DEFINING IRS' TREATMENT OF CRYPTOCURRENCIES AND ITS IMPACT ON THEIR PRACTICAL APPLICATION.

• Author: Dumbroff, Timothy J.

1. WHAT IS CRYPTOCURRENCY? 403 II. WHY CAN CRYPTOCURRENCY BE TAXED? 407 III. CONFLICTING CLASSIFICATIONS OF CRYPTOCURRENCY 409 IV. How DOES THE TAX CODE DEAL WITH VIRTUAL CURRENCIES? 413 V. PROBLEMS WITH THE CURRENT PROPERTY SYSTEM 419 I. WHAT IS CRYPTOCURRENCY?

   In the past two decades the world has seen the proliferation of internet platforms that shape the way that we interact, do business, and invest. With a rapidly expanding digital marketplace it comes as no surprise that the world is seeing an explosion of internet-based currency. In this note some of the questions surrounding cryptocurrencies and the federally imposed conditions for using them will be answered. First, we must address the rather complex question of how to define cryptocurrency. Cryptocurrency is digital currency that is decentralized, meaning that there is no government or authority that manages the value of the currency. (1) This also means that there is no one actor that is in charge of printing or creating more cryptocurrency. Cryptocurrency is also a versatile currency and can be used to pay for regular goods and services, or held for investment purposes like a traditional stock asset. When deals are done using cryptocurrency, they are recorded in the blockchain. The blockchain essentially a ledger that records transactions that use cryptocurrency in code.

   The blockchain is the cornerstone of the cryptocurrency market because it allows transactions between two users without a central authority regulating the trade. (2) Each block has a relationship with the preceding block and that relationship allows the blocks users to authenticate transactions by cross referencing them. (3) Because the blocks are open to the public to view, anyone is able to verify the transactions and essentially audit the transaction. (4) There are known benefits to a currency platform that is not under centralized control such as transparency which is not present when transactions are processed through a central bank. (5) The decentralized platform was created to enable user to user transactions wherein a sender can initiate a transfer by entering their public key and the receivers public key. (6) The requirement that the transactions be publicly verified eliminated the problem of double spending without involving a bank. (7) This was the intention of the creator of cryptocurrency, Satoshi Nakamoto in an attempt to eliminate the middleman and its associated transactional costs. (8) If a person wants to sell their cryptocurrency in exchange for a denomination like USD, they would have to find another user that is willing to buy their assets who would essentially be functioning as a bank. (9) Cryptocurrency allows the user to enter into a transaction anonymously, and technology such as TOR has helped people mask their digital identity when using the platform. (10) One of the areas where cryptocurrency is reported to have the biggest cost saving potential is international money transfers which usually involve more intermediaries during the exchange of one country's money for another. (11) Another supposed benefit of cryptocurrency is that it does not depend on the stability of a country's financial institutions and its currencies value. (12) An example of this is Venezuela which has experienced extremely high inflation of its currency, the bolivar, reaching inflation levels of 6500 percent. (13) This is seen to be the catalyst for the spike in the country's cryptocurrency activity and cryptocurrency has actually become more accepted in practical usage to pay for goods than it is in the United States. (14)

   Of all of the cryptocurrencies, the most widely known is bitcoin. Bitcoin has soared to new highs for cryptocurrency and reached a market cap of over 1 trillion dollars. (15) It took only 12 years for Bitcoin to reach this market cap making it the fastest growing asset in history. (16) Ether is the second largest currency; however, the market has fragmented and one industry group reported that 5,524 currencies now exist with a value in circulation of more that 1.66 trillion.

   Bitcoin like other cryptocurrencies can be mined; this is the digital equivalent of a country's treasury minting new currency to be put into circulation. (17) Mining is performed using hardware that solves an extremely complex math problem and the first computer to solve the problem receives a "block" of bitcoins and then the process repeats. Their reward for this complicated mathematical solution is the ability to earn bitcoin tokens that can later be traded or used to buy whatever the miner wants. To be clear the term mining in the context of bitcoin does not denote that mining requires you to get your hands dirty, rather it is the term used for people that are essentially performing the function of an auditor for other bitcoin transaction. Mining was created by the mysterious founder of bitcoin, Satoshi Nakamoto, as a way of preventing the double spending problem. The blockchain miner is responsible for making sure that the users are not trying to spend the same bitcoin twice. It has been established that bitcoin can be mined, however the number of coins that are able to be mined is limited, similar to gold and other precious metals. The maximum number of bitcoins that can be mined is 21 million and as of January 2022 approximately 18.9 bitcoins have been mined. (18) Once bitcoin reaches its cap of 21 million miners will likely only receive income from processing fees rather than the current combination of processing fees and block rewards. In order to operate the decentralized network a massive amount of computer power is needed to validate these transactions. (19) Energy reports have shown that the daily energy consumption needed to maintain the Bitcoin network is comparable to the entire country of Ireland. (20)

   It is argued that the transactional cost that are apparently saved because of the platform are expended during this process. (21) Because bitcoin is capped at 21 million coins it is different than the United States dollar because there is a limited number of coins that back the value. Bitcoin is stored in an online wallet that doesn't require you to use your own identity. (22) Because of this cryptocurrency was thought to be anonymous and virtually untraceable. A few problems arise with this theory. First, even though spending cryptocurrency may be completely anonymous, buying it isn't. The platforms where you can exchange your government-backed currency for cryptocurrency, all require some kind of proof of identity, be it a passport, a driver's license, or a government-issued ID. As stated previously, the blockchain is public and open to anyone which means that the authorities can see the exchanges occurring. This is not to say that the government hasn't had its issues adjusting to the digital currency market but within the last year these online transactions have been closely monitored. What all this means is that the government will want its share from the people that are making a living off virtual currencies, and the mechanism that the government can use to implement these changes is the tax code.

2. WHY CAN CRYPTOCURRENCY BE TAXED?

   According to the IRS all sales and exchanges of cryptocurrency are taxable transactions. (23) A taxpayers gross income is income from whatever source derived subject to specific exemptions. (24) There are three elements for taxable income laid out by the United States Supreme Court in Commissioner v Glenshaw Glass Co. (25) which are (1) the "undeniable accession to wealth"; (2) that is "clearly realized"; and (3) "over which the taxpayer [] ha[s] complete dominion." (26) The IRS has now clearly taken the position that dealings in cryptocurrency are accessions to wealth that are taxable although debate occurs over the other requirements. Accessions to wealth can be taxable income regardless of the form or source, examples of accessions to wealth are lottery winnings, punitive damages and game show prizes. (27)

   In 2016 the IRS served a summons on Coinbase seeking all records relating to transactions of virtual currency between 2013 and 2015. Coinbase lost its motion to quash and was ordered to provide the IRS with information about more than 13,000 of its users. (28) The IRS has collected more than 13 million dollars in taxes as a result of those disclosures, however it is estimated that unreported cryptocurrency tax liabilities total more than 11 billion dollars. (29) Another federal court approved an IRS summons for records of cryptocurrency exchanges from one of the biggest platforms called Kraken. (30)

   In the case of In...