What Exactly is Bitcoin and Other Forms of Cryptocurrency?

What Every Tax Advisor NEEDS to know about 21st Century E Money

By: David W. Klasing Esq. M.S. – Tax CPA

What is Bitcoin?

  • Created 2009 by an individual (or group) using the alias as “Satoshi Nakamoto.” The U.S Treasury identifies Bitcoin as a decentralized virtual currency.
  • Can be transferred without a central bank, clearing-house or other third-party administrator, successfully reducing transaction fees and other charges. 1%
  • With no central authority, Bitcoin gives each person the ability to directly and freely choose with whom to associate, interact or exchange. (Money Laundering Concern)
  • Transactions are conducted directly between the sender and receiver, and verified by network nodes using a block chain public ledger.
  • The verification process is entered through the system through a process called “mining.”
  • “Miners” solve increasingly complex mathematical equations to authenticate transfers, and are compensated for their services with newly created bitcoins.
  • Approximately 15 million bitcoins have been mined thus far.
    • As of March 2016, the average price of Bitcoin was $415.
    • A finite number of bitcoins are available for generation, to be capped at $21 million.
    • Experts anticipate the last bitcoin’s issuance with by reached in 2140.
    • As of 11/22/17, 16,700,000 bitcoins have been mined and are currently valued at $17,664.99.
  • While Bitcoin is one type of digital currency (Cryptocurrency) competitors include Litecoin, Dogecoin, Peercoin, Quark, NXT, and others.
  • Bitcoin is akin to utilizing a digital wallet, however, additional complexity lurks beneath the surface of user-friendly Bitcoin wallet interfaces.

Users Can Contribute Computing Resources to “Mine” Bitcoins

  • Bitcoin’s value engineered to appreciate due to the artificial scarcity specifically designed into the model.
    • That is, there will never be more than, roughly, 21 million Bitcoins.
    • However, all 21 million coins have not yet been discovered.
  • Users can “mine” for Bitcoins which will inject new Bitcoins into the money supply.
    • What is actually occurring in the mining process is that people are choosing to contribute computing power to maintain the public ledger (blockchain) containing all Bitcoin transactions ever conducted.
    • For work performed in keeping the Bitcoin network running and functioning as expected, miners are rewarded in Bitcoin.
    • Bitcoin miners generally owe self-employment taxes on the bitcoin income.
  • Individuals and businesses that accept Bitcoin as payment must pay taxes on this income.
  • Any individual who holds or uses Bitcoin is required to engage in fastidious record-keeping.
    • A failure to do so can subject one to a number of informational reporting and other tax penalties.

Tax Implications and Reporting Requirements

  • The tax implications of Bitcoin are similar to shares of stock or securities in that records need to be maintained in order to track basis of each bitcoin; however, wash sales likely do not apply to bitcoins since they do not meet the definition of a stock share.
  • The IRS did indicate that the normal basis rules would apply to bitcoins, therefore Bitcoin users would have the option to sell their assets on a first-in-first-out (FIFO) basis, a last-in-first-out (LIFO) basis, or a selective cost-basis method.
  • In a rising market, LIFO will produce the lowest tax liability, while FIFO will do so in a falling market.
  • Taxpayers paid in Bitcoin for services constitute self-employment income and subject to self-employment tax.
  • Businesses making payment using virtual currency have Form 1099 reporting requirements if the value is $600 or more to a non-exempt recipient and backup withholding could also apply.
  • Recently, a bill was proposed to create tax exemptions for cryptocurrency transactions under $600.

What are the most current IRS guidance on Virtual Currency Found?

The most current guidance on IRS virtual currency is found in
Internal Revenue Bulletin: 2014-16.

Excerpts from Internal Revenue Bulletin: 2014-16:

  • IRS knows that “virtual currency” can be used to acquire goods and services, or held as an investment.
  • Defines virtual currency as a digital representation of value used as a medium of exchange, or to store value and has some functions like “real” currency of the U.S. or many foreign jurisdictions.
  • It can function like legal tender, but does not enjoy the legal status as “legal tender” in any jurisdiction.
  • Convertible virtual currency, Bitcoin for example, has an equivalent value in real currency and functions as a substitute for real currency and can be digitally exchanged between buyers and sellers, purchased via or exchanged into, U.S. dollars and many other foreign currencies.

The common U.S. federal tax consequences related to virtual currencies are described below:

  • Virtual currency is currently not treated as currency such that would generate foreign currency gain or loss for U.S. federal tax purposes.
  • A taxpayer who receives virtual currency where goods or services are sold must include the fair market value of the virtual currency, in U.S. dollars at the date of receipt.
  • The basis of virtual currency is the fair market value in U.S. dollars at the date of payment or receipt.
  • Where virtual currency is listed on an exchange that reflects market supply and demand, its FMV is determined by converting to U.S. dollars at the applicable exchange rate, in a reasonable and consistent manner.
  • Where the FMV of the property received in an exchange involving virtual currency exceeds the taxpayer’s adjusted basis in the virtual currency, the taxpayer has incurred a taxable capital gain.
  • In contrast, a capital loss occurs where the FMV of the property received is less than the adjusted basis of the virtual currency.
  • The character of the gain or loss generally turns on if the virtual currency is a capital asset in the hands of the individual taxpayer.
  • A taxpayer realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in their hands.
  • Virtual currency held as inventory in a trade or business is not a capital asset.
  • Where a taxpayer “mines” virtual currency, the fair market value of the virtual currency at the time of receipt is includible in gross income.
  • The FMV of virtual currency received as payment for services performed as an independent contractor constitutes self-employment income and is subject to the self-employment tax.
  • The fair market value of virtual currency paid as wages is subject to self-employment tax and federal income tax withholding, and must be reported on Form W–2
  • All payments made using virtual currency are subject to identical information reporting as any other payment that is made in property.
  • Payments made via virtual currency to foreign payees are also subject to backup withholding as are other payments made in property.
  • A business or organization interacting with a substantial number of unrelated money, service or business merchants to settle payments between the various merchants and their individual customers is deemed a third-party settlement organization
  • It is required to report the total payments made to an individual merchant during a calendar tax year on a Form 1099-K.
  • Underpayments related to virtual currency transactions are subject to accuracy-related penalties.
  • Failures correctly report virtual currency transactions where required are subject to information reporting penalties found under section 6721 and 6722.

The current uncertainty when dealing with virtual currency is best illustrated by the following link to an AICPA request to the IRS for further guidance in this area:

https://www.aicpa.org/advocacy/tax/downloadabledocuments/aicpa-comment-letter-on-notice-2014-21-virtual-currency-6-10-16.pdf

Tax Mistakes May be Rampant Regarding the Failure to File IRS Form 8949

  • One study seems to suggest that while taxpayers may have an obligation to file 8949s along with their Schedule D, many do not.
  • Despite the belief that at least hundreds of thousands, if not millions, of people utilize Bitcoin and other cryptocurrencies, the IRS found that a very small percentage is filing the 8949. The IRS study found that:
    • In 2013, 807 individuals reported a transaction on Form 8949 using a property description likely related to Bitcoin.
    • In 2014, 893 individuals reported a transaction on Form 8949 using a property description likely related to Bitcoin.
    • In 2015, 802 individuals reported a transaction on Form 8949 using a property description likely related to Bitcoin.
  • While the study is imperfect and relies on the description provided by the taxpayer, it is clear that filings are far below the numbers that the level of Bitcoin activity should suggest.
  • Generally, when taxpayers have engaged in Bitcoin transactions, Form 8949 should be included along with 1040 Schedule D. Per the instructions set forth for a Schedule D filing, a taxpayers should:

Use Form 8949 to report the sale or exchange of a capital asset (defined later) not reported on another form or schedule.

  • Virtual currency is likely to qualify as a capital asset. The Schedule D instructions include “virtual currency” as an “item for special treatment” and directs users to the IRS 2014 virtual currency publication.
  • While taxpayers who are currency dealers or otherwise hold Bitcoin as inventory mainly for sale to customers are an example of individuals who hold bitcoin as a non-capital asset, most other taxpayers who hold Bitcoin/cryptocurrency will do so as a capital asset.

8949 or Schedule D?

  • As a starting point, it is first essential to note that many of the reports prepared and made available by popular Bitcoin/cryptocurrency exchanges and wallets may be insufficient for tax purposes.
  • Many users of Bitcoin and virtual currency will use an array of wallets and services.
  • Where a taxpayer uses a variety of virtual currency services, a single wallet or exchange cannot determine what occurred prior to importing the Bitcoin or after it has been exported to another exchange or printed.
  • The first step in preparing a Bitcoin/cryptocurrency tax filing is to ensure that gain and loss for individual transactions is accurately computed.
  • This information should be input on a Form 8949 for each transaction or other reportable events.

Virtual Currency & Section 1031 – Is it Possible to do a 1031 exchange with Bitcoin, Etherum, or Other Electronic/Crypto Currencies?

  • Individuals who were quick to recognize the opportunity presented by cryptocurrencies like Bitcoin, DogeCoin, and Ethereum have likely rode the market to significant gains as capital from China and other developing nations have flooded the market.
  • People who bought or mined Bitcoin due to an interest in the underlying technology or because they saw an investment opportunity may be looking to diversify their cryptocurrency holdings.
  • In any case, they may consider changing the overall balance of digital currencies held to increase the likelihood of investment gains or hedge against potential volatility.

Can a 1031 Exchange Apply to Bitcoin and Digital Currency?

  • The IRS has issued guidance holding that Bitcoin and similar digital currencies will not be treated as currency for tax purposes. Rather, Bitcoin and similar cryptocurrencies should be considered property for tax purposes.
  • In practice, the government is the true arbiter of what assets are like-kind and what assets aren’t. In a recent letter to the IRS, the AICPA asked the Service to provide guidance as to whether varying types of cryptocurrency were like-kind properties for Section 1031 purposes.
  • Since the release of Notice 2014-21, the IRS and the federal government as a whole have shown a considerable amount of hostility toward virtual currency.
  • Recently, the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) has cracked down on virtual currency exchanges that have not registered with the federal government as a Money Services Business.
  • No definitions in Federal Tax Law defining what is like kind as to cryptocurrency
  • A taxpayer exchanging Euros for U.S. Dollars would not be able to rely on Section 1031 to defer any currency exchange gain and so it appears that the same could be said about exchanging one type of virtual currency for another.
  • A taxpayer exchanging from Boing to Coca Cola Stock could not utilize 1031

No definitions in Federal Tax Law defining what is like kind as to cryptocurrency

1031 – Conclusion

  • At present our office does not believe 1031 can be utilized where cryptocurrency is concerned. Presenting the issue to the IRS through a private letter ruling is the only way to obtain certainty however.

What to do when the IRS wants my clients’ Bitcoin Trade History?

  • Users of Bitcoin who have failed to account for capital gains and other tax obligations could face penalties and fines.
  • If your client engaged in a scheme to avoid or evade income taxes, however, penalties can be much harsher and may include a federal prison sentence.

Court Granting of IRS John Doe Summons means the IRS is Likely to Obtain Coinbase Account Data:

  • The IRS has previously used this tactic to successfully crackdown on the fraudulent use of offshore credit cards and foreign accounts and entities to commit offshore tax evasion.
  • In several subsequent enforcement proceedings against taxpayers, the John Doe summons was the first step in discovering the accountholder’s real-world identity.

Updates to the Coinbase John Doe Summons:

  • In late 2017 Coinbase refused to comply with the summons and the IRS took the issue to court in an enforcement hearing.
  • Anonymous Coinbase users have attempted to join the litigation, arguing that they will suffer injury if the summons is enforced.

Taxpayer Criminal Exposure for Failure to Comply:

  • Many Bitcoin users were not aware that they were supposed to record their gains and losses as taxable events each time they made purchases with their bitcoins, sold them for money, exchanged them or even mined them.
  • Because of the recent John Doe summons, they are at risk for tax evasion.
  • Consequently, they may be subject to penalties for failure to comply with tax laws.
  • Underpayments attributable to virtual currency transactions include accuracy-related penalties and information reporting penalties.
  • Penalty relief may be available to taxpayers and persons required to file an information return who can establish reasonable cause.

Potential Tax Practitioner Criminal Liability:

  • Tax preparers that are aware a client had taxable Bitcoin or other Virtual Currency transactions and counsels against reporting this activity are at risk of conviction for several different tax crimes.

Voluntary Disclosures:

  • Another way in which the CPA and attorney may team up is through voluntary disclosures to the IRS.
  • In a voluntary disclosure, the client will come into your office, state that he cheated on his taxes, but that he wants to make things right.
  • The CPA’s first responsibility will be to tell the client to not discuss the matter with the CPA, and consult a tax attorney.
  • Although the purpose of the voluntary disclosure is to prevent cases from becoming criminal, a tax attorney needs to be consulted for various reasons.
    1. First, the attorney will need to identify whether the client is eligible for a voluntary disclosure.
    2. The attorney needs to contact the IRS with the client’s information and do a “pre-check” to see whether the client can enter the voluntary disclosure process.
    3. If the client is accepted in the pre-check stage, the voluntary disclosure can begin.
    4. If the client is not accepted, it may mean that a criminal investigation has already begun.

Is Cryptocurrency really Anonymous?

  • User’s identities are protected to a certain extent.
  • While Bitcoin and similar digital currencies are often advertised as “anonymous” the fact of the matter is that this generally refers to the fact that people can send and receive money without directly revealing personally identifiable information.
  • Far too many people misinterpret that last point and believe that once money is “in” Bitcoin, it is invisible to the IRS and U.S. government.
  • This is a faulty assumption by your clients can lead to an audit, tax enforcement actions, and even criminal tax evasion charges.

Bitcoin Does Not Provide Perfect or Reasonable Anonymity in Many Scenarios

  • Bitcoin functions by making a public ledger containing all transactions ever conducted available.
  • All transactions are publicly available. Thus, there is no such thing as a “private” Bitcoin transaction.
  • A level of anonymity is preserved by disassociating a user’s identity with the public transaction – however a record of the transaction time, amount, and other information is always kept publicly.
  • The problem that exists is when users sign up with popular Bitcoin wallet services, their identity is revealed in an e-mail.
  • For users who use Bitcoin in this method, it is no more anonymous or private then a bank transaction.

What you should advise a client to do if he/she had a Coinbase or Bitcoin Wallet Account in 2014, 2015, 2016 and Failed to File and Pay Taxes?

  • If a client had a Coinbase account or otherwise mined, held, traded, or engaged in transactions involving Bitcoin, it is essential that steps are taken to mitigate the potential consequences your client faces and he/she may need to file an FBAR.
  • This may include amending past tax returns, filing missed returns, or making a voluntary disclosure.
  • The IRS has already taken steps to identify those taxpayers who are utilizing Bitcoin and cryptocurrency to commit tax evasion.
  • As the IRS continues to gather information from an array of domestic and international financial institutions, it is highly likely that it will become increasingly aggressive in its enforcement activities.

What Are the Cryptocurrency FBAR and FATCA Reporting Obligations?

What Does Virtual Currency Have to Do with Foreign Accounts and Taxes?

  • A user of the currency could print out his or her full or partial bitcoin and carry it around like cash in his or her wallet or purse.
  • The user could also store his or her Bitcoins in a digital account known as a Bitcoin wallet.
    • Location of the wallet determined by location of the hardware or coin brokerage he is doing business with.
  • This distinction is important because hard currency, real estate, precious metals held directly, personal property, and certain covered benefits programs are not reportable for purposes of FBAR or FATCA.
  • However, once these assets are placed in a foreign financial account, they become reportable for purposes of FBAR and FATCA.
  • Since users of Bitcoin can place the value of their Bitcoins in an account that may be held overseas, or stored, trade cryptocurrencies with a foreign exchange this would seem to be an area of some concern.

What Guidance Has the IRS Issued on the Potential Duty to Report Bitcoin and Cryptocurrency for Purposes of FBAR & FATCA?

  • In 2014, Rod Lundquist, a senior program analyst for the Small Business/Self-Employed Division indicated that the IRS would not require Bitcoin to be reported as part of FBAR for 2014 only.
  • He elaborated by adding that that “FinCEN has said that virtual currency is not going to be reportable on the FBAR, at least for this filing season [emphasis added].”
  • The IRS later clarified this statement in response to a reporter’s inquiry. It clarified that virtual currency accounts also fell under the non-reportable guidance.
  • Despite the unofficial nature of this guidance, this is still the only statement taxpayers must guide their offshore account reporting. And this statement was explicitly limited to the context of a single tax filing year.
  • Recent enforcement actions taken by the IRS may suggest the possibility that the IRS is reconsidering its approach to Bitcoin and foreign account informational disclosures.

FBAR Inclusion – FinCen Form 114 and Cryptocurrency?

  • Taxpayers could align their handling of Bitcoin to comport with that of gold, hard currency and real estate.
    • That is, these assets are generally not reportable for foreign account purposes when held directly, but become reportable when they are stored in a foreign financial account.
  • Under this type of approach, a taxpayer who carries around a printed Bitcoin would not report Bitcoin for purposes of FBAR or FATCA.
  • A taxpayer who has placed the value of his or her bitcoin in a virtual wallet hosted overseas should include Bitcoin for purposes of aggregation and reporting.
  • This type of approach would, at the least, provide the taxpayer with a reasonable approach to an unsettled issue.

Valuation

  • There is no official valuation authority for bitcoin and most other virtual currency.
    • Instead, various websites across the internet update exchange rates throughout the day.
  • A simple Google search can evidence the fact that each bitcoin valuation estimate varies from one website to the next, making it extremely difficult for a taxpayer to measure the value of their virtual currency at the time of its disposition.
  • Furthermore, taxpayers have not received guidance as to whether averaging valuations can be an appropriate valuation methodology.

Emerging Regulations Create Tax and Regulatory Framework for Bitcoin and Other Cryptocurrencies:

  • With cryptocurrencies and other blockchain currencies becoming more and more popular, the amount of money that goes into these currencies grows each day.
  • This also means that more and more currencies are becoming problems for security breach, money laundering, banking privacy, and other securities regulations.
  • Recent documents released this summer by the Securities Exchange Commission (SEC) and other US regulatory agencies have thrown new light on how Bitcoin and other coin and blockchain currencies will be regulated going forward.

State Passing Laws Addressing Blockchain, A Cryptocurrency Technology

Washington State:

  • In Washington State, Virtual Currency included in the definition of “money transmission” in the uniform money services act.
  • Companies wishing to transmit money (via Crypto) for Washington state residents must contact the Washington Department of Finance and get a determination if licensing under the Uniform Money Services Act is required. If so… requires a License…

California:

  • California AB-1326 “Digital Currency”Required to register with CA Commission of Business Oversight or be considered exempt under the CA Money Transmission Act..
  • Must maintain a bond set by the state. AB-1326 creates a Digital Currency Business Enrollment Program (DCBEP) and is granted the power to regulate digital currency in CA.
  • Bill prohibits the engaging in a digital currency business without enrolling in the DCBEP or via conducting business through an unenrolled agent.
  • Fingerprints that will be provided to law enforcement required.
  • All enrollees examined to be of good character in order to receive a license.
  • Enrollees into the DCBEP required to provide audited financial statements on an annual basis.

New York:

  • New York Regulation of Virtual Currencies by the Superintendent of Financial Services.
  • Defines virtual currency business as having the following types of activities:
    1. Receiving or transmitting virtual currency except where for non-financial purposes or where nominal value at issue.
    2. Storing or holding virtual currency for others
    3. Buying and selling virtual currency as a business
    4. Controlling administering or issuing a virtual currency
  • Cannot run a virtual currency business in New York without first obtaining a License.
  • Merchants and consumers that utilize virtual currency as a means to sell or purchase goods or for investment purposes – exempt from licensing requirements.
  • Each licensee required to maintain and enforce a written policy designed to prevent fraud, money laundering, provide cyber security, privacy and information security.
  • Maintenance of specified amount of capital acquired set by state of N.Y.
  • Must submit to examination upon request.
  • New York’s BitLicensing program probably a good start to a best practices compliance requirements.

TIGTA Urged the IRS to Crackdown on Bitcoin:

  • In September 2016, TIGTA issued a report titled As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions Are Needed to Ensure Taxpayer Compliance, Reference Number 2016-30-083, Sept. 21, 2016.
  • In the report, TIGTA wrote that taxpayer use of virtual currencies, like Bitcoin, had expanded significantly in recent years.
  • The report reflects TIGTA’s belief that while there are legitimate reasons to use virtual currency, some taxpayers are attracted to the ostensible anonymity that the platform can offer.
  • TIGTA believes that many people are attracted to this sense of anonymity because they wish to engage in illegal acts or transactions including tax evasion.
  • The report concluded that the IRS divisions had failed to coordinate and none had developed “compliance initiatives or guidelines for conducting examinations or investigations specific to tax noncompliance related to virtual currencies.”
  • Thus, TIGTA recommended for the IRS to develop a coordinated virtual currency strategy to identify and prosecute this emerging form of tax evasion.
  • It appears that this strategy was developed and is now being implemented by the IRS.

IRS Investigations of Virtual Currency May Ramp Up After Congressional Testimony

  • In June 2017, the House of Representative’s Financial Services Committee heard testimony from a panel regarding the potential dangers of cryptocurrency.
  • The expert panel discussed how cryptocurrency can be used to perpetuate crimes and how even national security can be placed in jeopardy.
  • The testimony is particularly ripe as many of the ransomware viruses that have circulated around the Internet in the recent weeks have relied on cryptocurrency such as Bitcoin as the exclusive currency by which to pay a ransom to retrieve data that has been held digitally hostage.
  • LARGER SECURITY THREAT
  • A common misconception among those using Bitcoin or other virtual currencies as a part of criminal activities is that it is a trace-free way to transfer money or to make purchases.
  • In reality, cryptocurrency is becoming one of the most traceable ways to transact. Startup companies like Elliptic are working with law enforcement to track the identity of those behind online transfers of Bitcoin and other virtual currencies that are suspected of being connected to criminal behavior.

Uncoordinated Potpourri of Federal Enforcement Actions Applicable to Cryptocurrency: How the SEC Regulates Cryptocurrency:

  • The Securities and Exchange Commission (SEC) decided that Cryptocurrency is like stocks, and are covered under their rules and regulations.
  • This means that sale, transfer, and conversion of cryptocurrency coins may be held to the same standards as other securities and stocks, which the SEC oversees.
  • This means that coin offerings must now be registered with the SEC, or else they could violate federal regulations.

Ultimately, going forward, this means that the SEC will regulate crypto coin offerings in some of the following ways:

  • The SEC may require registering coin sales as the sale or exchange of securities.
  • All tokens may have to be registered and follow SEC regulation unless they fall into an exemption.
  • Crowdfunding regulations must be followed for crowdfunded coins.
  • The professionals and investment managers that deal in cryptocurrency must be appropriately registered or licensed.
  • Failing to follow SEC regulations could put your client’s at risk of regulatory enforcement, resulting in penalties or effectively preventing additional transactions. In worse case scenarios, purposely failing to follow SEC regulations could be charged criminally.
  • Offering cryptocurrency to the general public without registering with the SEC where cryptocurrency is treated as a security = securities fraud.
  • Securities fraud conducted through the telephones / internet (interstate instrumentalities) is wire fraud…
  • Creating an online portal to trade bitcoin and litecoin without first registering the service as a broker dealers or stock exchange.
  • Cryptocurrency itself not a “security” but entities that own or trade virtual securities require registering with SEC – Providing returns based on investments in digital currency qualifies as a security for SEC regulation purposes.
  • SEC has created multi office Digital Currencies Working Group on 8/30/13 and it has 50 SEC agents
    • Big issues with Crypto – money laundering, Ponzi Schemes, Unregistered Security with SEC / Securities Fraud
  • US Dept of Justice has formed Global Illicit Finance Team (GIFT) – consists of Investigators from the U.S. Attorney’s Office, Secret Service, Immigrations and Customs, Dept. of Justice’s Asset Forfeiture and Money Laundering Section
  • Gift Shut down Liberty Reserve – 6-Billion-dollar currency system used to aid and abet money laundering.
  • SEC v. Trendon Shavers and Bitcoin Savings and Trust – Shavers convicted for running a Ponzi Scheme and ordered to pay 40 million in disgorgement and penalties.
  • May have to register with the SEC as the operator of an Alternative Trading System, and with SEC and FINRA as a broker dealer.
  • May have to register as a financial technology company with SEC (FINTECH)
  • Possible regulation by Federal Trade Commission FTC
  • Dodd Frank Act Violations
  • Anti-Money Laundering and Bank Secrecy Act Violations
  • SEC enforcement actions have argued the digital assets are investment contracts which by definition are securities.
  • SEC v. J. Howey Co. Investment contract is any transaction or scheme involving an investment of money in a common enterprise with the expectation that profits will be derived from the efforts of the promoter or a third party.
  • If digital assets seen as a security, firm selling investments must comply with state and federal securities laws and must be registered with the SEC or exempt from registration.
  • Firm facilitating the trading of digital assets must register as a broker dealer, an exchange or an Alternative Trading Service.
  • Peer to Peer lending platforms that use digital assets may be required to register as broker dealers or ATS via the Howey test above if the loans are classified as investment contracts because the level of services rendered by the organization ensure the loans success.
  • Cryptocurrency because of its ability to be used as a vehicle for money laundering:
    • May have to file an anti-money laundering policy with Fin Cen if viewed as a money transmission service
  • “Money transmission services” means the acceptance of currency, funds, or other value that substitutes for currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.
    • Under Bank Secrecy Act money service businesses have the duty to file SAR’s and can be prosecuted for not doing so.
  • In re: Coinflip http://www.cftc.gov/PressRoom/PressReleases/pr7231-15
    • Cryptocurrency properly classified as commodity under the Commodity and Exchange Act (CEA) and thus regulatable by the Commodities Futures Trading Commission (CFTC)
    • Coinflip violated the CEA by operating a facility for the trading and processing of commodities options without registering with the CFTC as a swap execution facility or as a designated contract market.
  • Conclusion – Regulators have implemented recordkeeping and know your customer requirements antimony laundering requirements that demonstrate that traditional currencies, securities and systems will apply to cryptocurrencies.
  • Administrator or Exchanger of virtual currency will have register with FinCen’s as a money service business and comply with BSA regulations (Bank Secrecy Act).
    • Must access their risk of being used to facilitate money laundering or financing terrorism and must keep records on both the money transmitter and receiver including each customer’s name and address of any transmitter or receiver of $3,000 or more or any exchange of $1,000 or more.
  • Consumer Fraud Protection Bureau warns the public that virtual currency accounts not insured by the FDC or national credit union so if company fails Fed will no insure the loss
  • Federal government has preemption over state governments in regulating cryptocurrency as a form of currency under Article 1 sec 8 of the U.S. constitution which states congress has the power to coin money and to regulate the value thereof.
  • U.S. Dept of justice has recognized bitcoin as a medium of exchange.

Virtual Currencies and the Bank Secrecy Act (BSA)

  • BSA enacted to help prevent money laundering by creating a number of reporting obligations by banks and Money Service Businesses (MSB).
  • MSB’s include check cashers, issuers and redeemers of traveler’s checks, money orders and money transmitters.
  • MSB’s are subject to BSA reporting requirements including currency transaction reports and Suspicious Activity Reports.
  • Though a delegation of authority from FINCEN, IRS has BSA enforcement responsibilities for financial institutions not regulated by a federal bank agency or another federal agency.
  • MSB are the type of non-bank institution regulated by the IRS as far as the BSA goes.
  • See FINCEN definition of Users, Administrators and Exchangers of virtual currency (above).
  • Failure to comply with BSA subject violator MSB = civil and criminal liability. 31 USC Section 5322
  • Operating a MSB without a MSB license or FinCen registration is a violation of 18 USC Section 1960
    • (A) Whoever knowingly conducts, controls, manages, supervises, directs, or owns all or part of an unlicensed money transmitting business, shall be fined in accordance with this title or imprisoned not more than 5 years, or both.
    • (B) As used in this section— the term “unlicensed money transmitting business” means a money transmitting business which affects interstate or foreign commerce in any manner or degree.

31 U.S. Code § 5330 – Registration of Money Transmitting Businesses

  • REGISTRATION WITH SECRETARY OF THE TREASURY REQUIRED.— (1)IN GENERAL.—Any person who owns or controls a money transmitting business shall register the business (whether or not the business is licensed as a money transmitting business in any State) with the Secretary of the Treasury
  • TREATMENT OF AGENT AS MONEY TRANSMITTING BUSINESS.— (2)The Secretary of the Treasury shall prescribe regulations establishing, on the basis of such criteria as the Secretary determines to be appropriate, a threshold point for treating an agent of a money transmitting business as a money transmitting business for purposes of this section. DANGER!!!
  • Provides check cashing, currency exchange, or money transmitting or remittance services, or issues or redeems money orders, travelers’ checks, and other similar instruments or any other person who engages as a business in the transmission of funds, including any person who engages as a business in an informal money transfer system or any network of people who engage as a business in facilitating the transfer of money domestically or internationally outside of the conventional financial institutions system.
  • Any person who fails to comply with any requirement of this section or any regulation prescribed under this section shall be liable to the United States for a civil penalty of $5,000 for each such violation.

Examples of Cryptocurrency Enforcement Action to Date:

  • The federal government fears that organized crime is using e commerce, and virtual currency such as BitCoin, as a means for money laundering and income tax evasion.
  • The following story about a website called “Silk Road” is a great example of how this fear came into being.
  • Silk Road was created by a man from San Francisco named Ross Ulbricht.
  • Silk Road was an underground website created to sell a variety of illegal drugs along with other unlawful goods and services.
  • The site was a fairly sophisticated criminal marketplace designed to keep all transactions anonymous.
  • Silk Road was also used launder hundreds of millions of dollars that were received from buyers.
  • Site creators attempted to keep everything anonymous by creating a network of computers located around the world that concealed the IP addresses of the computers that used the network. This concealed the identities of the networks users.
  • The site was also designed to take only Bitcoin as payment, further concealing the identities and locations of the customers who were making the payments through the site.
  • Authorities took down Silk Road in October of 2013 after it had been in operation for a little over 2 years. On May 15, 2015 Ulbricht was forced to forfeit $183,961,921 and was also sentenced to life in prison.

Prosecution of Robert M. Faiella:

  • Faiella was an underground Bitcoin exchanger who was operating an unlicensed fund transmitting business.
  • Silk Road users needed to get Bitcoin from somewhere, and Faiella was happy to help.
  • Faiella would get orders for Bitcoin from Silk Road users that he filled through another site called BitInstant. BitInstant is a site that enabled customers to buy Bitcoin with cash anonymously.
  • Customers of BitInstant didn’t need to supply any personal identifying information and the site charged a fee for their services.
  • Robert Faiella was sentenced to forfeit $950,000 and serve 48 months in prison with 3 years of supervised release.

Prosecution of Charlie Shrem:

  • The CEO of BitInstant, Charlie Shrem, was sentenced to forfeit $950,000 along with 2 years in prison and 3 years of supervised release.

Avalanche Network Dismantled in International Cyber Operation:

  • A Multinational sting was conducted involving searches and arrests in four countries with the aim of dismantling a sophisticated and complex network of servers collectively known as “Avalanche.”
  • The network was alleged to host greater than two dozen of the world’s most troublesome and malicious software along with several money laundering campaigns.
  • The criminal network launched ransomware attacks that encrypted victims’ computer files until they paid a ransom via electronic currency to the end-user cybercriminals.
  • Other types of malware initiated fraudulent wire transfers or utilized “mules” who purchased goods with stolen funds, which enabled the cybercriminals to launder the stolen money they acquired via malware attacks or other criminal means.
  • The sting involved the U.S. Attorney’s Office, the FBI, Department of Homeland Security’s U.S.-Computer Emergency Readiness Team (US-CERT), the Shadowserver Foundation, Fraunhofer Institute for Communication, Registry of Last Resort, ICANN and domain registries from around the world.

Texas Man Sentenced for Operating Bitcoin Ponzi Scheme in the First Federal Securities Fraud Case Involving Bitcoin

  • TRENDON T. SHAVERS, a/k/a “pirateat40,” was sentenced to 18 months in prison for securities fraud involving a Bitcoin-related Ponzi scheme.
  • He ran a classic Ponzi scheme by raising Bitcoins while promising spectacular returns and offering personal guarantees, while merely paying back older investors with newer investors’ Bitcoins.
  • He utilized an internet based public “Bitcoin Forum” to attract victims who lent Bitcoin in exchange for being paid up to seven percent interest weekly which amounts to an annualized interest rate of 3,641% per year while being promised the ability to withdraw their investments at any time.
    • SHAVERS was ordered to pay $1,228,660.93 in forfeiture, and $1,228,660.93 in restitution and to pay more than $40 million in disgorgement and prejudgment interest, and a civil penalty of $150,000.

Operator of Unlawful Bitcoin Exchange Pleads Guilty in Multimillion-Dollar Money Laundering and Fraud Scheme

  • Murgio used Coin.mx, an internet-based Bitcoin exchange, to process over $10 million in Bitcoin transactions in violation of federal anti-money laundering laws, and then obstructed a regulatory examination to hide his scheme.”