I The Basics

II Price and Value

III What type of Asset is Bitcoin?

III Aquiring Bitcoins

IV Bitcoins Storage

V Taxation

VI Conclusion

 

A DIVORCE PRACTITIONER’S BITCOIN PRIMER
by Richard West* and Jonathan Fields*

If you don’t believe it or don’t get it, I don’t
have the time to try to convince you, sorry.
Satoshi Nakamot

While the initial media mania about bitcoins and the thousands of other digital currencies or cryptocurrencies has subsided, “there is no question that the technology in this sector has the potential to fundamentally change traditional payment systems, the way we do business, and people’s everyday lives.” As the market capitalization of all cryptocurrencies exceeds two hundred fifty billion dollars, and young people and other countries with unstable governments are increasingly committed to it, a primer on cryptocurrencies for divorce practitioners is timely, if not overdue.

“Satoshi Nakamoto” created Bitcoin in response to the financial crisis of 2008 when he published his white paper “Bitcoin-A Peer to Peer Electronic Cash System.” In general, since bitcoin is used in daily speech as a synonym for cryptocurrencies (like Kleenex for tissue) the authors use “bitcoin” as a generic term for all cryptocurrencies even though it is not technically correct.

Because bitcoins are incorporeal, have no intrinsic value (such as gold or silver), and are not backed by any government or financial institution, a host of problems must be addressed. Among these are classification as a currency or investment asset, valuation, taxation, and, in a divorce, finding and dividing them. This article will briefly touch on these issues.

A basic glossary is included in Appendix “A” to assist the reader in understanding the terminology used in this article.

I The Basics

Unlike fiat currency, Bitcoin was introduced in 2009 to operate without a centralized institution such as a bank or the Federal Reserve. Nakomoto had a deep distrust of central banks, writing they “must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.” Nakomoto’s creation, then, was designed to be impervious to the monetary policies of central bankers and politicians.

Bitcoins are unlike traditional currencies because there is no central bank, nation state, or regulatory authority backing it. Bitcoins do not rely on gold or silver as a basis of value. Nakamoto’s concept was to create a means of exchange, without any central authority, that could be transferred electronically in a secure, verifiable, and immutable manner. This is known as decentralization, which means no single institution controls the Bitcoin network. Instead of a central authority validating transactions, they are recorded on a public ledger, called the blockchain.

While not the first digital currency, Bitcoin was the first to solve the “double spend” problem. Cash does not have the problem digital currency does. Because bitcoins don’t have a physical existence, like a dollar bill, how can one ensure the bitcoins won’t be spent more than once? The blockchain permanently monitors the exchange of cryptocurrency so nobody can spend the same bitcoins twice, solving the “double-spend problem.” A transaction does not become part of the blockchain until verified by “miners,” whose computers perform mathematical calculations for the Bitcoin network to confirm transactions.

The blockchain is “a peer-to-peer immutable distributed ledger which generates computational proof of the chronological order of the transactions, an incorruptible digital ledger of economic transactions that can be programmed to record not just financial transactions but virtually everything of value.” Imagine a spreadsheet copied thousands of times across a network of computers. Then imagine the network updates the spreadsheet every 10 minutes and you have a basic understanding of the blockchain. The blockchain database is not stored in a specific location, or under the control of a single authority, meaning the records it keeps are public and verifiable. No centralized version of this information exists for a hacker to corrupt. Hosted by millions of computers simultaneously, its data is accessible to anyone. Every transaction back to the very first, known as the “genesis block,” can be viewed. This is good news for divorce lawyers who have the public and private addresses in question.

Bitcoin and its blockchain are basically a collection of computers, or nodes, around the world that all have Bitcoin’s code downloaded on them. Each of these computers have all of Bitcoin’s blockchain stored on them. This means that each computer has the entire history of bitcoin transactions, which ensures that no one can cheat the system, since every computer would deny the transaction. In this way, Bitcoin is entirely transparent, and no one can make a transaction without everyone seeing it happen. Even those who do not participate in the network as a node or miner can view the transactions taking place live by looking at block explorers, which are browsers for the blockchain, similar to how browsers like Mozilla or Google Chrome work for internet web pages.

II Price and Value

Where does the value in bitcoins come from? Warren Buffett famously called Bitcoin “a mirage” in 2014, saying “it’s a method of transmitting money . . . The idea that it has some huge intrinsic value is just a joke in my view.” Is there a distinction between price and value? It is not backed by a valuable commodity like gold or silver. It is not issued by a central bank or backed by a government. It is not like buying shares in a company where one can examine corporate balance sheets or earnings history. So, do bitcoins have value?

This same question can be asked about fiat currencies. As citizens of a country with both a stable government and economy, Americans have faith in the “greenback.” Historically, people probably had faith in the Confederate dollar, the German Deutschmark, and the Zimbabwe dollar. Of course, these currencies were nearly worthless after the Civil War, after World War II, and after 2008 in Zimbabwe (when the government increased the money supply in response to rising national debt, significant declines in economic output and exports, poor government expectations, political corruption, and a weak economy).

The value in bitcoins comes from simple economics: scarcity, utility, supply, and demand. If something is rare and desirable, those characteristics create value. Gold has value because it is rare and desirable. The price of gold is determined by supply and demand.

Bitcoins are scarce by design. No more than 21 million bitcoins can ever exist. The common characteristics of all traditional currencies are scarcity, portability, durability, and divisibility. Bitcoins are more portable than fiat currencies and not easily subject to governmental controls. Bitcoins can easily cross borders. Bitcoins are more durable than physical currency because they have no physical existence to wear out. Each bitcoin is divisible to the 8th decimal place, so each can be split into 100,000,000 units. Each unit of bitcoin, or 0.00000001 bitcoin, is called a satoshi.

Price is determined by the market in which bitcoins trade: by means of supply and demand. This is the same way the price of your secondhand car, a dozen eggs in the supermarket, an ounce of gold, and just about every other commodity is set.

When determining price, one must also consider the amount buyers are currently willing to pay for the future value of a specific item. In other words, if the market believes the price of something – like property, a certain stock, or bitcoins – will increase in the future, they are more likely to pay more for it now.

Valuation of bitcoins is not as straightforward as valuing a publicly traded security. First, the prices fluctuate dramatically from hour to hour – making it much more volatile than, say, a share of Disney. Second, there is no single fixed price at any given moment in time as with stocks. Parties, therefore, tend to agree they will look to any number of price indices – CoinDesk, Winkdex, and Coinbase are popular. Third, bitcoins do not have a closing day price, as do publicly traded stocks. Typically, with such stocks, we may value them as of the closing price on a given day. Practitioners ought to keep these considerations in mind when the issue of dividing these assets arises. The easiest solution, if appropriate for the case, avoiding valuation complexities, is to divide the assets (on a percentage basis) at an agreed time. In other words, simply transfer the assets, in real time, from wallet to wallet. Both parties would individually bear the losses or profits associated with future price fluctuations.

III What Type of Asset Is Bitcoin?

Trying to classify bitcoins as a currency, a security, a commodity, or property is like trying to classify H2O as a liquid, gas, or solid. It just depends. Trying to classify a new asset that is only a little more than a decade old is confounding financial experts as well as U.S. government agencies. asset. A detailed articulation of these classification issues follow:

CURRENCY

Arguments For: Bitcoin was envisioned as a currency when it came online in 2009 and has been steadily gaining acceptance as a form of payment ever since. Japanese electrical companies accept it as payment for consumer bills and so do some North American brand names, including Overstock, Subway, and Microsoft. For retailers with the funds and infrastructure to adapt, this policy makes perfect sense, especially to appeal to the Gen Xers and Millennials who are the most likely to purchase bitcoins. These two groups make up 64% of all online shoppers.
Arguments Against: From the point of view of the Department of the Treasury, bitcoins have yet to behave like a currency, as they lack the relative stability of most fiat currency. Consider that during 2017 alone, bitcoins rose from $1,000 to $20,000 and then slid down again to $14,000. Some cryptocurrencies are tethered to fiat money (like the USD), but that arguably defeats the purpose of having a new currency outside of the control of government monetary policy.

SECURITY

Arguments For: According to the “Howey Test” used by the Securities and Exchange Commission (SEC), an asset is a security if ‘investors invest money in it with a reasonable expectation of profit derived from the managerial efforts of others’. This definition applies to many ICOs, according to the SEC, and functionally many investors buy cryptocurrencies for the same reasons as stocks.
Arguments Against: The SEC has gone on to differentiate between bitcoins and ether compared to other ICOs flooding the marketplace. The key is that bitcoins and ether are decentralized, with no managers, while many other ICOs feature cryptocurrencies built to solve a specific problem and managed by a corporation.

COMMODITY

Arguments For: Goldman Sachs’ head of commodities research, Jeff Currie, qualifies bitcoin as a commodity because it “do[es] not have liabilities”. He compares it to gold in that it does not answer to a single entity, unlike, say, the dollar, which ultimately ties back to the US government. Legal experts from the Case Western Reserve Law Review have argued that since cryptocurrencies “[act] as a kind of money between its users”, they function similarly to gold, which is a commodity. The Commodity Futures Trading Commission (CFTC) stated in 2015 that cryptocurrencies are commodities (and hence under their regulatory purview), each being “a basic good used in commerce that is interchangeable with other commodities of the same type”.
Arguments Against: To be classified as a commodity, something must have use value. Corn is a commodity, for instance, because humans and livestock eat it. Steel is a commodity because it is an essential component in the construction of thousands of items. What use value does bitcoin inherently possess?

PROPERTY

Arguments For: In 2014, the IRS formally mentioned virtual currencies for the first time when it declared them as property for tax purposes. For long-term investors, this was good news, as it meant cryptocurrency could be invested in on a tax-deferred basis within a retirement account. A further look at what makes something “property” (in the eyes of the IRS) sees bitcoin ticking all five of the boxes. Property must be (quoting the article):

Definable
Identifiable by third parties
Capable of assumption by third parties
Have some degree of permanence and persistence
Grant the person who holds it the proprietary right legal protection from third parties

Arguments Against: The Foreign Account Tax Compliance Act (FATCA) specifically lists cryptocurrency exchanges as financial institutions, which suggests they are platforms for exchanging currencies or commodities. Classifying cryptocurrency as property hinders it from gaining widespread adoption because investors currently must pay a sales tax on their coins as well as either a short-term or long-term capital gains tax.

IV. Acquiring Bitcoins

Bitcoins can be obtained in a few different ways. They can be “mined.” Bitcoin mining is performed by high-powered computers that solve complex computational math problems which tax even the most powerful computers.

More commonly, people buy bitcoins on exchanges. This is as easy as opening an account at, say, Coinbase or Kraken, and buying bitcoins with a credit card. Exchanges provide the most convenient use of bitcoins because, in addition to buying and selling bitcoins, they provide storage for the bitcoins, and the ability to pay for goods and services. This is done through apps downloaded on computers or mobile devices.

Critical for the divorce practitioner to know: many of these exchanges have “know your customer” requirements requiring identity verification. Further, U.S.-based exchanges (such as Coinbase or Kraken) report certain transactions to the Internal Revenue Service. The company completes a 1099-K for customers receiving at least $20,000 in cash for sales of virtual currencies that are related to at least two hundred separate transactions in a calendar year. Some states have their own requirements. Massachusetts, for example, requires that institutions complete the 1099-K for Massachusetts customers with transactions of $600 or more in a calendar year. A few other states have different thresholds: Arkansas ($2,500), Mississippi ($600), Missouri ($1,200), District of Columbia ($600), New Jersey ($1,000), Vermont ($600).

There are more furtive ways to acquire cryptocurrency as well. A person can buy anonymously through a source (often an individual) listed on a decentralized peer-to-peer network such as LocalBitcoins.com. In contrast to the exchanges like Coinbase, this modality permits transactions without identity verification. Cryptocurrencies can be purchased via credit card and bank wire but also for cash; in many cases, the buyer will meet the seller at an agreed upon physical location and the exchange will take place there. In the context of a divorce, this can be very difficult to discover. Moreover, it should be noted that issuing subpoenas would be ineffective in most cases since the website would have no information on the transacting spouse. This is because these sites operate effectively as classified advertising; a prospective buyer typically responds directly to the seller’s offer by email, text, or cell and not within the website.

Spouses can buy cryptocurrency, as noted above. But it can be a part of the fabric of the divorce in other ways as well. For example, a business-owner spouse might offer discounts for payments in cryptocurrency (just as they would with cash) and build up a stockpile that could remain hidden.

V. Bitcoins Storage

Once it is determined bitcoins have been acquired, the next inquiry is identifying how and where the bitcoins are stored. Bitcoins, essentially long alphanumeric keys (public and private addresses) and not physical objects, are stored in different ways. Storage can be either “hot” (connected to internet) or “cold” (not connected).

Simply put, a private address (or private key) is a secret, alphanumeric password used to spend or send bitcoins to another address. The private key enables the transaction of bitcoins and opens the door to all information regarding them. It is a 256-bit long number picked randomly when a wallet is created. The degree of randomness and uniqueness is defined by cryptographic functions for security purposes. Because the private key allows for the sale of the bitcoins, it must be carefully guarded. If the private address is lost the bitcoins are gone forever.

A private address always starts with 5 and looks like this:

5Kb8kLf9zgWQnogidDA76MzPL6TsZZY36hWXMssSzNydYXYB9KF

A public address (or public key) is an alphanumeric address/number which is derived from a private address only by using cryptographic math functions. It is impossible to reverse engineer and reach the private address from which it was generated. A public address is used to publicly receive bitcoins.

A public address always starts with 1 and looks like this:

1EHNa6Q4Jz2uvNExL497mE43ikXhwF6kZm

Writing the public and private addresses on paper, a “paper wallet,” is the simplest method of cold storage. This is not practical for everyday use because bitcoin transactions require a computer. Another cold storage option is storing the addresses on a memory stick. Either of these methods make the addresses almost impossible to find.

Another storage option is in a mobile “software wallet” app on a cellphone or tablet such as Edge, Mycelium, Bither, and Breadwallet. With a software wallet, unlike with an exchange app, the user must install and manage a Bitcoin wallet program, backup the data as with a computer, and prevent the loss of the wallet’s password or data files.

Exchanges such as Coinbase and Kraken have their own built-in hot wallets. Exchange customers, therefore, would not necessarily need a separate software wallet app.

Another hot wallet is a hardware digital wallet which is a physical device connected to the internet without the need for a computer, smart phone, or tablet. These devices, made by companies such as Trezor and Ledger, allow users to store, send, and receive bitcoins.

VI. Taxation

In 2014, the Internal Revenue Service issued guidance to taxpayers, IRS Notice 2014-21, 2014-16 I.R.B. 938 , characterizing cryptocurrencies as capital assets, if they are convertible to cash. If cryptocurrencies are bought and sold as investments, gains and losses are calculated the same as when buying and selling stock. The same rules apply when it comes to basis, holding period, and a triggering event.

Capital gains and losses are determined by calculating how much the value has increased or decreased from the time of acquisition until there is a taxable event. A taxable event is a sale or exchange of an asset. A taxable event occurs when cryptocurrencies are traded for cash or other cryptocurrencies or used to buy goods or services. Each purchase of goods or services is treated as a sale. If one cryptocurrency is traded for another, a taxable event occurs.

Practitioners who become aware of a party’s history of Bitcoin transactions not reported in their tax returns should, unless the practitioner is qualified to handle it, refer the client to a CPA or tax attorney to consider filing amended returns. Furthermore, careful consideration to drafting appropriate indemnification language for the divorce agreement is essential. This is because underpayments attributable to virtual currency transactions may subject the parties to accuracy-related penalties under I.R.C. § 6662. Additionally, failure to timely or correctly report virtual currency transactions may be subject a client to information reporting penalties under §§ 6721 and 6722.

Presently, the IRS does not require exchanges to report on Bitcoin, so there is no form 1099-B issued by the exchange. Some companies like Coinbase will provide Form 1099-K to some users who have received at least $20,000.00 cash for sales of cryptocurrencies related to at least two hundred transactions in a calendar year. Coinbase can create a report that gives a summary of transactions and cost basis which is useful to trace transactions.

For 2020, long term capital gains rates (those held more than a year) range up to 20%. The marginal tax rate of the taxpayer will apply to short-term gains taxed as ordinary income. Realized gains and losses are reported on a Schedule D and transferred to the reconciliation page of form 1040. No Schedule D is filed if there are no realized gains or losses.

Generally, parties who have a financial interest over $10,000 in foreign financial accounts must file a Foreign Bank Account Report (“FBAR”). The Financial Crimes Enforcement Network (“FinCEN”) recently advised FBAR reporting is not required in order to comply with FBAR rules. Nonetheless, practitioners should keep in mind this situation may change in the near future. Prudence suggests checking with an experienced advisor conversant with this area of taxation.

A. Dissipation

Dissipation may come into play in divorce cases involving Bitcoin. Because the Bitcoin market is especially volatile, some courts may regard losses as dissipation of the marital estate. Practitioners, however, ought to be wary of this characterization. Consider, for example, Kittredge v. Kittredge,. In that case, the husband had $400,000 in gambling losses and the Massachusetts Supreme Judicial Court affirmed the trial court’s refusal to treat most of the losses as marital waste because, for the most part, the losses never affected the lifestyle of the parties. Note that while gambling may be considered marital waste in many states, these authors could find no reported decisions that determined bitcoin was akin to gambling, and, therefore, marital waste. Further, it is worth noting “negligent mismanagement of marital property does not constitute dissipation of marital assets” in most states.

B. Discovery

Practitioners should question clients at the outset of a matter to determine whether Bitcoin may play a role in the divorce. Inquiries might include whether the client or their spouse: (a) is tech savvy; (b) has ever bought and sold bitcoins; and (c) has ever received bitcoins in exchange for goods and services.

If there is a history of Bitcoin ownership, further inquiries should include: (a) How did the client or spouse store or transact in bitcoins? (b) Where are important records kept and does client have access to them? (c) What electronic devices does the client or spouse own? (d) Does the client have physical access to such electronic devices?

If the practitioner determines Bitcoin discovery is warranted, the first step in a sound discovery plan is to send a “preservation letter” to the spouse’s attorney reminding that spouse to preserve evidence on phones and computers. If evidence is not preserved, the letter helps to establish a claim for spoliation, an element of which is bad faith and a conscious disregard of the duty to preserve relevant evidence. If a court finds spoliation, it may preclude evidence or make an adverse inference should the matter go to trial. Because every time a person continues to use a computer or phone, there is the potential that relevant data is overwritten, the letter should remind the opponent to “image” (copy/ghost) their drives immediately so there is a record of them at or about the point in time the preservation letter was received.

While seemingly perplexing, Bitcoin discovery is no different from tracing more traditional assets and may even provide more information. Blockchain transactions are not strictly anonymous but rather pseudonymous, since they can be linked to a public address. Because of the immutable nature of the blockchain, information on every transaction remains available forever, unlike conventional financial institutions which may only keep records for seven years. Interrogatories, document requests, and depositions simply need to be tailored to use the new terminology of Bitcoin.

Examination of bank or credit card statements might reveal payments to Bitcoin exchanges (e.g., Coinbase). If they do, records can be obtained from the exchanges showing the history of all transactions. In United States v. Coinbase, Inc., the IRS successfully enforced a summons (subpoena) to obtain the records of Coinbase customers. These records included transaction logs, records of payments processed, correspondence between the exchange and the other spouse, amongst others.

The most direct method of obtaining the complete history of Bitcoin transactions is to obtain the private address. If a court has personal jurisdiction over the other spouse, the court can order that spouse to provide the private address, just as a court could order them to provide account logins and passwords.

A forensic examination (with or without the private address) of the other spouse’s computer, smartphone, or tablet may yield evidence of past or present use of wallet apps (e.g. Mycelium) or exchange apps (e.g. Coinbase). If the attorney is fortunate and obtains the private keys associated with the bitcoins, a forensic expert will be able to examine the blockchain and trace the movement and amount of every transaction the other spouse has made.

Once a court orders the examination of the contents of a hard drive, several considerations come into play since a party is not going to simply hand over a hard drive to the other side. Therefore, it is critical to work with a computer forensic expert to draft pleadings or stipulate to a protocol. The protocol must have search parameters such as keywords (e.g., “Bitcoin,” “Mycelium”) and a date range, as well as a procedure to deal with privileged communications and irrelevant data. The protocol must require the device owner to provide his/her password. Although the world of Bitcoin is cutting-edge, as noted above, the fundamental discovery rules about breadth and scope and the use of protective orders still apply.

The shrewdest of spouses may well evade even the ablest forensic investigator by a process known as “bitcoin mixing.” By using a mixing service or tumbler, such as UltraMixer or CoinMixer, the user can break the link between addresses by either creating temporary addresses or by swapping coins with other addresses of the same value. Another way people are maintaining the secrecy of cryptocurrencies is “private coins” such as Monero and Zcash. Mixers and private coins make the trail hard to follow on the blockchain.

Regarding the examination of computer devices, many clients are tempted to resort to self-help. They might search their spouse’s cell phone or computer, or install key-stroking software and, in so doing, depending on the circumstances, violate state or federal privacy laws. Practitioners, therefore, must consider these statutes, and other applicable laws, before counselling clients regarding self-help.

VII. Conclusion

As indicated by the title, this is a primer intended to provide the practitioner a 50,000-foot view of Bitcoin, the fundamental concepts of this emerging currency, and the technology on which it relies. If this article achieved the intended purpose, the reader should be able to identify cases in which Bitcoin may play a role.
This basic knowledge should allow the family lawyer to determine if a forensic expert, experienced in tracing Bitcoin assets, is needed and to communicate effectively with the expert to formulate a discovery plan. This knowledge should be helpful in convincing clients, opposing counsel, and courts of the necessity of the proposed discovery plan in an articulate manner. This primer provides the practitioner with the ability to recognize potential issues including, valuation, dissipation, distribution, and taxation of Bitcoin assets.
As the use of Bitcoin increases, both as an investment and as currency, the savvy divorce practitioner would do well to continue to keep current on technical and legal developments.

 

APPENDIX “A”
Glossary

Address

A Bitcoin address is like a physical address or an email. It is the only information you need to provide for someone to pay you with bitcoin. A crucial difference, however, is that each address should only be used for a single transaction.

Bit

Bit is a common unit used to designate a sub-unit of a bitcoin – 1,000,000 bits is equal to 1 bitcoin (BTC or B⃦). This unit is usually more convenient for pricing tips, goods, and services.

Bitcoin

The open source software used to create the bitcoin virtual currency and the peer-to-peer network formed as a result (when capitalized). The individual units of the bitcoin virtual currency (when lowercase). e.g. “I sent ten bitcoins today.”; it is also often abbreviated BTC or XBT.

Bitcoin mixing

Bitcoin mixers are solutions (software or services) that let users mix their coins with other users, in order to preserve their privacy

Block

A block is a record in the blockchain that contains and confirms many waiting transactions. Roughly every 10 minutes, on average, a new block including transactions is appended to the blockchain through mining.

Blockchain

The blockchain is a public record of Bitcoin transactions in chronological order. The blockchain is shared between all Bitcoin users. It is used to verify the permanence of Bitcoin transactions and to prevent double spending.

BTC

BTC is a common unit used to designate one bitcoin (B⃦).

Confirmation

Confirmation means that a transaction has been processed by the network and is highly unlikely to be reversed. Transactions receive a confirmation when they are included in a block and for each subsequent block. Even a single confirmation can be considered secure for low value transactions, although for larger amounts like $1,000, it makes sense to wait for 6 confirmations or more. Each confirmation exponentially decreases the risk of a reversed transaction.

Convertible Virtual Currency

Virtual currency that has an equivalent value in real currency or that acts as a substitute for real currency.

Cryptography

Cryptography is the branch of mathematics that lets us create mathematical proofs that provide high levels of security. Online commerce and banking already use cryptography. In the case of Bitcoin, cryptography is used to make it impossible for anybody to spend funds from another user’s wallet or to corrupt the block chain. It can also be used to encrypt a wallet, so that it cannot be used without a password.

Double Spend

If a malicious user tries to spend their bitcoins to two different recipients at the same time, this is double spending. Bitcoin mining and the block chain are there to create a consensus on the network about which of the two transactions will confirm and be considered valid.

Fiat Currency

Fiat currency is legal tender whose value is backed by the government that issued it. The U.S. dollar is fiat money, as are the euro and many other major world currencies. This approach differs from money whose value is underpinned by some physical good such as gold or silver, called commodity money.

Hash Rate

The hash rate is the measuring unit of the processing power of the Bitcoin network. The Bitcoin network must make intensive mathematical operations for security purposes. When the network reached a hash rate of 10 Th/s, it meant it could make 10 trillion calculations per second.

Mining

Bitcoin mining is the process of making computer hardware do mathematical calculations for the Bitcoin network to confirm transactions and increase security. As a reward for their services, Bitcoin miners can collect transaction fees for the transactions they confirm, along with newly created bitcoins. Mining is a specialized and competitive market where the rewards are divided up according to how much calculation is done. Not all Bitcoin users do Bitcoin mining, and it is not an effortless way to make money.

P2P

Peer-to-peer refers to systems that work like an organized collective by allowing everyone to interact directly with the others. In the case of Bitcoin, the network is built in such a way that each user is broadcasting the transactions of other users. And, crucially, no bank is required as a third party.

Private Key

A private key is a secret piece of data that proves your right to spend bitcoins from a specific wallet through a cryptographic signature. Your private key(s) are stored in your computer if you use a software wallet; they are stored on some remote servers if you use a web wallet. Private keys must never be revealed as they allow you to spend bitcoins for their respective Bitcoin wallet.

Signature

A cryptographic signature is a mathematical mechanism that allows someone to prove ownership. In the case of bitcoin, a Bitcoin wallet and its private key(s) are linked by some mathematical magic. When your Bitcoin software signs a transaction with the appropriate private key, the whole network can see that the signature matches the bitcoins being spent. However, there is no way for the world to guess your private key to steal your hard-earned bitcoins.

Wallet

A Bitcoin wallet is loosely the equivalent of a physical wallet on the Bitcoin network. The wallet actually contains your private key(s) which allow you to spend the bitcoins allocated to it in the blockchain. Each Bitcoin wallet can show you the total balance of all bitcoins it controls and lets you pay a specific amount to a specific person, just like a real wallet. This is different to credit cards where the merchant charges you.

APPENDIX “B”

Bitcoin: A Peer-to-Peer Electronic Cash System
Satoshi Nakamoto
October 31, 2008

Abstract
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power. As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they’ll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-of-work chain as proof of what happened while they were gone.

1. Introduction
Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust-based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.

2. Transactions
We define an electronic coin as a chain of digital signatures. Each owner transfers the coin to the next by digitally signing a hash of the previous transaction and the public key of the next owner and adding these to the end of the coin. A payee can verify the signatures to verify the chain of ownership.

The problem of course is the payee can’t verify that one of the owners did not double-spend the coin. A common solution is to introduce a trusted central authority, or mint, that checks every transaction for double spending. After each transaction, the coin must be returned to the mint to issue a new coin, and only coins issued directly from the mint are trusted not to be double-spent. The problem with this solution is that the fate of the entire money system depends on the company running the mint, with every transaction having to go through them, just like a bank.

We need a way for the payee to know that the previous owners did not sign any earlier transactions. For our purposes, the earliest transaction is the one that counts, so we don’t care about later attempts to double-spend. The only way to confirm the absence of a transaction is to be aware of all transactions. In the mint based model, the mint was aware of all transactions and decided which arrived first. To accomplish this without a trusted party, transactions must be publicly announced[1], and we need a system for participants to agree on a single history of the order in which they were received. The payee needs proof that at the time of each transaction, the majority of nodes agreed it was the first received.

3. Timestamp Server
The solution we propose begins with a timestamp server. A timestamp server works by taking a hash of a block of items to be timestamped and widely publishing the hash, such as in a newspaper or Usenet post[2-5]. The timestamp proves that the data must have existed at the time, obviously, in order to get into the hash. Each timestamp includes the previous timestamp in its hash, forming a chain, with each additional timestamp reinforcing the ones before it.

4. Proof-of-Work
To implement a distributed timestamp server on a peer-to-peer basis, we will need to use a proof-of-work system similar to Adam Back’s Hashcash[6], rather than newspaper or Usenet posts. The proof-of-work involves scanning for a value that when hashed, such as with SHA-256, the hash begins with a number of zero bits. The average work required is exponential in the number of zero bits required and can be verified by executing a single hash.

For our timestamp network, we implement the proof-of-work by incrementing a nonce in the block until a value is found that gives the block’s hash the required zero bits. Once the CPU effort has been expended to make it satisfy the proof-of-work, the block cannot be changed without redoing the work. As later blocks are chained after it, the work to change the block would include redoing all the blocks after it.

The proof-of-work also solves the problem of determining representation in majority decision making. If the majority were based on one-IP-address-one-vote, it could be subverted by anyone able to allocate many IPs. Proof-of-work is essentially one-CPU-one-vote. The majority decision is represented by the longest chain, which has the greatest proof-of-work effort invested in it. If a majority of CPU power is controlled by honest nodes, the honest chain will grow the fastest and outpace any competing chains. To modify a past block, an attacker would have to redo the proof-of-work of the block and all blocks after it and then catch up with and surpass the work of the honest nodes. We will show later that the probability of a slower attacker catching up diminishes exponentially as subsequent blocks are added.

To compensate for increasing hardware speed and varying interest in running nodes over time, the proof-of-work difficulty is determined by a moving average targeting an average number of blocks per hour. If they’re generated too fast, the difficulty increases.

5. Network

The steps to run the network are as follows:

1. New transactions are broadcast to all nodes.
2. Each node collects new transactions into a block.
3. Each node works on finding a difficult proof-of-work for its block.
4. When a node finds a proof-of-work, it broadcasts the block to all nodes.
5. Nodes accept the block only if all transactions in it are valid and not already spent.
6. Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash.

Nodes always consider the longest chain to be the correct one and will keep working on extending it. If two nodes broadcast different versions of the next block simultaneously, some nodes may receive one or the other first. In that case, they work on the first one they received, but save the other branch in case it becomes longer. The tie will be broken when the next proof-of-work is found and one branch becomes longer; the nodes that were working on the other branch will then switch to the longer one.

New transaction broadcasts do not necessarily need to reach all nodes. As long as they reach many nodes, they will get into a block before long. Block broadcasts are also tolerant of dropped messages. If a node does not receive a block, it will request it when it receives the next block and realizes it missed one.

6. Incentive

By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them. The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.

The incentive can also be funded with transaction fees. If the output value of a transaction is less than its input value, the difference is a transaction fee that is added to the incentive value of the block containing the transaction. Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.
The incentive may help encourage nodes to stay honest. If a greedy attacker is able to assemble more CPU power than all the honest nodes, he would have to choose between using it to defraud people by stealing back his payments, or using it to generate new coins. He ought to find it more profitable to play by the rules, such rules that favour him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth.

7. Reclaiming Disk Space
Once the latest transaction in a coin is buried under enough blocks, the spent transactions before it can be discarded to save disk space. To facilitate this without breaking the block’s hash, transactions are hashed in a Merkle Tree [7][2][5], with only the root included in the block’s hash. Old blocks can then be compacted by stubbing off branches of the tree. The interior hashes do not need to be stored.

A block header with no transactions would be about 80 bytes. If we suppose blocks are generated every 10 minutes, 80 bytes * 6 * 24 * 365 = 4.2MB per year. With computer systems typically selling with 2GB of RAM as of 2008, and Moore’s Law predicting current growth of 1.2GB per year, storage should not be a problem even if the block headers must be kept in memory.

8. Simplified Payment Verification

It is possible to verify payments without running a full network node. A user only needs to keep a copy of the block headers of the longest proof-of-work chain, which he can get by querying network nodes until he’s convinced he has the longest chain, and obtain the Merkle branch linking the transaction to the block it’s timestamped in. He can’t check the transaction for himself, but by linking it to a place in the chain, he can see that a network node has accepted it, and blocks added after it further confirm the network has accepted it.

As such, the verification is reliable as long as honest nodes control the network, but is more vulnerable if the network is overpowered by an attacker. While network nodes can verify transactions for themselves, the simplified method can be fooled by an attacker’s fabricated transactions for as long as the attacker can continue to overpower the network. One strategy to protect against this would be to accept alerts from network nodes when they detect an invalid block, prompting the user’s software to download the full block and alerted transactions to confirm the inconsistency. Businesses that receive frequent payments will probably still want to run their own nodes for more independent security and quicker verification.

9. Combining and Splitting Value

Although it would be possible to handle coins individually, it would be unwieldy to make a separate transaction for every cent in a transfer. To allow value to be split and combined, transactions contain multiple inputs and outputs. Normally there will be either a single input from a larger previous transaction or multiple inputs combining smaller amounts, and at most two outputs: one for the payment, and one returning the change, if any, back to the sender.

It should be noted that fan-out, where a transaction depends on several transactions, and those transactions depend on many more, is not a problem here. There is never the need to extract a complete standalone copy of a transaction’s history.

10. Privacy

The traditional banking model achieves a level of privacy by limiting access to information to the parties involved and the trusted third party. The necessity to announce all transactions publicly precludes this method, but privacy can still be maintained by breaking the flow of information in another place: by keeping public keys anonymous. The public can see that someone is sending an amount to someone else, but without information linking the transaction to anyone. This is similar to the level of information released by stock exchanges, where the time and size of individual trades, the “tape”, is made public, but without telling who the parties were.

As an additional firewall, a new key pair should be used for each transaction to keep them from being linked to a common owner. Some linking is still unavoidable with multi-input transactions, which necessarily reveal that their inputs were owned by the same owner. The risk is that if the owner of a key is revealed, linking could reveal other transactions that belonged to the same owner.

11. Calculations

We consider the scenario of an attacker trying to generate an alternate chain faster than the honest chain. Even if this is accomplished, it does not throw the system open to arbitrary changes, such as creating value out of thin air or taking money that never belonged to the attacker. Nodes are not going to accept an invalid transaction as payment, and honest nodes will never accept a block containing them. An attacker can only try to change one of his own transactions to take back money he recently spent.

The race between the honest chain and an attacker chain can be characterized as a Binomial Random Walk. The success event is the honest chain being extended by one block, increasing its lead by +1, and the failure event is the attacker’s chain being extended by one block, reducing the gap by -1.

The probability of an attacker catching up from a given deficit is analogous to a Gambler’s Ruin problem. Suppose a gambler with unlimited credit starts at a deficit and plays potentially an infinite number of trials to try to reach breakeven. We can calculate the probability he ever reaches breakeven, or that an attacker ever catches up with the honest chain, as follows[8]:

pqqz=== probability an honest node finds the next block probability the attacker finds the next block probability the attacker will ever catch up from z blocks behindp= probability an honest node finds the next blockq= probability the attacker finds the next blockqz= probability the attacker will ever catch up from z blocks behind

qz={1(q/p)zifp≤qifp>q}qz={1ifp≤q(q/p)zifp>q}

Given our assumption that p>qp>q , the probability drops exponentially as the number of blocks the attacker has to catch up with increases. With the odds against him, if he doesn’t make a lucky lunge forward early on, his chances become vanishingly small as he falls further behind.

We now consider how long the recipient of a new transaction needs to wait before being sufficiently certain the sender can’t change the transaction. We assume the sender is an attacker who wants to make the recipient believe he paid him for a while, then switch it to pay back to himself after some time has passed. The receiver will be alerted when that happens, but the sender hopes it will be too late.

The receiver generates a new key pair and gives the public key to the sender shortly before signing. This prevents the sender from preparing a chain of blocks ahead of time by working on it continuously until he is lucky enough to get far enough ahead, then executing the transaction at that moment. Once the transaction is sent, the dishonest sender starts working in secret on a parallel chain containing an alternate version of his transaction.

The recipient waits until the transaction has been added to a block and zz blocks have been linked after it. He doesn’t know the exact amount of progress the attacker has made, but assuming the honest blocks took the average expected time per block, the attacker’s potential progress will be a Poisson distribution with expected value:

λ=zqpλ=zqp

To get the probability the attacker could still catch up now, we multiply the Poisson density for each amount of progress he could have made by the probability he could catch up from that point:
∑k=0∞λke−λk!⋅{(q/p)(z−k)1ifk≤zifk>z}∑k=0∞λke−λk!⋅{(q/p)(z−k)ifk≤z1ifk>z}
Rearranging to avoid summing the infinite tail of the distribution…

1−∑k=0zλke−λk!(1−(q/p)(z−k))1−∑k=0zλke−λk!(1−(q/p)(z−k))

Converting to C code…
#include
double AttackerSuccessProbability(double q, int z)
{
double p = 1.0 – q;

double lambda = z * (q / p);
double sum = 1.0;
int i, k;
for (k = 0; k <= z; k++)
{
double poisson = exp(-lambda);
for (i = 1; i <= k; i++)
poisson *= lambda / i;
sum -= poisson * (1 – pow(q / p, z – k));
}
return sum;

}
Running some results, we can see the probability drop off exponentially with zz .
q=0.1
z=0 P=1.0000000
z=1 P=0.2045873
z=2 P=0.0509779
z=3 P=0.0131722
z=4 P=0.0034552
z=5 P=0.0009137
z=6 P=0.0002428
z=7 P=0.0000647
z=8 P=0.0000173
z=9 P=0.0000046
z=10 P=0.0000012

q=0.3
z=0 P=1.0000000
z=5 P=0.1773523
z=10 P=0.0416605
z=15 P=0.0101008
z=20 P=0.0024804
z=25 P=0.0006132
z=30 P=0.0001522
z=35 P=0.0000379
z=40 P=0.0000095
z=45 P=0.0000024
z=50 P=0.0000006
Solving for P less than 0.1%…

P < 0.001
q=0.10 z=5
q=0.15 z=8
q=0.20 z=11
q=0.25 z=15
q=0.30 z=24
q=0.35 z=41
q=0.40 z=89
q=0.45 z=340
12. Conclusion
We have proposed a system for electronic transactions without relying on trust. We started with the usual framework of coins made from digital signatures, which provides strong control of ownership, but is incomplete without a way to prevent double-spending. To solve this, we proposed a peer-to-peer network using proof-of-work to record a public history of transactions that quickly becomes computationally impractical for an attacker to change if honest nodes control a majority of CPU power. The network is robust in its unstructured simplicity. Nodes work all at once with little coordination. They do not need to be identified, since messages are not routed to any particular place and only need to be delivered on a best effort basis. Nodes can leave and rejoin the network at will, accepting the proof-of-work chain as proof of what happened while they were gone. They vote with their CPU power, expressing their acceptance of valid blocks by working on extending them and rejecting invalid blocks by refusing to work on them. Any needed rules and incentives can be enforced with this consensus mechanism.
References
W. Dai, “b-money,” http://www.weidai.com/bmoney.txt, 1998.
H. Massias, X.S. Avila, and J.-J. Quisquater, “Design of a secure timestamping service with minimal trust requirements,” In 20th Symposium on Information Theory in the Benelux, May 1999.
S. Haber, W.S. Stornetta, “How to time-stamp a digital document,” In Journal of Cryptology, vol 3, no 2, pages 99-111, 1991.
D. Bayer, S. Haber, W.S. Stornetta, “Improving the efficiency and reliability of digital time-stamping,” In Sequences II: Methods in Communication, Security and Computer Science, pages 329-334, 1993.
S. Haber, W.S. Stornetta, “Secure names for bit-strings,” In Proceedings of the 4th ACM Conference on Computer and Communications Security, pages 28-35, April 1997.
A. Back, “Hashcash – a denial of service counter-measure,” http://www.hashcash.org/papers/hashcash.pdf, 2002.
R.C. Merkle, “Protocols for public key cryptosystems,” In Proc. 1980 Symposium on Security and Privacy, IEEE Computer Society, pages 122-133, April 1980.
W. Feller, “An introduction to probability theory and its applications,” 1957.

APPENDIX “C”

IRS Notice 2014-21

SECTION 1. PURPOSE 

This notice describes how existing general tax principles apply to transactions using virtual currency.  The notice provides this guidance in the form of answers to frequently asked questions. 

SECTION 2. BACKGROUND 

The Internal Revenue Service (IRS) is aware that “virtual currency” may be used to pay for goods or services or held for investment.  Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.  In some environments, it operates like “real” currency — i.e., the coin and paper money of the United States or of any other country that is designated as legal tender, circulates, and is customarily used and accepted as a medium of exchange in the country of issuance — but it does not have legal tender status in any jurisdiction. 

Virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency, is referred to as “convertible” virtual currency.  Bitcoin is one example of a convertible virtual currency.  Bitcoin can be digitally traded between users and can be purchased for, or exchanged into, U.S. dollars, Euros, and other real or virtual currencies.  For a more comprehensive description of convertible virtual currencies to date, see Financial Crimes Enforcement Network (FinCEN) Guidance on the Application of FinCEN’s Regulations to Persons Administering, Exchanging, or Using Virtual Currencies (FIN-2013-G001, March 18, 2013).  

SECTION 3. SCOPE 

In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.  This notice addresses only the U.S. federal tax consequences of transactions in, or transactions that use, convertible virtual currency, and the term “virtual currency” as used in Section 4 refers only to convertible virtual currency.  No inference should be drawn with respect to virtual currencies not described in this notice.     

The Treasury Department and the IRS recognize that there may be other questions regarding the tax consequences of virtual currency not addressed in this notice that warrant consideration.  Therefore, the Treasury Department and the IRS request comments from the public regarding other types or aspects of virtual currency transactions that should be addressed in future guidance.

Comments should be addressed to: 

Internal Revenue Service Attn:  CC:PA:LPD:PR (Notice 2014-21) Room 5203 P.O. Box 7604 Ben Franklin Station Washington, D.C. 20044 or hand delivered Monday through Friday between the hours of 8 A.M. and 4 P.M. to: 

 Courier’s Desk Internal Revenue Service Attn:  CC:PA:LPD:PR (Notice 2014-21) 1111 Constitution Avenue, N.W. Washington, D.C. 20224 

 Alternatively, taxpayers may submit comments electronically via e-mail to the following address: Notice.Comments@irscounsel.treas.gov.  Taxpayers should include “Notice 2014-21” in the subject line.  All comments submitted by the public will be available for public inspection and copying in their entirety. 

For purposes of the FAQs in this notice, the taxpayer’s functional currency is assumed to be the U.S. dollar, the taxpayer is assumed to use the cash receipts and disbursements method of accounting and the taxpayer is assumed not to be under common control with any other party to a transaction.

SECTION 4. FREQUENTLY ASKED QUESTIONS 

Q-1:  How is virtual currency treated for federal tax purposes? 

A-1:  For federal tax purposes, virtual currency is treated as property.  General tax principles applicable to property transactions apply to transactions using virtual currency. 

Q-2:  Is virtual currency treated as currency for purposes of determining whether a transaction results in foreign currency gain or loss under U.S. federal tax laws? 

A-2:  No.  Under currently applicable law, virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes. 

Q-3:  Must a taxpayer who receives virtual currency as payment for goods or services include in computing gross income the fair market value of the virtual currency? 

A-3:  Yes.  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.  See Publication 525, Taxable and Nontaxable Income, for more information on miscellaneous income from exchanges involving property or services. 

Q-4:  What is the basis of virtual currency received as payment for goods or services in Q&A-3? 

A-4:  The basis of virtual currency that a taxpayer receives as payment for goods or services in Q&A-3 is the fair market value of the virtual currency in U.S. dollars as of the date of receipt.  See Publication 551, Basis of Assets, for more information on the computation of basis when property is received for goods or services. 

Q-5:  How is the fair market value of virtual currency determined? 

A-5:  For U.S. tax purposes, transactions using virtual currency must be reported in U.S. dollars.  Therefore, taxpayers will be required to determine the fair market value of virtual currency in U.S. dollars as of the date of payment or receipt.  If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.    

Q-6:  Does a taxpayer have gain or loss upon an exchange of virtual currency for other property? 

A-6:  Yes.  If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain.  The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.  See Publication 544, Sales and Other Dispositions of Assets, for information about the tax treatment of sales and exchanges, such as whether a loss is deductible. 

Q-7:  What type of gain or loss does a taxpayer realize on the sale or exchange of virtual currency? 

A-7:  The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer.  A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer.  For example, stocks, bonds, and other investment property are generally capital assets.   A taxpayer generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer.  Inventory and other property held mainly for sale to customers in a trade or business are examples of property that is not a capital asset.  See Publication 544 for more information about capital assets and the character of gain or loss. 

Q-8:  Does a taxpayer who “mines” virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) realize gross income upon receipt of the virtual currency resulting from those activities? 

A-8:  Yes, when a taxpayer successfully “mines” virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income.  See

Publication 525, Taxable and Nontaxable Income, for more information on taxable income. 

Q-9:  Is an individual who “mines” virtual currency as a trade or business subject to self-employment tax on the income derived from those activities? 

A-9: If a taxpayer’s “mining” of virtual currency constitutes a trade or business, and the “mining” activity is not undertaken by the taxpayer as an employee, the net earnings from self-employment (generally, gross income derived from carrying on a trade or business less allowable deductions) resulting from those activities constitute self-employment income and are subject to the self-employment tax.  See Chapter 10 of Publication 334, Tax Guide for Small Business, for more information on self-employment tax and Publication 535, Business Expenses, for more information on determining whether expenses are from a business activity carried on to make a profit. 

Q-10:  Does virtual currency received by an independent contractor for performing services constitute self-employment income? 

A-10:  Yes.  Generally, self-employment income includes all gross income derived by an individual from any trade or business carried on by the individual as other than an employee.  Consequently, the fair market value of virtual currency received for services performed as an independent contractor, measured in U.S. dollars as of the date of receipt, constitutes self-employment income and is subject to the self-employment tax.  See FS-2007-18, April 2007, Business or Hobby? Answer Has Implications for Deductions, for information on determining whether an activity is a business or a hobby. 

Q-11:  Does virtual currency paid by an employer as remuneration for services constitute wages for employment tax purposes? 

A-11:  Yes.  Generally, the medium in which remuneration for services is paid is immaterial to the determination of whether the remuneration constitutes wages for employment tax purposes.  Consequently, the fair market value of virtual currency paid as wages is subject to federal income tax withholding, Federal Insurance Contributions Act (FICA) tax, and Federal Unemployment Tax Act (FUTA) tax and must be reported on Form W-2, Wage and Tax Statement.  See Publication 15 (Circular E), Employer’s Tax Guide, for information on the withholding, depositing, reporting, and paying of employment taxes. 

Q-12:  Is a payment made using virtual currency subject to information reporting? 

A-12:  A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.  For example, a person who in the course of a trade or business makes a payment of fixed and determinable income using virtual currency with a value of $600 or more to a U.S. non-exempt recipient in a taxable year is required to report the payment to the IRS and to the payee.  Examples of  payments of fixed and determinable income include rent, salaries, wages, premiums, annuities, and compensation.   

Q-13:  Is a person who in the course of a trade or business makes a payment using virtual currency worth $600 or more to an independent contractor for performing services required to file an information return with the IRS?  

A-13:  Generally, a person who in the course of a trade or business makes a payment of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment to the IRS and to the payee on Form 1099MISC, Miscellaneous Income.  Payments of virtual currency required to be reported on Form 1099-MISC should be reported using the fair market value of the virtual currency in U.S. dollars as of the date of payment.  The payment recipient may have income even if the recipient does not receive a Form 1099-MISC.  See the Instructions to Form 1099-MISC and the General Instructions for Certain Information Returns for more information.  For payments to non-U.S. persons, see Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities. 

Q-14:  Are payments made using virtual currency subject to backup withholding? 

A-14:  Payments made using virtual currency are subject to backup withholding to the same extent as other payments made in property.  Therefore, payors making reportable payments using virtual currency must solicit a taxpayer identification number (TIN) from the payee.  The payor must backup withhold from the payment if a TIN is not obtained prior to payment or if the payor receives notification from the IRS that backup withholding is required.  See Publication 1281, Backup Withholding for Missing and Incorrect Name/TINs, for more information. 

Q-15:  Are there IRS information reporting requirements for a person who settles payments made in virtual currency on behalf of merchants that accept virtual currency from their customers?  

A-15:  Yes, if certain requirements are met.  In general, a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third-party settlement organization (TPSO).  A TPSO is required to report payments made to a merchant on a Form 1099-K, Payment Card and Third Party Network Transactions, if, for the calendar year, both (1) the number of transactions settled for the merchant exceeds 200, and (2) the gross amount of payments made to the merchant exceeds $20,000.  When completing Boxes 1, 3, and 5a-1 on the Form 1099-K, transactions where the TPSO settles payments made with virtual currency are aggregated with transactions where the TPSO settles payments made with real currency to determine the total amounts to be reported in those boxes.  When determining whether the transactions are reportable, the value of the virtual currency is the fair market value of the virtual currency in U.S. dollars on the date of payment.   

See The Third Party Information Reporting Center, http://www.irs.gov/TaxProfessionals/Third-Party-Reporting-Information-Center, for more information on reporting transactions on Form 1099-K. 

Q-16:  Will taxpayers be subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with this notice prior to March 25, 2014? 

A-16:  Taxpayers may be subject to penalties for failure to comply with tax laws.  For example, underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties under section 6662.  In addition, failure to timely or correctly report virtual currency transactions when required to do so may be subject to information reporting penalties under section 6721 and 6722.  However, penalty relief may be available to taxpayers and persons required to file an information return who are able to establish that the underpayment or failure to properly file information returns is due to reasonable cause.

SECTION 5. DRAFTING INFORMATION 

The principal author of this notice is Keith A. Aqui of the Office of Associate Chief Counsel (Income Tax & Accounting).  For further information about income tax issues addressed in this notice, please contact Mr. Aqui at (202) 317-4718; for further information about employment tax issues addressed in this notice, please contact Mr. Neil D. Shepherd at (202) 317- 4774; for further information about information reporting issues addressed in this notice, please contact Ms. Adrienne E. Griffin at (202) 317- 6845; and for further information regarding foreign currency issues addressed in this notice, please contact Mr. Raymond J. Stahl at (202) 317- 6938.  These are not toll-free calls.

APPENDIX “E”

 

Discovery to the opposing party either by interrogatories or deposition should include:

 

1. Do you own any form of cryptocurrency?
2. Have you ever owned any form of cryptocurrency?
3. Does anyone now, or in the past, hold any cryptocurrency for you?
4. Are any held by overseas exchanges?

If yes;

1. Do you have any form of E-wallet? (generic term)
2. Have you ever had an E-wallet?
3. If you have a crypto account what exchange or exchanges do you use?
4. Which have you used in the past?
5. What is your private key?
6. What is your public key?
7. Have you reported/intend to report capital gains?
8. If not, will you be filing an amended return?

 

Looking at the Order in the Coinbase case, at a minimum, document requests to Coinbase or other exchanges should include: 

1. Complete user profiles;
2. Know-your-customer due diligence;
3. Documents regarding third-party access;
4. Transaction logs; 
5. Records of payments processed;
6. Correspondence between the exchange and the other spouse;
7. Account or invoice statements;
8. Records of payments.

 

The address for Coinbase is: Coinbase, Inc.

548 Market Street #23008

San Francisco, CA 94104

DOCUMENTS TO BE PRODUCED

 

1. All account statements solely or jointly in the name of ____________.

 

1. All account statements solely or jointly in the name of ____________.
2. All documents regarding detailed account activity for Coinbase accounts solely or jointly in the name of _______________.
3. All documents regarding deposits of currency or money in Coinbase accounts solely or jointly in the name of __________.
4. All documents regarding deposits of bitcoins or cryptocurrencies in Coinbase accounts solely or jointly in the name of __________.
5. All documents regarding withdrawals of currency or money from Coinbase accounts solely or jointly in the name of ____________.
6. All documents regarding withdrawals of bitcoins or cryptocurrencies from Coinbase accounts solely or jointly in the name of _____________.
7. All documents regarding storing, buying, selling, trading, exchanging, sending, receiving, or using bitcoins or cryptocurrencies in Coinbase accounts solely or jointly in the name of _________________.
8. All documents regarding converting or exchanging bitcoins or cryptocurrencies into currency, products, services or otherwise in Coinbase accounts solely or jointly in the name of ___________________.
9. All documents regarding converting currency, products, services or otherwise into bitcoins or cryptocurrencies in Coin base accounts solely or jointly in the name of ____________________.
10. All account opening documents for all Coinbase accounts solely or jointly in the name of ____________________.
11. All documents regarding the codes or identification of bitcoins or cryptocurrencies in Coinbase accounts solely or jointly in the name of ____________________.
12. All documents regarding wallets, blockchains, transaction I.D.’ s, inputs of transactions and input keys in Coinbase accounts solely or jointly in the name of ____________________.

All documents in Coinbase’s file on ____________________.