INTRODUCTION
The use of virtual currency is on the rise, and investors and government agencies are taking notice. The recent surge and subsequent decline in the value of Bitcoin – which hit a record high exceeding $17,000 in early December1 – is prompting worldwide legislative attention.2 It has also caught the financial market's eye, with the first Bitcoin futures trading launched on December 10, 2017.3 Adding to this frenzy is Venezuelan president Nicolas Maduro's announcement of the "petro," which, if launched, would be the first government-backed cryptocurrency, backed by Venezuela's oil and other natural resources.
The market's clear attraction to this alternative, decentralized currency-type asset comes despite criticism from high-profile personalities, such as JPMorgan's Jamie Dimon who recently referred to cryptocurrency as a fraud,4 and scrutiny from law enforcement agencies. Cryptocurrency-based websites facilitating illicit commerce are highly targeted by worldwide law enforcement agencies. AlphaBay, the largest darknet market, was shut down on July 20, 2017, along with its competitor Hansa.5 The operation required the cooperation of worldwide law enforcement agencies, including the F.B.I., the D.E.A., the Dutch Police, and Europol. It follows the 2013 crackdown on Silk Road, another Bitcoin-based website facilitating criminal activities.6
So, where does this lead? To understand the dynamics at play, this article begins with a brief explanation of Bitcoin before examining the U.S. tax treatment and reporting obligations of virtual currency holders.
A BRIEF OVERVIEW OF BITCOIN
Bitcoin was created in 2008, allegedly by a person (or group) known as Satoshi Nakamoto.7 The first Bitcoin was generated in early January 2009 and the first Bitcoin transaction took place later that month.8
Bitcoin was created to constitute a peer-to-peer, decentralized version of electronic cash.9 It is a cryptocurrency, meaning a convertible virtual currency.10 Think of it as a long code. This code is divided into several blocks. All the blocks together are referred to as a blockchain.
The various blocks are not created by one or more identifiable individuals, but rather by a worldwide network of individuals often referred to as "miners" or "nodes." The miners are essentially individual hosts that agree to implement and use the Bitcoin protocol.
This network of miners constitutes one of the particularities of Bitcoin: Instead of having a trusted central institution, such as a central bank, verify the validity of a given Bitcoin transaction, a widespread network of miners works together, or "mines," to verify the transaction. The incentive for the miners is their entitlement to a sort of "transaction fee."
If, for example, individual A holds six Bitcoins and wishes to transfer three Bitcoins to individual B, A would indicate his or her wish to transfer six Bitcoins and to get two Bitcoins back. The one Bitcoin difference would be a transaction fee paid to the miners, as an incentive for their work.
A good way to understand the underlying logic of Bitcoin and other cryptocurrencies is to start with our current banking system: When A wishes to wire X amount to B, A's bank will send the wire information to a central bank, which would then effectuate the transfer to B's bank to have the amount deposited into B's account. The central bank would retain records of the interbank transaction and make certain that no double-spending occurs.11 In the Bitcoin system, no such central institution and record retention is needed. The decentralized mining system, coupled with the blockchain technology and good faith, makes it almost impossible to duplicate a given Bitcoin. The traditional record retention is embedded into the blockchain and, thus, is irreversible.
Another characteristic of Bitcoin is that it prevents double spending, whereas regular wire transfers of fiat currencies can be fraudulent.
Take, for example, the mobile payment service Venmo: If A wishes to wire X amount to B, and sends such amount to B via Venmo on date Y, B's Venmo account will indicate the payment as of date Y. However, A's actual bank account linked to A's Venmo account will only debit the funds on Y+1 or Y+2. This leaves A the time to withdraw the funds from A's account and B's receipt of X will be reversed. A simpler example would be counterfeit money.
As stated earlier, in the case of Bitcoin, the transaction chain constituting the cryptocurrency, and essentially created by the miners, is unique and not reversible. In the example, this transaction chain records all transactions up to and including A's transfer to B. It will include A's virtual identity ("public key") and B's public key. This public key is simply a chain of numbers and constitutes the owner's virtual identity. The transfer can only be completed once the miners verify the transaction and once A uses his or her "private key," which is unique and specific to every Bitcoin user.
A third characteristic of the Bitcoin system is the anonymity it provides to Bitcoin owners. Every Bitcoin owner is identified through a public key. The public key is broadcast into the network of miners when a Bitcoin owner wishes to enter into a transaction. Only when the transaction is coupled with the Bitcoin owner's private key can the transaction be verified by the miners. A private key is essentially the equivalent of the owner's signature to the transaction.
Footnotes
1 See Coindesk.
2 "Bitcoin: UK and EU Plan Crackdown Amid Crime and Tax Evasion Fears," The Guardian, December 4, 2017.
3 "Cboe Announces Bitcoin Futures to Start Trading Sunday," CNBC, December 4, 2017.
4 "JPMorgan CEO Jamie Dimon Says Bitcoin Is a 'Fraud' that Will Eventually Blow Up," CNBC, September 12, 2017.
5 Department of Justice, Office of Public Affairs, "AphaBay, the Largest Online 'Dark Market,' Shut Down," news release, July 20, 2017; Europol, "Massive Blow to Criminal Dark Web Activities After Globally Coordinated Operation," news release, July 20, 2017.
6 "Silk Road Shut Down and 'Owner' Ross William Ulbricht Arrested," Coindesk, October 2, 2013.
7 See History of Bitcoin. Also see "Bitcoin: A Peer-to-Peer Electronic Cash Sys- tem," Satoshi Nakatomo Insititute, October 31, 2008.
8 Dates vary depending on the source. See, for instance, History of Bitcoin.
9 "Bitcoin: A Peer-to-Peer Electronic Cash System."
10 Treasury Inspector General for Tax Administration, "As the Use of Virtual Cur- rencies in Taxable Transactions Becomes more Common, Additional Actions Are needed to Ensure Taxpayer Compliance," September 21, 2016, p. 1.
11 For a clear illustration, see the IMF staff discussion note "Virtual Currencies and Beyond: Initial Considerations," SDN/16/03, January 2016, p. 20.
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