The IRS Drops the Hammer on Virtual Currencies

Recently the American IRS issued a Q&A to supply some "guidance" as to the tax treatment of Bitcoin, and by extension other virtual or crypto currencies. You can (and should) read the full text of it here. As usual, this all sounds pretty dire and inescapable, and has produced the expected quantity of supposed analysis, scare mongering, whinging, petitioning, and even (from the "regulation is good for Bitcoin" crowd) grateful acquiescence.

People who never much liked Bitcoin anyway are quick to conclude that Bitcoin has jumped the shark, and that this tax ruling is one more hammer blow of fate which will ultimately fell the hero. (Cue the ominous tones of Mahler's 6th). Meanwhile, complaints from the crypto-currency community about the ruling have mainly revolved around the extent of the bookkeeping burden the new tax treatment would impose.

Please. No one can assess the impact of a tax agency's tax guidance without first asking themselves how it is that the tax liability arises in the first place. (Or at any rate, no one should.) What makes the use of virtual currencies subject to the jurisdiction of the IRS to begin with?

Excising Excise

The revealing text supplied by the IRS repeatedly uses the phrase "trade or business" in both the questions and their answers. For example: 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? While the answer given to this question is yes, the clear implication is that if the miner's activity were not done as a trade or business, such would not be the case. Even self-employment is parenthetically defined as: (generally, gross income derived from carrying on a trade or business less allowable deductions).

So clearly it would behoove us to examine the definition of engaging in trade or business in the tax code. That definition is as follows:
26 USC § 7701: (26) Trade or business
The term "trade or business" includes the performance of the functions of a public office.

(Yes, that's the whole definition.) By the rules of statutory construction, the use of "includes" in a definition means that any illustrative list supplied need not be exhaustive, but also that nothing of a character fundamentally different from the items present on the list can be deemed to be included. In this case, we have a very short list. You are engaged in trade or business if you are in some way assisting in the performance of a public office. Similar definitional legerdemain has been applied to the terms "wages" and "employee," but for Bitcoin businesses and users the "trade or business" definition is the most pertinent. Although some have wrongly inferred that it implies that only federal government employees owe taxes, this terse definition makes absolute sense, and is in no way incomplete.

In order to understand why, we must consider the nature of the US income tax itself. Simply put, ever since 1862 (not 1914!) it has been an excise tax, or (interchangeably) a privilege tax, levied on "income," which connotes earnings derived from federally granted privileges, licensing, or patronage. Thus the receipts subject to the federal excise are those produced through the exercise of certain federal privileges. Just as the name says, it’s a "federal income tax," i.e. a tax on earnings derived from a nexus with the US federal government. It's an indirect excise tax on "federal income," not a federal tax on all income (which would be a direct tax). A thorough discussion of this subtle distinction, and the associated legal history, case law, SCOTUS rulings, and evolution of the federal excise tax in general, must fall outside the scope of this article. However, you can find a lot of good material on websites such as this one.

So what has all this got to do with Bitcoin? The answer is absolutely nothing, unless the miner, trader, exchanger, or investor otherwise has some nexus with Washington. For example, any firm which holds a federal MSB (money service business) license from the Treasury Dept. would definitely be "engaged in trade or business." Why? Because by maintaining a customer identity database and making various reports (as required by their license), they are assisting the Treasury in enforcing certain regulations concerning money laundering, terrorist financing, and the like. Their licensed activity helps to implement public policy. Other examples of business activities which would likewise fall under the purview of the federal income excise include:

  • Federally chartered "National Association" (N.A.) banks or federal credit unions, their shareholder dividends, bondholder interest, interest paid to depositors, etc.
  • US government civilian and military employees (obviously)
  • Television and radio stations with FCC broadcast licenses
  • Airlines, pilots, and mechanics with FAA licenses
  • Medical clinics which serve Medicare and Medicaid patients (to the extent that they do so)
  • Railroads licensed for interstate commerce
  • Mining and oil companies working claims on BLM land
  • Interstate trucking companies with US DOT licenses
  • Non-citizen green card and H1-B work visa holders legally working in the US (at anything)
  • US citizens working abroad and taking advantage of a US tax treaty
  • Private sector companies working on federal government contracts
  • Companies producing goods protected by US patent filings (govt granted monopolies)
  • Stockbrokers and others holding SEC licenses
  • Perhaps: profits derived from trading on US-regulated exchanges (NYSE, NASDAQ, COMEX, etc.)

In all of these cases, there is a federal nexus because money is being made by virtue of federal government employment, permission, licensing, or patronage. All such things are privileges, not rights, and as such produce income subject to excise. This is the very definition of "federal income." This being the case, the above definition of "trade or business," and the repeated use of that phrase in the IRS's virtual currency tax Q&A, make perfect and absolute sense. The IRS is emphatically not claiming that all bitcoiners everywhere owe them taxes on their property; that would be absurd. It is merely asserting that those using bitcoin in the course of making money off of their federal privileges will owe excise tax on their income realized in bitcoin. Naturally. But if you exercise no such privilege to make money, then you have no taxable federal income — neither in bitcoin nor in dollars!

The IRS intentionally uses deceptive language meant to confuse as many people as possible into volunteering to pay a tax they don't actually owe. And guess what? If you do volunteer, you make yourself equally subject as anyone who would have been subject by law. You can be audited, you can be fined for mistakes, you can even be prosecuted criminally for perjury if you knowingly make false statements on a return. (Most people not otherwise subject volunteer when they give their employer a Form W-4, "Request for Withholding.") It is a cardinal error, when reading any government statute or regulation, to assume in advance that you know what any of the terms used actually mean. For instance, if you say to yourself: "Well, I trade crypto-currencies as a business, therefore I'm self-employed, and this guidance here says that therefore I owe self-employment tax," well congratulations: you just swallowed the bait, hook line and sinker. When terms like "income", "trade or business," and "self-employment" have specific statutory definitions which are not the ordinary meanings, such confusion is inevitable unless you are much better informed than the average person.

Which for Bitcoin Means What?

So here's the plain truth: for the most part, this ruling is much ado about nothing in the world of virtual currencies. A few large US-based Bitcoin businesses which have MSB licenses (or are browbeaten into getting one) will be affected by these regulations. Most of their customers will not, unless they ignorantly volunteer, just as many bank customers do. Frankly, a bigger issue is whether a given business would require a MSB license. The FinCEN guidance issued last year suggests that many "Bitcoin Local" entrepreneurs dealing in cash above a certain amount probably do.

In a related situation, if one troubles to read the statute, the so-called "individual mandate" in Obamacare requiring the purchase of health insurance only applies to those who earn "wages," or are "engaged in trade or business." It should thus come as no surprise that the Supreme Court, in its ruling on the ACA, struck down the mandate but allowed that the "penalty" for not buying insurance could still be enforced, if it were treated as a specific excise tax rather than as a fine. Well of course. No other interpretation would have been remotely logical, given that the income tax itself is an excise, and only those subject to that excise are made subject to the ACA. The ACA presupposes federal income tax liability! The Court obviously understands these issues perfectly. For the same reason, it's also unsurprising that the IRS is the agency charged with enforcing the ACA and collecting the duties for non-compliance.

Nevertheless, we should probably assume that the greater part of the Bitcoin user community will never understand these issues, or would never dare to act on their understanding even if they had such, and therefore will be shepherded neatly back into the pen with the other tax cattle. That's a real shame, given that the whole promise of crypto-currencies was and is to move economic activity outside the sphere of the state. So for those who are better informed and less timid, here's a thumbnail sketch of how good tradecraft technology can be used to stay out of harm's way altogether.

Indirection Avoids False Indirect Tax Reporting

Let's assume that Bob and Alice are two users of Bitcoin. Bob has BTC which he wants to convert to USD, while Alice has USD which she wishes to convert to BTC. If Bob and Alice know each other and can meet in person, this deal could be done privately, and likely in cash. But let's assume that they are strangers, and not eager to meet in person or even to exchange identities and contact coordinates.

Now they could each open accounts at an exchange, such as Coinbase. Once they've gone through the required KYC procedures (Know Your Customer, or perhaps more accurately Klepto Your Commerce), they could then do business with each other using the exchange as intermediary. The trouble with this is twofold: first, Coinbase is perforce going to report any gains either of them might realize to the IRS; and second, the BTC wallet hashes which they used will effectively become associated (in Coinbase's database) with their real life identities and verified bank accounts. Granted, that doesn't mean they'll legally owe any tax, but it does mean they'll likely be subjected to some harassment via CP-515 letters or the like. There's got to be a better way, and there is.

Let's suppose that Bob downloads and installs the Silent-Vault wallet client, creates a wallet, and then goes into the Silent-Vault Exchange (SVX). He uses his BTC to purchase a SBC (Silent Bitcoin) voucher of equal value. He then places a trade order to swap his SBC for USV (US dollar vouchers). He can stipulate any premium or discount above or below spot that he wishes. He pays up escrow for his side of the trade using his SBC voucher. This renders his order searchable by others.

Meanwhile, Alice likewise downloads the SV client and sets up a wallet. She goes to the website for the USV voucher issuer (USV=USD vouchers), opens an account, and registers her SV wallet ID against it. While she will need to do some KYC to verify her account, note that this issuer is not in the USA, nor does it have anything to do with Bitcoin. She sends an international bank wire to buy a USV voucher, which is then issued to her wallet. Once she receives it, she goes into the SVX and searches for offers to trade BTC which are seeking USV. She finds Bob's order, likes the terms, and accepts it. She pays up her side of the escrow using her USV voucher.

The SVX immediately marks the order fulfilled, and pays out escrow to both wallets in reverse. So Alice gets a voucher for SBC, while Bob receives a voucher for USV. If Alice wishes, she can then redeem her SBC voucher for BTC paid directly out to her bitcoin wallet. Or she can spend her SBC voucher to another party. If Bob wishes to cash in his USV voucher, he will either need to open an account of his own at the USV issuer in order to sell it for a bank wire, or else find someone who will accept it from him in exchange for something else (cash perhaps). As with the exchange on Coinbase, neither Bob nor Alice has any idea with whom they just traded. There are however some significant differences:

  • Bob and Alice have both neatly avoided linking their BTC wallet hashes against their identities or bank accounts.
  • Their SV wallet IDs may be linked to their verified accounts at the USV issuer, but that company is not in the US. It also has no knowledge of what happens to vouchers once they are placed into circulation, just as a bank cannot know what subsequently happens to the bills the teller hands to someone who is cashing a check.
  • Unlike Bitcoin, the Voucher-Safe system is not saddled with a public blockchain. Instead, vouchers are always replaced in every transaction. Thus they carry no history and cannot be traced. This means that spends of SBC vouchers are by nature "off blockchain" transactions. (Those who remember 1MDC and e-gold will also be familiar with this concept.)
  • SV wallets, like BTC wallets, cost nothing to create. But because spends between them leave no footprints, it's trivial to move voucher value invisibly from one wallet that you control to another.
  • The SVX only needs to be trusted for the amount of the escrow being held while an offer is outstanding. Open offers can be cancelled before expiry and the escrow withdrawn to the source wallet.
  • The SVX does not have a "house" trading account, merely a collection of escrow wallets in the cloud which are assigned at random to different orders. In view of the MtGox fiasco, this is an incredibly important distinction. There is no chance of fractional reserve within the SVX.
  • Because you have to surrender (and destroy) a SBC voucher in order to withdraw its value in BTC, there is no possibility that anyone could "over-withdraw" bitcoin from SBC's reserve, as was alleged to have happened with MtGox.
  • The SVX has absolutely no idea as to the identity of either Alice or Bob, nor does it see their IP addresses. It knows only the wallet IDs which they employed for the particular escrow transaction.
  • Even if both Bob and Alice exchange bank wires with the USV issuer, this creates no indication that Bob and Alice are doing business with one another. Likewise, no such indication is ever created on the books of the issuer.
  • Like the Bitcoin network (so far), the Voucher-Safe network has zero knowledge of the real world identity of any user. Because it stores data encrypted with keys known only to the users, server operators could not meaningfully respond to a subpoena or warrant for user data. (Even the law cannot compel the cryptographically impossible.)
  • In sum, no one other than Alice and Bob themselves has any capability whatsoever of deducing whether a profit or loss was made by either party. So if there are any taxes owed in their jurisdictions, it will be solely up to them to report it.
  • No one involved in the transaction as described is doing anything illegal. However, privacy is being strongly protected. It would be protected even more strongly if third party exchangers supplied the banking interface functions with the USV issuer on behalf of Alice and/or Bob.

Knowledge Wins

Before panicking over posturing pronouncements by piratical tax parasites, please become properly informed. This requires study of the law; although they certainly do not make that easy. The truth is actually quite liberating. Once you understand your true obligations, arrange your affairs intelligently so as to create the minimum amount of hassle and exposure to the wrongheaded actions of those who (probably) know less than you do.

Your right to privacy, in your financial affairs as with anything else, is meaningless if you do not exercise it.