Avoiding Liability: Changing the Regulatory Structure of Cryptocurrencies to Better Ensure Legal Use

• Author: Allison M. Lovell
• Position: J.D. Candidate, The University of Iowa College of Law, 2019; B.A., University of Illinois at Urbana-Champaign, 2016
• Pages: 927-955

Avoiding Liability: Changing the Regulatory Structure of Cryptocurrencies to Better Ensure Legal Use Allison M. Lovell * ABSTRACT: Monitoring the transactions consumers in the United States make when buying and selling virtual currency requires an inventive regulatory system because many types of virtual currency, like Bitcoin, are operated anonymously and independently. In the United States today, the Internal Revenue Service (“IRS”) has little structure in how it monitors cryptocurrencies, merely classifying them as property and having the taxpayer report all losses and gains subject to the rules of personal property. This classification is difficult to apply because the IRS has little control over how the system is regulated. To solve this issue, the United States should either outlaw the use of cryptocurrency altogether or reclassify virtual currency as foreign currency. Making virtual currency use illegal might not be the most practical solution because of its prominence in the market today, but it would provide the federal government a clear way to deal with cryptocurrency. If the United States reclassifies virtual currency as a foreign currency, there would be an established regulatory framework in place that the IRS would be able to follow when attempting to monitor the use of virtual currency. With either solution, the United States will be better equipped to regulate the financial marketplace of virtual currencies. I. INTRODUCTION ............................................................................. 928 II. HISTORY AND REGULATION OF CRYPTOCURRENCY ....................... 929 A. W HAT I S A C RYPTOCURRENCY ? ................................................ 929 B. B ITCOIN .................................................................................. 931 1. Structure ........................................................................ 931 2. How the System Operates ............................................. 933 C. U NITED S TATES R EGULATION OF C RYPTOCURRENCY ................. 934 * J.D. Candidate, The University of Iowa College of Law, 2019; B.A., University of Illinois at Urbana-Champaign, 2016. Thank you to my parents for the lifetime of love and support, especially for their encouragement while I pursue my legal career. I would also like to thank my friends for listening to me discuss the publication process and cryptocurrency for months on end. 927 928 IOWA LAW REVIEW [Vol. 104:927 1. Importance of Classifying Cryptocurrency .................. 934 2. Classification Within the Existing Tax Structure ........ 936 III. PROBLEMS REGULATING BITCOIN IN THE UNITED STATES AND OTHER COUNTRIES ............................................................... 938 A. I SSUES WITH B ITCOIN ’ S S TRUCTURE IN THE U NITED S TATES ...... 938 1. Criminal Activity ............................................................ 938 2. Failure to Report Bitcoin in Taxes ............................... 940 B. F OREIGN C OUNTRY ’ S R EGULATION OF C RYPTOCURRENCY .......... 944 1. China .............................................................................. 944 2. Japan .............................................................................. 945 3. Iceland ........................................................................... 947 IV. CHANGING HOW THE UNITED STATES CLASSIFIES CRYPTOCURRENCY ......................................................................... 948 A. F OLLOW C HINA /I CELAND ’ S M ODEL TO E LIMINATE B ITCOIN U SAGE ....................................................................... 948 B. F OLLOW J APANESE M ODEL TO T REAT C RYPTOCURRENCIES AS F OREIGN C URRENCY ............................................................ 950 V. CONCLUSION ................................................................................ 953 I. INTRODUCTION Money is a tool of exchange, which can’t exist unless there are goods produced and men able to produce them. Money is the material shape of the principle that men who wish to deal with one another must deal by trade and give value for value. . . . Money is made possible only by the men who produce. 1 When Ayn Rand wrote those words in 1957, she could not have known that she was describing cryptocurrency, because the Internet did not yet exist. However, Rand was able to loosely describe today’s preeminent form of cryptocurrency—Bitcoin. 2 The new structure of cryptocurrency is similar to a “deal by trade” where different consumers are willing to exchange “value for value” based upon work performed by the men willing to produce the electronic currency. 3 While coins and paper currency are still one of the most prominent forms of currency today, virtual currency has emerged and will 1. AYN RAND, ATLAS SHRUGGED 313 (1957). 2 . See generally Daniel Shane, Bitcoin: What’s Driving the Frenzy? , CNN MONEY (Dec. 8, 2017, 6:23 AM), http://money.cnn.com/2017/12/07/investing/bitcoin-what-is-going-on/index.html (explaining the phenomenon behind Bitcoin’s increasing popularity as an alternative means of exchange, giving new meaning to the term “money”). 3 . See RAND, supra note 1, at 313. 2019] REGULATORY STRUCTURE OF CRYPTOCURRENCIES 929 likely continue to emerge as technology continues to advance, 4 bringing with it a host of new issues. As this unprecedented new form of cryptocurrency has become more prominent, a myriad of issues have arisen due to the “currency” being significantly different from anything previously in existence. This Note explores the different issues surrounding Bitcoin and how the U.S. government, specifically the Internal Revenue Service (“IRS”), should regulate cryptocurrencies to solve the issues inherent within Bitcoin. Part II introduces the background of electronic currency, using Bitcoin as a case study. Part III looks at the difficulty in regulating Bitcoin because it was developed as a currency that is to be independent of banks and government interference. Part IV explores the different solutions and some of the potential counterarguments of the proposed solutions. Finally, Part V concludes that classification of cryptocurrency as a foreign currency would be the best way to regulate this new type of money. II. HISTORY AND REGULATION OF CRYPTOCURRENCY This section will delve into the current regulatory background of cryptocurrency to aid in a more accurate understanding of the complexity of regulating virtual currencies. Section II.A explores what a cryptocurrency is. Section II.B explains Bitcoin specifically by analyzing the structure in which Bitcoin operates. Section II.C analyzes how the U.S. government currently classifies virtual currency within the tax system and the responsibilities taxpayers have in reporting cryptocurrencies for tax purposes. A. W HAT I S A C RYPTOCURRENCY ? Cryptocurrency, also known as cyber currency or virtual currency, is an “online payment system[] that may function as real currenc[y] but [is] not issued or backed by central governments.” 5 A simplified explanation of basically all virtual currency systems is that they are computer files that can be used when making purchases so long as the merchant accepts cryptocurrencies as a form of payment. 6 Essentially, a consumer purchases the computer file, which is the virtual currency, with a “government-backed currency”—i.e., something like the dollar bill or peso. 7 At this point, the 4 . See Kaitlin Mulhere, Cash Is Still King , MONEY (Nov. 4, 2016), http://time.com/money/ 4558351/cash-popular-payment-form; NOVA, The History of Money , PBS (Oct. 26, 1996), http:// www.pbs.org/wgbh/nova/ancient/history-money.html. 5. Omri Marian, Comment, Are Cryptocurrencies Super Tax Havens? , 112 MICH. L. REV. FIRST IMPRESSIONS 38, 38 (2013). 6. CAL. DEP’T OF BUS. OVERSIGHT, WHAT YOU SHOULD KNOW ABOUT VIRTUAL CURRENCIES 1 (2014), http://www.dbo.ca.gov/Consumers/Advisories/Virtual_Currencies_0414.pdf. 7 . Id. (“Virtual currencies (also called crypto-currencies, virtual money, or digital cash), are essentially unique, typically encrypted, computer files that can be converted to or from a government-backed currency to purchase goods and services from merchants that accept virtual currencies.”). 930 IOWA LAW REVIEW [Vol. 104:927 consumer is able to purchase any goods or services he or she desires using the computer file, so long as the merchant is willing to accept this system of payment, which provides independence from the government and traditional financial institutions and gives individuals more flexibility and control over the “currency.” 8 This subjects consumers using cryptocurrency to the whim of merchants who are willing to accept payment in a form that is not an official government-backed currency. Beyond the risk that merchants will not accept cryptocurrencies, consumers face numerous other obstacles when deciding whether to use cryptocurrencies. For example, because the federal government does not formally back any cryptocurrencies, there is no way to recover the “currency” if it is stolen. 9 Unlike a credit card, which can be cancelled and the money possibly recovered, if the system storing the cryptocurrency is lost or destroyed, there is no way to get the “currency” back because the system operates anonymously. 10 Not knowing who is making the monetary purchases makes it nearly impossible to recover money from the federal government, especially, because the government does not back cryptocurrencies. 11 Further, there are two ways in which cryptocurrencies fluctuate, which can make them unreliable. First, the valuation of the “currency” can change rapidly. 12 For example, on February 5, 2018, the value of a single Bitcoin was $8,253.91, but ten days later, the value of a Bitcoin had already increased to $9,370.49. 13 For those who purchased Bitcoin ten days earlier, it was a sound investment, which could have potentially made the consumer a great deal of money. However, this fluctuation in price leads to market uncertainty. Second, as...