Source: https://www.americanbar.org/groups/taxation/publications/abataxtimes_home/16nov/16nov-ac-larson-implications-of-bitcoin-not-being-actual-currency/
Timestamp: 2019-04-22 00:07:08+00:00

Document:
There is a finite number of bitcoins available, about 21 million when all are mined. The program’s designer projected that number to be reached in 2140.5 As part of this finite system, each bitcoin has its own private digital fingerprint that cannot be used again after it has been activated.
IV. What About the Tax Implications?
The seller. In the case discussed, the seller explained to the detective what he was doing. He was selling appreciated property. Gain from the sale of appreciated property must be recognized by the seller.41 It is unclear from the court’s order granting the defendant’s motion to dismiss whether the seller reported any of the gain from the bitcoin sales, though it is beyond question that he should have. The reason he bought and sold bitcoins was to make a profit.
For the seller-defendant, the only real difficulty would have been determining which bitcoin he sold. To the extent he held multiple bitcoins purchased on different days and at different prices, he would have needed to determine which bitcoins were sold to know the basis in each and, from there, the amount of gain or loss from each sale. Notice 2014-2146 does not provide guidance on how a seller makes this determination.
Presumably, a seller could merely identify which bitcoins he sold. If he failed to do so, the fungibility of bitcoins suggests that an analogy could be made to stock sales. When a seller sells stock and does not adequately identify which stock was sold, the stock identification regulations treat the seller as having sold the last stock that was purchased (last in, first out).47 The same presumption could apply to a bitcoin seller.
Not only would the seller-defendant be liable for the tax on the gains generated from the sales, but if he failed to report the gain, he would be liable for the negligence penalty.50 Negligence includes the failure to make a reasonable attempt to comply with the Code, exercise ordinary and reasonable care in preparing the return, keep adequate books and records, and substantiate items properly.51 In light of Notice 2014-21 classifying bitcoins as property, any failure by the seller to report gain from a disposition of bitcoins constitutes negligence.
Of course, if the seller-defendants’ failure to include the gain was intentional, he might be liable for the civil fraud penalty.52 The Service would have the burden of establishing that the seller committed fraud by conduct intended to conceal, mislead, or otherwise prevent the collection of taxes.53 To satisfy this burden, the Service would have to show the seller engaged in wrongdoing with the specific intent to avoid a tax on the gain that he knew or believed to be due. Without direct evidence of the seller’s intent, the Service would look to circumstantial evidence through the so-called “badges of fraud.”54 More would have to be known before there could be any assumptions made about the applicability of the fraud penalty to the seller-defendant.
Neither the Code nor the regulations include a definition of what it means to “barter property or services.” However, a barter transaction usually means a transaction where property or services are traded directly and no cash is involved.
To the extent bitcoins are purchased and sold for cash, the organization is a money transmitter business and not a barter club. If bitcoins are being exchanged for property or services, as with the Silk Road website where bitcoins were being exchanged for (illegal and illicit) goods and services, the exchange would be a barter club. In Espinoza, if most transactions resembled those suggested by the detective, bitcoin for stolen credit card numbers, the peer-to-peer exchange likely is a barter club. Without more information about the nature of the transactions, it is not possible to draw any conclusion about whether the website was a barter club.
Because the bitcoin seller was the focus of the detective’s investigation and the Service was not clearly involved, it is unclear whether the Service would have taken the position that the peer-to-peer site should have been treated as a barter exchange required to issue Forms 1099-B. Moreover, it is not clear whether the site dealt with a sufficient number of barter transactions to make it a “barter club” subject to the reporting obligations.
In Espinoza, the detective and the members of the Task Force seemed to equate the buying and selling of bitcoin with engaging in an illegal activity. Certainly, their suspicions were not completely without foundation, as others who had bought and sold bitcoin had been convicted of the crimes with which they charged the seller-defendant.
The Financial Crimes Enforcement Network (FinCEN) is a bureau in the Treasury Department that operates as a bridge between law enforcement and the financial industry. One of its responsibilities is implementation of the Bank Secrecy Act (BSA),69 which includes a comprehensive federal anti-money laundering and counter-terrorism financing statute. The requirement to register a money transmitting business is part of the BSA.
The facts in Espinoza were different from the Silk Road cases. There was no evidence the seller was accepting cash to create a bitcoin account on behalf of the buyer, as Callahan and Faiella had done. In short, there was no evidence of anything other than that the seller was selling bitcoin for cash.
The fact the seller was selling bitcoin for cash should have raised the question of whether he was complying with the tax laws. Any potential tax implications from bitcoin as currency were put to rest when the Service ruled that bitcoins do not meet the definition of currency but are, instead, property.77 Accordingly, from a tax perspective, in Espinoza, the seller explained to the detective that he was selling appreciated property. Did he report the gain? This question seems to represent the lowest hanging fruit in terms of establishing the seller had done something wrong. However, nothing in the case suggests that avenue was pursued. Going forward, it might make more sense to first consider the more straight-forward tax implications of selling bitcoin. Moreover, by tracing how the bitcoin are being sold, the detective would have had the basic information needed to determine if the seller was in an unlicensed money transmitting business. If the information supported such an allegation, then the seller could have been so charged.
1 Satoshi Nakamoto”, not his real name, posted papers online laying out the structure of bitcoin, a virtual currency. See Bitcoin: A Peer-to-Peer Electronic Cash System, bitcoin.org; Frequently Asked Questions: How Does Bitcoin Work?, bitcoin.org. A few months later, bitcoin was an operating currency with a market capitalization in excess of $5 million. For information on cryptocurrency market capitalization, see Crypto-Currency Market Capitalizations.
2 Users may own as many wallets as they want.
3 “To perform the work of mining, bitcoin miners download free bitcoin software that they use to solve complex equations. These equations serve to verify the validity of bitcoin transactions by grouping several transactions into a block and mathematically proving that the transactions occurred and do not represent double spending of a bitcoin. When a miner’s computer solves an equation, the bitcoin network accepts the block of transactions as valid and creates 25 new bitcoins and awards them to the successful miner.” U.S. Gov’t Accountability Off., GAO-13-516, Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks 6 (2013). See also Christopher Rajotte, Andrew Ittleman & Mitchell Fuerst, Bitcoin Taxation: Understanding IRS Notice 2014-21, Bitcoin Magazine (Apr. 4, 2014).
4 Nikolei M. Kaplanov, Nerdy Money: Bitcoin, the Private Digital Currency, and the Case Against its Regulation, 25 Loy. Consumer L. Rev. 111, 121-23 (2012).
5 Omri Y. Marian, Are Cryptocurrencies ‘Super’ Tax Havens?, 112 Mich. L. Rev. 38, 41-42 (2013).
7 For a further discussion on the difficulties of regulating bitcoin and other virtual currencies, see Omri Y. Marian, supra n.8; Reuben Grinberg, Bitcoin: An Innovative Alternative Digital Currency, 4 Hastings Sci. & Tech. L.J. 160 (2011).
8 See United States v. Ulbright, 31 F.Supp. 3d 540 (S.D.N.Y. 2014). See also Ross Ulbricht Convicted of Running Silk Road as Dread Pirate, Bloomberg Business News (Feb. 4, 2015). Bitcoin is not the only cryptocurrency used to carry out illegal activities. On May 23, 2013, the government brought an indictment against the operators of Liberty Reserve, a popular virtual currency, charging the operators with money laundering and operating an unlicensed money transmitting business. Indictment, at *14, 16, United States v. Liberty Reserve, 13 Crim. 368 (S.D.N.Y. May 23, 2013).
9 Blockchain Information. Bitcoin statistics can be found at https://blockchain.info/stats and http://bitcoincharts.com/bitcoin/.
10 Dean Walsh, Digital Cash – A Beginner’s Guide to Anonymous Digital Currency, HubPages (June 23, 2014); Some Things You Need to Know, Bitcoin.org; Roger Wu, Why We Accept Bitcoin, Forbes (February 13, 2014).
11 Notice 2014-21, 2014-16 I.R.B. 938, Sec. 4, Q/A 1. The notice applies to the federal tax consequences of transactions that use convertible virtual currency. Sec. 3, Notice 2014-21. Accordingly, it applies to bitcoin and the convertible virtual currencies of online video games. See also Rajotte et al., Bitcoin Taxation, supra n. 4.
12 I.R.C. §61(a)(1), (3); Notice 2014-21, Sec. 4, Q/A 3. The taxpayer has the burden of establishing the fair market value of bitcoin received and will take a tax-cost basis. I.R.C. §1012; Notice 2014-21, Sec. 4, Q/A4. The fair market value of bitcoin can be determined by the exchange rate as listed on an exchange if “the exchange rate is established by market supply and demand.” Notice 2014-21, Sec. 4, Q/A 5. Because bitcoin maintains daily historical pricing, purchase and sale prices can be easily tracked.
13 Notice 2014-21, Sec. 4, Q/A 11.
14 Notice 2014-21, Sec. 4, Q/A 12, 13.
15 I.R.C. §61(a)(1); Notice 2014-21, Sec. 4, Q/A 8.
16 I.R.C. §1401; Notice 2014-21, Sec. 4, Q/A 9-10.
17 Any realized loss under section 1001(a) is recognized. Notice 2014-21, Sec. 4, Q/A 1, 6. Losses derived from transactions entered into for profit are generally allowed. I.R.C. §165(c)(2). If a bitcoin payment constitutes a business or investment expense, presumably the taxpayer can claim a deduction equal to the amount paid. I.R.C. §§ 162, 212. If the payment is a salary, the employer is required to withhold FICA and FUTA tax and file a Form W-2, the same as if the employee had been paid in cash. Notice 2014-21, Sec. 4, Q/A 11-14.
18 I.R.C. §1221(a); Notice 2014-21, Sec.4, Q/A 7.
19 Notice 2014-21, Sec. 4, Q/A 7; I.R.C. §1221. Bitcoin would fail to meet any of the exceptions in Section 1221(a).
22 I.R.C. §1221(a)(1); Sec. 4, Notice 2014-21, Q/A 7. In the hands of a taxpayer who is a “dealer” in that he in the business of buying and selling bitcoin, it will be characterized as an ordinary asset. Id.
24 Florida v. Espinoza, Order Granting Defendant’s Motion to Dismiss the Information, at *1-2 (F14-2923, 2016).
28 The detective’s cash was counterfeit. Id. at * 3.
29 See Fla. Stat. § 560.125(5)(a).
30 See Fla. Stat. § 896.101(5)(a) and (b).
31 The government also failed to establish that defendant charged a fee for any money transmitting. Florida v. Espinoza, Order Granting Defendant’s Motion to Dismiss the Information, at *4-5 (F14-2923, 2016).
32 See Fla. Stat. § 560.103(30).
33 Fla Stat. § 560.103(29).
34 Florida v. Espinoza, Order Granting Defendant’s Motion to Dismiss the Information, at *5 (F14-2923, 2016).
41 I.R.C. §1001(b). Of course, the seller also would be able to recognize any loss. I.R.C. §165(c)(1), (2).
42 Announcement 2002-18, 2002-1 C.B. 621. It excluded from amnesty situations where points were converted to cash. See Charley v. Commissioner, 91 F.3d 72 (9th Cir. 1996).
43 143 T.C. 140 (2014).
45 Shankar v. Commissioner, 143 T.C. 140 (2014).
49 It would seem this would come into play only when bitcoins are purchased from different sellers at different prices. One seller selling more than one bitcoin would charge the same price for all bitcoins purchased.
51 I.R.C. §6662(c); Treas. Reg. §1.6662-3(b)(1).
52 The penalty is 75 percent of the underpayment that is attributable to fraud. I.R.C. §6663.
55 The exchange can be found at https://www.localbitcoins.com. This website allows buyers and sellers in specific locations, where it has a presence, to connect with each other.
56 “The term does not include arrangements that provide solely for the informal exchange of similar services on a non-commercial basis.” Treas. Reg. §1.6045-1(a)(4). See also I.R.C. §6045(c)(3); Instructions for Form 1099-B (Barter Exchanges); IRS, Barter Exchanges (website information for small businesses).
57 I.R.C. §61(a)(1); Treas. Reg. §1.61-2(d); Rev. Rul. 79-24, 1979-1 C.B. 60. The Service has established a Bartering Tax Center that explains the tax consequences and the proper forms to be used to report a barter transaction. In addition, Publication 525, Taxable and Nontaxable Income, addresses the tax consequences of a barter transaction. See, e.g., Rooney v. Commissioner, 88 T.C. 523 (1987) (goods and services received as payment for services required to be included in income at retail value). See also Sergio Pareja, It Takes a Village: The Problem with Routinely Taxing Barter Transactions, 59 Cath. U. L. Rev. 785 (2010).
58 I.R.C. §6045; Treas. Reg. §1.6045-1. Taxpayers not participating in an exchange may be required to file a Form 1099-MISC. Note that the barter club itself may have tax consequences. See Barter Systems, Inc. of Wichita v. Commissioner, T.C. Memo. 1990-125 (barter exchange must report the fair market value of property received from members in exchange for trade units); Baker v. Commissioner, 88 T.C. 1282 (1987) (owner of barter exchange subject to tax).
59 Generally, information returns must be filed with the Service by March 1. I.R.C. §6721.
60 The maximum penalty is $3 million per calendar year or, for a small business with less than $5 million in gross receipts, $1,000,000. I.R.C. §6721(a), (d)(1)(A).
61 For the reduced penalty, the maximum amount is $500,000 per calendar year and $175,000 for a small business. If the barter club corrects the error 30 days after the due date (generally March 30) but before August 1, the penalty is $100 per return, and the maximum penalty is $1,500,000 per calendar year, $500,000 for small businesses. I.R.C. §6721(b), (d)(1)(B), (C).
62 United States v. 50.44 Bitcoins, 2016 WL 3049166, at *2 (D.C. Md. 2016).
63 At the time of the court’s decision, 50.44 bitcoin was worth approximately $27,000.
64 50.44 Bitcoins, 2016 WL at *2. Because the United States had established a connection between the bitcoins and a criminal offense, the bitcoins were forfeited. Id. at *2, n.5. See 18 U.S.C. §§ 981, 983.
65 United States v. Faiella, 39 F.Supp.3d 544, 545 (S.D.N.Y. 2014).
66 Faiella, 39 F.Supp.3d at 546.
67 Id. at 545. See also United States v. Budovsky, 2015 WL 5602853, at *14 (S.D.N.Y. 2015).
68 Faiella, supra n. 83, at 547, denying the defendant’s motion to dismiss.
69 More specifically, FinCEN exercises regulatory functions primarily under the Currency and Financial Transactions Reporting Act of 1970, as amended by Title III of the USA PATRIOT Act of 2001 and other legislation, which legislative framework is commonly referred to as the Bank Secrecy Act.
70 31 U.S.C. §5330(d)(1). See United States v. Velastegui, 199 F.3d 590, 592 (2d Cir. 1999).
72 31 U.S.C. §5330(d)(2). Other means of transfer are also included.
73 31 U.S.C. §330; 31 C.F.R. §1022.380(a)(1). A money services business includes any money transmitter, which is a person who transmits currency, funds, or value that substitutes for currency between people or locations. 31 C.F.R. §1010.100(ff)(5).
74 United States v. Dimitrov, 546 F.3d 409, 411 (7th Cir. 2008).
75 18 U.S.C. §1960. A person is guilty of this offense if he “knowingly conducts, controls, manages, supervises, directs, or owns all or part of an unlicensed money transmitting business.” 18 U.S.C. §1960(a). “Money transmitting” is “transferring funds on behalf of the public by any and all means.” 18 U.S.C. §1960(b)(2). “Funds” includes bitcoins. United States v. Faiella, 39 F. Supp. 3d 544, 545 (S.D.N.Y. 2014). A business is unlicensed if it fails to meet the regulations under 18 U.S.C. §1960.
76 See Fin. Crimes Enforcement Network, Dep’t of Treasury Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies, FIN-2013-G001. It also clarified that a mere user of virtual currency is not engaged in a money transmitting business. Id.
77 Notice 2014-21, Sec. 2. See also U.S. Gov’t Accountability Off., GOA-14-496, Virtual Currencies: Emerging Regulatory, Law Enforcement, and Consumer Protection Challenges 4 (2014) (a virtual currency is “a digital representation of value that is not government-issued legal tender”); U.S. Gov’t Accountability Off., GAO-13-516, Virtual Economies and Currencies: Additional IRS Guidance Could Reduce Tax Compliance Risks 3 (2013) (a virtual currency is “a digital unit of exchange that is not backed by a government-issued legal tender. Virtual currencies can be used entirely within a virtual economy, or can be used in lieu of a government-issued currency to purchase goods and services in the real economy”); Fin. Crimes Enforcement Network, Dep’t of Treasury, FIN-2013-G001, Guidance: Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies 1 (Mar. 18, 2013) (virtual currency is “a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. In particular, virtual currency does not have legal tender status in any jurisdiction.”).

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