IRS when filing their taxes. These disclosures would include reporting the total payment and receipt of bitcoins during the tax year and the public key associated with the address. Finally, the IRS could invest in the miners’ equipment and participate in the process of recording transactions into the blockchain. Participation would not be for the incentives, but to obtain an understanding of the Bitcoin system and keep abreast with any changes taking place. Furthermore, addresses with material transactions could be cross-checked to the public key reported to the IRS in order to see if the taxpayer disclosed the correct payment and receipt of Bitcoin transactions. It must be noted that these investments will only be warranted if the expected benefits will outweigh the cost of the investment.


carnetbrownCarnet A. Brown, CPA, is an accountant at NYU Langone Medical Center and a member of the NYSSCPA. He also serves on the Society’s: Taxation of Individuals and Employee Benefits committees; as treasurer for the Manhattan/Bronx Chapter Board; and as a delegate of the Political Action Committee. Mr. Brown has more than 15 years financial accounting and auditing experience. He can be reached at 917-569-4109 or carnet1020@yahoo.com.

 
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