A Primer on Bitcoin

April 7th 2014

Bitcoin is a digital or virtual currency that uses peer-to-peer technology for the payment of goods and services. It is an internet-based currency that was established in 2009, and has experienced such exponential growth that companies such as eBay and Overstock now accept it as a form of payment. Bitcoin operates in a decentralized system and does not have any central governing authority.  Instead, it is governed/maintained by an online community. Further, it is a peer-to -peer based system which eliminates any middlemen. The absence of ‘middlemen’ eliminates many transaction costs associated with credit card fees, exchange rates and others. Although many cryptocurrencies have come out of the woodwork, Bitcoin remains the most popular and accepted. Cryptocurrencies are currencies based on cryptography, which is a security information technology also used in banking to protect information in chip-based credit card. Naturally, this new form of payment for goods and services has been compared to traditional fiat money (money which has been established by a government as legal tender). The value of traditional fiat money, such as the US dollar, is based on its market value. That is, the acceptance of the public to use it as a legal tender. However, the government’s power and ability to assign that currency as the jurisdiction’s legal tender, is the major factor in its acceptance as a currency.  Historically, currencies were backed by gold reserves of the sovereign states, but today they are backed by the “full faith and credit” of the issuing state. The value of a digital currency such as Bitcoin is derived from its acceptance and use, with no sovereign state backing the “currency.” The difference between fiat money and digital currency is that there is no governing body vouching for its value or legitimizing its use. Rather, it garners its value from collective acceptance and use.   Money was not always “money,” i.e., coins or state issued notes.  In ancient times humans used beads, eggs, feathers, rice, salt and many other goods and commodities that had an accepted and commonly known value.  Bitcoins are similar to such pre-coin moneys, but without an intrinsic value.   The absence of a governing body is noted by Bitcoin supporters as one of the advantages of digital currency, because, they claim, it takes the power away from any one entity to control the production of, or manipulation of the currency. Also, because Bitcoin is not tendered by any one governing entity; it is truly a global currency that removes the cost of international transaction costs and foreign exchange rates.  Inflation or counterfeiting can be curtailed with this new digital currency, because the whole system is based off maintaining a fixed amount of bitcoins in circulation. There are currently 12million Bitcoins in circulation, and the total bitcoins to be allowed into circulation by or before the year 2140, is 21million. The release of new bitcoins into circulation, and all transactions using bitcoins, is publicly recorded. However, any personal information of those involved in Bitcoin transactions is kept private and secure. This maintains the transparency of the digital currency and eliminates the possibility of double spending or counterfeiting, while protecting the identities of those who use it. Bitcoin may offer many advantages; however, there are some noted drawbacks to this alternative currency.


Acceptance and Volatility

Although Bitcoin’s following is growing daily, this new payment method still causes uncertainty among majority of the public. This results in a lack of acceptance of Bitcoin as a legitimate currency, but more importantly, it makes the system prone to volatility. Economically, it is also a concept that is difficult to grasp.  There is no intrinsic value to Bitcoins and no “full faith and credit” of a sovereign state.  Consequently, value is determined solely based on supply and demand.  If tomorrow our society switches to the use of one-pint containers of low-fat cottage cheese as a value exchange mechanism, Bitcoins will become worthless.


Asset Protection and Privacy

For our clients, the advantage of Bitcoins may come from their use to gain asset protection and privacy.  There is no public registry of Bitcoin ownership, no visible chain of title and no easy way to discover their existence.  Even if a third-party discovers the existence of Bitcoins and demands that a debtor in possession of Bitcoins turns them over, what happens if the debtor is unable to retrieve his password?  There is no physical asset that a court can force the debtor to turn over to a creditor.  It is purely information that exists in debtor’s head.  Very “James Bond”!


Taxation

For U.S. federal income tax purposes, assets are divided into capital assets and inventory.  A sale of a capital asset is subject to the capital gain/loss rules and sale of inventory is subject to ordinary income/loss rules.  Thus, Bitcoin investors would be treated as holding a capital asset and Bitcoin dealers as holding inventory.  Bitcoin investors holding Bitcoins for over a year will be subject to the 20% capital gain tax rate, and possibly and additional 3.8% surtax on passive net investment income. It is important, for tax purposes, not to think of Bitcoins as a fiat currency.  We refer to Bitcoins as a digital, virtual or crypto- currency, but they are really just capital assets that can appreciate or depreciate in value.  Consequently, Bitcoins are not taxed as currency (until and unless Congress says otherwise). The tax realization event takes place each time a Bitcoin miner disposes of his Bitcoin.  The gain is simply the difference between sale price and purchase price.  Similar to other capital assets, Bitcoins would not be subject to the mark-to-market regime that dealers in Bitcoins would be subject to. For U.S. taxpayers, Bitcoins offer no tax planning potential.  U.S. taxpayers are taxed on their world-wide income from whatever source derived.  Tax planning may be possible for taxpayers in some of the countries that do not tax their residents on extra-territorial income. For FATCA purposes Bitcoins should not be treated as a “specified foreign financial assets” if they are not held at a financial institution.  When Bitcoins are held at a foreign brokerage account, they will be an asset of such an account and FATCA compliance (including FBAR disclosure) would apply. – See more at: http://ksilaw.com/blog/view/a-primer-on-bitcoin#sthash.ihQi9NIZ.dpuf