GALYAN LAW, a P.C.

Bitcoin. Virtual currency. Blockchain. These terms of the new frontier are often misunderstood, if not ignored in the financial reporting world.

Bitcoin was created in 2009 as a cryptocurrency to allow for a peer-to-peer electronic cash system that allows for encrypted transactions between two users within a short period of time. The transactions are verified and recorded in a distributed ledger, a blockchain, which is available to all users of the system. 

Each transaction between two users is verified and recorded by a miner in the blockchain associated with the currency. This activity is referred to as “mining,” and miners compete to verify and record the transaction—and are rewarded with additional bitcoins. The Bitcoin algorithm only allows for 21 million bitcoins to ever be mined.

A simple transaction is as follows: Individual A opens an account with an exchange (ex. Coinbase) and wires $10,000 to fund an account and purchase 100 bitcoins, which sit in the person’s virtual wallet/address. To initiate a transaction, such as purchasing goods, Individual A will request the receiver of the bitcoin to issue its public key (an account number/wallet ID/bitcoin address). 

Once received, Individual A can approve the transaction and issue the funds to the designated address associated with the public key. When the funds are issued, a miner will compete to verify that the information is correct and the funds exist to be transferred. A miner also will record the transaction in the blockchain/ledger once confirmed.  At the completion of the transaction, the receiver will have the bitcoins added to their virtual wallet. The public can access the blockchain to view current transactions and the historical tracing of the particular bitcoin used in the transaction.

Because of the way it operates, this peer-to-peer electronic cash system has its skeptics, who wonder what bitcoin/virtual currency really is. There are numerous forms of virtual currencies on the market, with the most popular being bitcoin. There are also numerous exchange platforms on the market that will enable the purchase of virtual currency. Bitcoin is one example of convertible virtual currency, because it can be traded between users, as well as purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currency. 

The use of bitcoin to purchase goods and services in everyday life has picked up traction, and online retailers like Overstock.com will accept payment by bitcoin. 

Department of Justice and IRS Criminal Investigation
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. Bitcoin, from its early days, has been used as an alternative form of payment to facilitate criminal activity. While all bitcoin transactions are recorded in a ledger the blockchain users can conduct transactions with considerable anonymity if users can avoid linking their identities to their online “wallets.”

Perhaps the most egregious use of Bitcoin is the case of Silk Road. In 2011, Ross Ulbricht created and operated the Silk Road website, a global illegal online black market designed to broker criminal transactions. Silk Road emerged as the most sophisticated and extensive criminal marketplace on the internet. It facilitated the sale of hundreds of millions of dollars’ worth of narcotics, stolen identities and numerous other illegal goods and services. All transactions were conducted exclusively in bitcoin. 

Ulbricht was arrested in 2013 and charged with, among other things, money laundering. The FBI seized 173,991 bitcoins worth $33.6 million when it took down the Silk Road. The Justice Department continues to charge and prosecute those who engage in unlawful activity—commonly money laundering and unlicensed money services business. In the 2015 IRS Criminal Investigation Fiscal Report, the IRS identified financial crimes that involved virtual currency as an area of focus. 

The report provided that the IRS Criminal Investigation will collaborate with Department of the Treasury Financial Crimes Enforcement Network (FinCEN) and also seek to work with private companies and organizations, such as Coinbase and the Blockchain Alliance, to stay atop the threats posed by the use of virtual currency.

On Nov. 30, the U.S. District Court, Northern District of California, authorized issuance of IRS John Doe Summons on Coinbase, Inc., a virtual currency exchange. The IRS has asked Coinbase to identify all U.S.-based Coinbase users who “conducted transactions in a convertible virtual currency” from 2013-15. Litigation regarding whether the summons is enforceable is ongoing by account holders of Coinbase. 

IRS Position
Per the IRS, virtual currency can and does operate like real currency—but does not have legal tender status in any jurisdiction. 

On April 14, 2014, the IRS issued Notice 2014-21 clarifying how virtual currency is viewed for purposes of the Internal Revenue Code. The notice provided that bitcoin, or any other virtual currency, is treated like property for federal tax purposes and that general tax principles applicable to property transactions apply to transactions using virtual currency.

The involvement of virtual currency in any transaction brings with it tax consequences. The fair market value of the virtual currency in U.S. dollars as of the date of receipt forms the basis of the currency acquired. If virtual currency is used in exchange for goods and services, the gross income reported from the exchange is the fair market value of the currency as of the date of receipt. 

The same principal applies if virtual currency is issued in lieu of wages and payment for services: The recipient must report as income the fair market value of the virtual currency on the date of receipt. Employers must report the payments as either wages on Form W-2, or payments on Form 1099-MISC for the fair market value of the virtual currency on the day of payment. 

Withholding requirements also are applied for payments using virtual currency. A miner who successful mines a bitcoin is required to include the fair market value of the currency mined as income. General taxing principals apply in determining gains and losses in the exchange of virtual currency as a capital asset. However, virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.

The preamble of the final regulations issued on Sec. 6038D, dealing with foreign asset information reporting requirements on Form 8938, provided that the Treasury Department and the IRS are considering the proper treatment of virtual currency. 

For now, it’s unclear whether virtual currency is a reportable asset, whether accounts held with foreign exchanges are considered financial accounts or whether the exchange itself is a financial institution. It’s not clear whether the statutory definitions of the Bank Secrecy Act, which sets forth the requirements of Report of Foreign Bank and Financial Accounts reporting for foreign financial accounts, apply for purposes of Sec. 6038D. 
To avoid any penalties, taxpayers should disclose virtual currency wallets/accounts held with a foreign exchange as a foreign asset on Form 8938.

FinCEN Position
In 2013, FinCEN issued guidance to persons administering, exchanging or using virtual currency. FinCEN 2013-G001 clarified the applicability of the regulations implementing the Bank Secrecy Act to persons creating, obtaining, distributing, exchanging, accepting or transmitting virtual currency, and determined whether each category was considered a money service business subject to Bank Secrecy Act regulations.

FinCEN identified three categories of persons: 

• User: Someone who purchases virtual currency and is not a money service business for purposes of the Bank Secrecy Act.

• Administrator: A person engaged as a business in issuing (putting into circulation) a virtual currency and who has the authority to redeem (to withdraw from circulation) such virtual currency.

• Exchanger: A person engaged in the exchange of virtual currency for real currency, funds or other virtual currency.

In addition, administrators and exchangers are deemed as money service business and subject to FinCEN’s registration, reporting and recordkeeping regulations for money service businesses.

In United States v. Hom, [2014 U.S. Dist. LEXIS 77489 (N.D. CA 2014)], the Court determined that virtual currency held with an exchanger offshore was subject to FBAR reporting. Hom was an online gambler who held accounts at two online poker companies: PokerStars and PartyPoker. Hom also held an account with Firepay.com, an online financial organization that received, held and paid funds on behalf of its customers. Hom used his Firepay.com account to facilitate his gambling with the poker companies by transferring money to and from the poker companies by use of virtual currency. 

The Court upheld the civil FBAR penalty for failure to report the financial account held with Firepay.com. The Court found that Firepay.com, a foreign exchange, acted as licensed sender of money or engaged as business in transmission of funds under the BSA, and thus considered financial institution for FBAR purposes. The Court also determined that a financial account is a considered a foreign account based on where the financial institution that created and managed the account is located.

Under the guidance of FinCEN, in combination with Hom, virtual currency accounts/wallets maintained with a foreign exchange by a U.S. person is subject to FBAR disclosure if the value of the virtual currency account, in aggregate with all foreign financial accounts, exceeds $10,000 at any time during the year.

Areas of Uncertainty
Reporting of transactions involving virtual currency presents many practical issues as a result of the limited guidance received on the issue. The AICPA submitted comments on Notice 2014-21 requesting the IRS to release guidance on the reporting of virtual currency. Practitioners requested additional guidance in determining basis of the property, whether IRC sections such as Sec. 1031 apply to exchange transactions of virtual currency, balance sheet classification for virtual currency and foreign reporting requirements. 

Another practitioner issue is determining the fair market value of the coin on a particular date, as there is no centralized exchange available. Various websites yield different value for a particular virtual coin traded on a particular day. Practitioners are instructed to apply reasonable methods in determining value, and the AICPA has addressed this issue in its comment letter.

The Treasury Inspector General for Tax Administration issued a report on Sept. 21—As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions Are Needed to Ensure Taxpayer Compliance—which recommended the IRS provide updated guidance to reflect the necessary documentation requirements and tax treatments needed for the various uses of virtual currencies.

Virtual currency is an emerging technology and the gray area in the applicable law for reporting is vast. Conflict between the various applicable laws also presents challenges in appropriately determining the reporting obligations involving virtual currency. 

When in doubt, practitioners should use reasonable manner and best professional judgement to report the transactions. They also should be alert to the nature of the activity of the taxpayer who is using a virtual currency. If criminal activity is suspected the practitioner should consult counsel.