Originally published on Forbes.com.
If the recent stir about IRS interest in bitcoins and other cryptocurrencies has you worried about whether your clients have been fooling with bitcoins or you have been fooling with them yourself, Perry Woodin of Node4o LLC might have some software to help you out. I had a nice chat with Perry on Friday and he advanced my education on cryptocurrencies quite a bit. He has not shaken me from my overall evaluation of cryptocurrencies which is summed up in two words – tulip bulbs.
Bitcoins As Tulip Bulbs?
According to CoinMarketcap.com , there are 710 cryptocurrencies worth tracking or trying to track. The aggregate value of all of them, as I write this, is $14.6 billion. Bitcoins with $12.7 billion in market value make up 86.7%. There are 20 altcoins (cryptocurrencies other than bitcoin) with market caps greater than $10 million. DASH, which Perry works with quite a bit comes in seventh with $67.2 million. All this value is created by burning a lot of computer time solving math puzzles to journalize every single transaction into blockchains of greater or lesser transparency, depending on which currency you are talking about.
And what does that have to do with tulip bulbs? Required reading for anyone ever involved with finance and markets should be Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay where you can learn about the tulipmania that gripped Holland in the seventeenth century. If you want a different two words you might try “new economy” which in retrospect we call the “tech bubble”.
But I’m just a tax blogger who flunked out of graduate school in history, not a financial seer, so let’s focus on the immediate practical problem faced by bitcoin users, which up until now have accounted for almost all the action. From here on I will just talk about bitcoins.
IRS And Bitcoins
Bitcoins were introduced in 2008, but it was not till 2014 that the IRS got around to issuing some guidance. The guidance in Notice 2014-21 told us, not unsurprisingly that bitcoins are not tax fairy dust allowing us to earn and spend without paying any taxes. If you received bitcoins for providing services, you had gross income and so on. More substantively the Notice told us that bitcoins were not, for tax purposes, a currency but were property. That meant that when you exchanged bitcoins for other stuff you had to recognize gain (and maybe loss) and that gain might be long or short term depending on how long you had held the bitcoin.
Then this September, the Treasury Inspector General for Tax Administration issued a report indicating that the IRS needs to get its act a little more together in addressing virtual currencies.
More recently in a development, either related or unrelated to the TIGTA report, the IRS issued a John Doe summons to Coinbase, which has been facilitating transactions in bitcoins. The summons generated quite a bit of coverage and a fairly quick reaction, which brings us up to date.
Bitcoins Byte Back
The IRS summons to Coinbase, is being challenged and the challenge promises to be robust. Jeffrey Berns, the aggrieved Coinbase customer, is the managing partner of Berns Weiss LLP, a firm focusing on class action lawsuits. Over two years ago Berns Weiss launched a Digital Money Practice Group. There is speculation on Techdirt that the decision to intervene may be “a bit of brand building, as the firm seems to want to be the go-to player for legal issues dealing with cryptocurrencies”. The intervention has been widely covered including a post by Kelly Erb, so I will just point out the part that intrigued me the most. Mr. Berns chose to invoke the IRS scandal narrative (now on Day 1318 by TaxProf count).
While the Court need not determine the IRS’s true motive in order to find abuse of process based upon bad faith, it is hardly far-fetched to conclude that the IRS has an ulterior motive for pursuing the IRS Summons. As this Court may be aware, the IRS recently used its power to retaliate against anti-administration political associations and political speech. In 2013, the IRS revealed that it had selected political groups applying for tax-exempt status, “Tea Party”, for intensive scrutiny based on their names or political themes, which triggered widespread condemnation of the agency. Multiple investigations of the IRS by the FBI and the U.S. Attorney General are pending, while lawsuits filed against the IRS were recently reinstated by the D.C. Circuit. See True the Vote, Inc. v. Internal Revenue Serv., 831 F.3d 551 (D.C. Cir. 2016). It is not a stretch to conclude that the government is similarly using the IRS’s John Doe summons authority to harass taxpayers who use virtual currencies, as politicians and financial leaders have suggested an anti-virtual currency bias by the government. For example, Jamie Dimon, CEO of JPMorgan Chase, stated: “Virtual currency, where it’s called a bitcoin vs. a U.S. dollar, that’s going to be stopped. No government will ever support a virtual currency that goes around borders and doesn’t have the same controls. It’s not going to happen.” Similarly, Sen. Joe Manchin (D-W. Va.), a former member of the Senate banking committee, stated: “If the feds can’t get their hands around to where they can secure it, then I would be very leery of investing in it or trading with it or buying with it.”
As the last IRS scandal agnostic, I’m glad to see one more extension of the scandal narrative -And then they came for the libertarian techno-geeks. I also tend to look for the practical lesson that can be gleaned from various developments.
Whatever Should You Do?
If you have been running a lot of bitcoin transactions in the last few years, you probably have a lot of unreported gains and losses. As it turns out the idea of using bitcoins to have all these anonymous transactions might not have been the smartest thing that ever entered into some villainous brain. The essence of the blockchain system means that there are many many identical copies of journals (I know they are called ledgers, but I think they are more like journals) that contain every single transaction with every single bitcoin ever. If a public key can be associated with you, then all the transactions done with that public key are identified as yours. There are things that mitigate this, such as the use of multiple public keys, but unlike cash which can go from hand to hand with no permanent record every bitcoin transaction is recorded – forever.
If you were using bitcoins to hide income on a grand scale, this shot across the bow by the IRS should make you reflect that it probably was not such a good idea. If you came to me, not likely, I would refer you to an attorney. If on the other hand you were just using bitcoins, it is a little more puzzling. Should you go back and try to figure out all those gains and losses?
That is where Node40 might be able to help. Node40 has been doing a lot of business in bitcoins and the like and wanted to be in compliance but recognized that there were challenges which he describes in this article.
At Node40, as a US Corporation, we are required to file taxes. Since most of our customers pay with digital currency, we needed a way to calculate the USD cost of all incoming transactions and then determine if there was a gain or loss when we converted to USD, so assigning value to each transaction was an absolute requirement. Day traders are involved in cryptocurrency because it is simply another vehicle for exchanging value between assets. Long term investors have to gauge performance by comparing a cryptocurrency’s value with other assets using a common base. And merchants set a cryptocurrency price based on the fiat conversion.
Perry has indicated that the software solution that his company devised to solve its own problem will be available to others in time for this tax season. And here is the advantage of that blockchain transparency. All those transactions are already journalized for you so good software with your public keys should be able to extract a gain or loss schedule from the blockchain. (There are some fine points that are a matter for concern, since you don’t really know the dollar value of the other side of a purchase transaction. Presumably there has to be some assumptions made. On the other hand, it might produce a good starting point or, if you come from the how wrong could it be school, a reasonable ending point)
I really don’t know enough to recommend that you should give their product a try, but you should be aware that you might need it. I do see that there are other software solutions available like bitcoin.tax. The thing you should probably not do is nothing, At least do something to get a handle on what you gain exposure might be.
About Those Tulips?
Perry Woodin is, as you might expect, much more sanguine about the prospects of cryptocurrencies than am I. One of the things he says they are great for is transferring money being much less expensive than solutions such as []Western Union or wiring. People using bitcoins like that are not really running any great risk, since their ownership is transitory and gains and losses are likely de minimis. Putting bitcoins in your IRA is a different story. Just because you apparently can, does not mean that you should. Perry does have a little bit of sympathy for my getting a whiff of tulips though. He wrote me.
I do see a connection between the internet bubble and blockchain proliferation. When I go to conferences, I hear these wild presentations about how the blockchain will solve all of our problems. It won’t. The blockchain solves very specific problems, and so far the best application of blockchain technology is as a digital currency. I have been using the term Bitcoin in our conversations to refer to cryptocurrencies in general. There are some real problems with Bitcoin that are solved by other cryptocurrencies. There’s a battle going on to see which cryptocurrency wins. Bitcoin has the first-mover advantage (and media attention) and has demonstrated utility. There is a very good chance that Bitcoin is a bubble and some other cryptocurrency will emerge as the winner. My bet is on Dash, but we’ll see. Regardless, I think that cryptocurrency (as a form of digital currency) is revolutionary and is a far superior way to move value from person to person.
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