Bitcoin and Taxes

The IRS's announcement about taxing Bitcoin won't kill the libertarian Bitcoin dream

The leading digital currency protocol Bitcoin has suffered blow after blow lately—each one interpreted by doubters as fatal. Major exchanges collapse, taking hundreds of thousands of customers' Bitcoins. Minor exchanges also suffer severe hacking attacks or disappear. Major players in the Bitcoin game, even from the respectable representatives of legitimate business at the Bitcoin Foundation, are arrested for money-laundering. China continues its push to stamp out its citizens ability to use it. After zooming above $1,000 late last year, Bitcoin's dollar price has fallen by more than half in the past few months. (However, the beleaguered coin is still worth double what it was in dollar value a mere five months ago.)

Last week, Bitcoin suffered what seemed to be its most insulting injury yet: the IRS officially announced that in its eyes Bitcoin is not the currency it purports to be, but merely property. This means, to quote the IRS, "a taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received."

You are also, says the taxman, liable for capital gains tax if a Bitcoin you spend or sell is worth more than when you bought it. This applies theoretically to every use of a Bitcoin, no matter how tiny, including buying a cup of coffee. If you are mining Bitcoin, you owe self-employment tax on the coin's value—and are liable for back tax penalties for your past mining if you haven't already been declaring it. In general, the IRS insists there are many things you have to tell them and pay them for if you make, take, or give Bitcoin.

A sad pass, it seems, for Bitcoin. The cryptocoin protocol hit the world a few years back with dizzying promise to the anarcho-libertarian; a digital currency that is stateless, deflationary, peer-to-peer, with strong potential for anonymity—or at least pseudonymity. It was supposed to combine the convenience of digital transfer with the privacy of physical cash. Now it seems it's just one more way for the taxman to get into your business and pick your pockets.

Still, the reaction of those deep into Bitcoin to the IRS news has not been, overall, particularly shocked or scared. As Jeffrey Tucker, a libertarian Bitcoin advocate, told me, "Every bit of Bitcoin news causes everyone to freak out except actual participants in Bitcoin." Despite all the recent bad news, more venture capital, more potential uses, more businesses getting on board the Bitcoin train, continue apace.

Many Bitcoiners don't care about this tax news because, given the general ability to obscure the actual identity of owners of particular Bitcoin wallets, they figure they'll continue making and using Bitcoin and just, you know, not tell the IRS about it. No one is filing W2s or 1099s on your Bitcoin profits and activities, if it stays in the virtual world.

Cody Wilson, the popularizer of the 3D printed gun, is moving into the Bitcoin field as a lead man in the "dark wallet," an attempt to ensure the anonymity and privacy of Bitcoin stays real despite the very public blockchain that traces every Bitcoin transaction ever made. Most Bitcoin holders are not as anonymous as they might think, Wilson tells me. He is sure that the federal government pretty much can identify who possesses most Bitcoin, a dilemma his team's dark wallet should help solve. All the interesting action in Bitcoin business is going to be pushed outside the United States, Wilson says, as the land of the free chokes the coin with taxes and regulations. His team is mostly based in Spain.

The obvious vulnerability in keeping Bitcoin gains secret from the IRS arrives when one leaves the hermetic world of making and trading Bitcoin only for goods and services directly with sellers. You become most traceable by the powers that be when turning virtual currency into "real" currency. Any existing Bitcoin exchange that wants to stay in business aboveground in the U.S. is already obeying, or is striving to obey, the stringent and complicated regulations as "money transmitting businesses" that the U.S. Treasury Department's Financial Crime Enforcement Network (FinCEN) announced last year apply to Bitcoin, which include "knowing your customer," making anonymity impossible.

Steve Hudak from FinCEN explained to me that Bitcoiners who think they've caught the feds in a contradiction–with the IRS saying Bitcoin's not a currency but FinCEN regulating exchanges as "money transmitting businesses"–are mistaken. FinCEN does not consider Bitcoin money either. But if you are in the business of turning anything into U.S. cash money and moving that cash around the nation or world, that makes you a regulatable money transmitter.

Very few exchanges currently do business with U.S. citizens in U.S. dollars. One that started doing so, Vault of Satoshi, gave up last month when they realized how complicated it was obeying U.S. regulations and how dangerous it could be to them and their customers if they failed to.

A different pair of U.S.-based entrepreneurs launching a Bitcoin exchange business decamped to Canada to operate because, they told me, the costs of getting up to FinCEN snuff federally and in all 50 states for a Bitcoin exchange could require $5 million and take 12-18 months. They told me how even discussing plans to enter a Bitcoin-mining business got some MIT students subpoenaed by the feds. They were not eager to risk the same by having their business plans discussed by name in print.

Most exchanges that pay you dollars for Bitcoin insist on knowing all about you, and huge influxes into any U.S. bank account have a high probability of attracting the taxman's attention. Evading taxes on dollar gains through any exchange striving to be legit is thus very risky.

That leads to the other main reason the core Bitcoin world hasn't been too roiled by the IRS's announcement: they already knew they were liable. Two libertarian early adopters of Bitcoin I talked to this week—one cashed out in mid-five figures, the other in low-seven figures, and neither was willing to be quoted by name—were already trying to pay their taxes on their gains even before this IRS announcement.

One Bitcoin multimillionaire—talking to me by phone from Richard Branson's private island, as he bought a ticket on Virgin Galactic with some of his Bitcoin**—is already complying with the IRS, and says he even made quarterly payments over the past year on his Bitcoin earnings. "As my assets were growing I didn't want to take that risk," of falling afoul of tax laws. "It's possible [the IRS] could have done nothing for a while, but eventually it might come back and haunt me."

The IRS would not tell me if it has gone after anyone yet explicitly for not declaring taxable Bitcoin gains, and no one I talked to in the Bitcoin community could tell me of any such cases they knew of—yet. "I don't see [the IRS] doing much right now," says the Bitcoin multimillionaire from Branson's island. "But it could be a nightmare for people they do eventually prosecute, who they might hold out as tokens" to instill the fear of the taxman into all the others.

That the IRS is taxing Bitcoin as property rather than as currency can work to the advantage of most holders, as it means they will generally pay the lower capital gains tax rate rather than a higher income tax rate. Many pundits were impressed with an argument floating around that the IRS's requiring you to calculate a cost basis on each Bitcoin you spend means that Bitcoins are no longer fungible and thus can't be considered currency either conceptually or legally.

But as University of Florida law professor Omri Marian, who has written on taxes and cryptocurrency, explained to me, with the exception of an explicit exemption for expenses under $200, U.S. tax law already treats existing foreign currencies the same way–"you already when you dispose of [foreign currency] need to know how much you've gained from fluctuations in exchange rates." No one is arguing that U.S. tax law thus makes foreign currencies not actual currencies. As many in the Bitcoin world point out, entrepreneurs developing Bitcoin wallet add-ons that do the necessary cost-basis tax calculations automatically should not be a very difficult task, for those who want to stay copacetic with the IRS.

How serious can we actually expect the IRS to be in rooting out Bitcoin tax evasion? As Marian points out, in a world where there is already likely $40-70 billion a year in tax underpayments, the world of Bitcoin, with its total market capitalization of around $5.3 billion now, is unlikely to be a high priority.

As the IRS news sunk in, major legit Bitcoin business financier Marc Andreessen proudly announced at a Coin Summit Conference in San Francisco last week that "the libertarians will turn on bitcoin," adding somewhat snidely—as if anyone who cares about bitcoin deeply didn't already know—"The libertarians will discover that the blockchain is public."

As many libertarian Bitcoiners told me, while pseudonymity is nifty—and thanks to things like Dark Wallet achievable even given the public blockchain—many libertarians just love Bitcoin for its ability to make end runs around inflationary state-manipulated currency.

But Andreessen's quip limned a split in the world of Bitcoin the press loves belaboring: the bitter war between the crypto-anarchists from whom Bitcoin arose and who were its first adopters, and the big-time legitimate businesses stepping in to normalize the market, who would just as soon lose the stink of weirdo anarchism surrounding Bitcoin that can scare off big money. These folk often have a cheery willingness to accept regulation, even to beg for it. Legitimate big business doesn't want to mess with things whose legality is dubious or confused. To these businesspeople, unlike for the anarchists, the formal taxation of Bitcoin is a feature not a bug. It will invite more financiers and marketers to work with or accept the cryptocoin.

Aaron Sankin at the Daily Dot proclaimed last week that it's now clear that libertarians have "lost" the "battle for Bitcoin." "These two conceptions of Bitcoin couldn't be more different," he wrote of this war between the anarchist crypto-freaks and the monied techno-geeks.

On the contrary, those two conceptions can, and will, co-exist peacefully. Bitcoin may become one of the biggest things in aboveground nearly cost-free financial transactions, with thousands of fully regulated and taxed companies dealing with moving and exchanging it. Bitcoin can become the latest success in the Internet's salubrious trend of enriching all of us by squeezing out unnecessary middlemen and needless transaction costs, at last the legitimate MasterCard-killer it promises to be.

At the same time, crypto-anarchists will still be using the protocol to secretly and instantly, without the possibility of censorship (of the sort Paypal and the major credit card companies imposed on those who wanted to support WikiLeaks) and with a very low possibility of successful involuntary taxation, build a system of value-storage and transfer that allows for both legal and illegal commerce. To boot, it may well topple the Federal Reserve and destroy the monopoly of the nation-state over the vital matter of currency.

As much as the two sides might feud now, Bitcoin will likely make both of their dreams come true, in uneasy but glorious harmony.

**CORRECTION: An earlier version of this article implied that he bought the ticket with U.S. dollars from selling Bitcoin, not with Bitcoin itself.