TAXING AND REGULATING BITCOIN: THE GOVERNMENT’S GAME OF CATCH UP Patrick McLeod* I. INTRODUCTION “Bitcoin is the most important invention in the history of the world since the Internet.”1 These are the words of Roger Ver, CEO of MemoryDealers and “Bitcoin evangelist.”2 While this enthusiasm has yet to permeate main street America, Bitcoin, the most popular crypto currency, has grabbed the attention of major news outlets, investors, and United States regulators.3 Bitcoin exists digitally on the Internet, not in physical form.4 Nearly every facet of our mod- ern lives is touched in some way by the presence of the Internet. Work, enter- tainment, and communication are all streamlined for the benefit of the global population that is “logged on.” It stands to reason that with the abundance of goods, services, and even jobs that are available online, the Internet can be viewed as its own unique society. In any society where trade flourishes there is a need for some sort of ex- change in values. Bitcoin has carved out an economic foothold as a dominant crypto currency on the Internet and has naturally attracted the attention of regulators in the United States who deem its use too widespread to ignore.5 Two of the central issues being scrutinized by the Federal Government are the tax implications for American users, such as how to classify these assets for tax purposes, and the fear of economic crimes, such as money laundering and * I would like to thank the following people: Professor Regina Jefferson, for serving as my expert reader with her wisdom, knowledge, and valuable insight into the United States Internal Revenue Code; my parents, Scott and Elaine, for always encouraging me to reach further than I thought possible. Kelly Knox, for her unwavering love and support throughout the entire process. Finally, I would like to thank the Editorial Board of the CommLaw Conspectus for selecting my article for publication and for all their guidance and assistance. 1 Kirby Garlitos, Bitcoin London Conference Ready to Open Its Doors on July 2, CALVINAYRE.COM (June 20, 2013), http://commcns.org/1mhkldo (quoting Roger Ver) (in- ternal quotation marks omitted). 2 Roger Ver, BITCOIN WIKI, http://commcns.org/TO36bP (last updated July 31, 2013, 5:41 AM). 3 Timothy B. Lee, The $11 Million in Bitcoins the Winkelvoss Brothers Bought Is Now Worth $32 Million, WASH. POST (Nov. 9, 2013, 12:22 PM), http://commcns.org/TO36ZA; Zachary Warmbrodt, Congress Starts Looking into Bitcoin, POLITICO (Aug. 13, 2013), http://commcns.org/1pbZFbC (discussing Congressional action with respect to Bitcoin). 4 Lauren French, Bitcoin: Tax Haven of the Future, POLITICO PRO (Aug. 10, 2013), http://commcns.org/1kiDAoY. 5 Warmbrodt, supra note 3. 379 COMMLAW CONSPECTUS tax evasion.6 The recent collapse of the world’s former leading Bitcoin ex- change7 may have provided one of the first large-scale financial crimes in the Bitcoin world. Currently there is no specific statutory provision that governs the taxation of crypto currency.8 The IRS is tasked with distributing guidelines that clarify how to report income via Bitcoin under the current Internal Revenue Code (“IRC”).9 The Financial Crimes Enforcement Network (“FinCEN”)10 has issued guidelines on how money-laundering regulations will be applied to the use of virtual currency such as Bitcoin.11 However, U.S. regulators and the general public are still very much in the dark as to what Bitcoin really is, how it works, and why anyone is using it.12 It is important to understand the nature of the sys- tem before any steps are taken to regulate it. This paper examines how crypto currency, specifically the Bitcoin model, fits within existing United States tax laws and discusses how the IRS should address this issue. This paper concludes that Bitcoins are financial instruments, 6 U.S. GOV’T ACCOUNTABILITY OFFICE, GAO-13-516, VIRTUAL ECONOMIES AND CUR- RENCIES: ADDITIONAL IRS GUIDANCE COULD REDUCE TAX COMPLIANCE RISKS 12–14 (2013) [hereinafter GAO REPORT], available at http://commcns.org/1nqwnGD. 7 See generally Brett Wolf & Emily Flitter, Mt Gox: The Brief Reign of Bitcoin’s Top Exchange, REUTERS (Feb. 28, 2014), http://commcns.org/1ilBSyt (“Once the world’s biggest bitcoin exchange, Mt. Gox on Friday filed for bankruptcy protection, saying it may have lost nearly half a billion dollars worth of the virtual coins due to hacking into its fault computer system.”). 8 GAO REPORT, supra note 6, at 16 (“IRS has not issued guidance specific to virtual currencies used outside of virtual economies . because [among other things] the use of virtual currencies is a relatively recent development that requires further consideration be- fore guidance can be issued . .); see also Robert W. Wood, Bitcoin in IRS Crosshairs, Says Government Report, FORBES (June 18, 2013), http://commcns.org/1ka1qyd (discussing the GAO report (GAO-13-516)). 9 GAO REPORT, supra note 6, at 9 (“IRS is responsible for ensuring taxpayer compli- ance for all economic areas, including virtual economies and currencies.”). 10 For a description of FinCEN’s purpose, see Financial Crimes Enforcement Network: What We Do, U.S. TREASURY DEPARTMENT (Sept. 30, 2013, 5:05 PM), http://commcns.org/1psDOdm (“FinCEN is a bureau of the U.S. Department of the Treas- ury. FinCEN’s mission is to safeguard the financial system from illicit use and combat money laundering and promote national security through the collection, analysis, and dis- semination of financial intelligence and strategic use of financial authorities.”). 11 See generally FINCEN, FIN-2013-G001, APPLICATION OF FINCEN’S REGULATIONS TO PERSONS ADMINISTERING, EXCHANGING, OR USING VIRTUAL CURRENCIES (2013) [hereinafter FINCEN INTERPRETIVE GUIDANCE] (“[FinCEN] is issuing this interpretive guidance to clar- ify the applicability of the regulations implementing the Bank Secrecy Act (‘BSA’) to . virtual currencies.”). 12 Ryan W. Neal, Bitcoin Foundation Meets with Regulators: Open Dialogue on the Future of Digital Currency, INT’L BUS. TIMES (Aug. 29, 2013), http://commcns.org/RubefF (discussing an event hosted by the Bitcoin Foundation to educate government officials about the digital currency). more specifically commodities, and should be classified as such for taxation purposes. Additionally, in the absence of express Bitcoin regulation, this paper argues that Bitcoin users may come into conflict with United States Tax Eva- sion and Money Laundering laws. In an attempt to provide guidance to taxpay- ers, the paper provides theories on the applicability of these laws to the Bitcoin network and analysis on compliance by various actors in the network with these laws. Part II begins by providing a general overview of Bitcoin, with a focus on how the network operates, how transactions occur and new Bitcoins are created, and how anonymous the system truly is. Part III analyzes the regu- latory interest in Bitcoin. Part IV discusses issues arising from U.S. citizens transacting in Bitcoins, focusing in particular on federal income taxation, tax evasion, and anti-money laundering laws. Part IV is divided into subsections that reflect provisions of the IRC that may be applicable to Bitcoin. Finally, Part IV concludes that commodities classification is the most appropriate model for Bitcoin currency. II. BITCOIN BACKGROUND Bitcoin is a decentralized crypto currency that exists digitally on the Internet through peer-to-peer networks.13 Bitcoin was created by Satoshi Nakamoto, the pseudonym for a programmer, or possibly a group of programmers, responsi- ble for the original plans and source code.14 The goal was to create a currency that did not rely on the traditional financial institutions for backing and ap- proval of transactions.15 Bitcoin relies on cryptography to encode each transac- tion, which allegedly protects users from fraudulent practices.16 Cryptography, as it relates to computers, is defined as, “the computerized encoding and de- coding of information.”17 Access to the Bitcoin network requires users to 13 Reuben Grinberg, Bitcoin: An Innovative Alternative Digital Currency, 4 HASTINGS SCI. & TECH. L.J. 159, 160 (2012). 14 Carter Dougherty et al., Bitcoin Creator Said Found As Enthusiasts Regret Unmask- ing, BLOOMBERG (Mar. 6, 2014), http://commcns.org/S9Bug2; see also Tim Worstall, Ted Nelson Says That Bitcoin’s Satoshi Nakamoto Is Shinichi Mochizuki, FORBES (Oct. 1, 2013, 11:34 AM), http://commcns.org/1h6vkcg. 15 Grinberg, supra note 13, at 162 (chronicling the rise of Bitcoin and how it fit into the desire of the “cypherpunks” to have an anonymous currency that would allow “‘untraceable pseudonymous entities to cooperate with each other more efficiently, by providing them with a medium of exchange.’”). 16 Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System 1 (unpublished manuscript), available at http://commcns.org/1jVw4RG (last visited May 18, 2014). 17 Definition of “Cryptography”, MERRIAM-WEBSTER, http://commcns.org/1waomqR (last visited Jan. 26, 2014). COMMLAW CONSPECTUS download the necessary software that creates a digital wallet,18 which is akin to a traditional bank account. This wallet provides the user with a unique address and a system for approving transactions including two keys, one “public” and one “private.”19 The “public” key serves as an address for other users wishing to transfer Bitcoins to the owner of a particular public key. The “private” key is 20 used to authorize access to the Bitcoins in that user’s wallet. Downloading the software also turns the user’s computer into a “node” for the Bitcoin network.21 In effect, the user’s computer assists in validating trans- actions.22 When a transaction occurs, there is an exchange of Bitcoins for some goods or services. The recipient of the Bitcoins provides the public key (which is attached to his or her digital wallet) to the other party, so as to enable that other party to transfer Bitcoins to the recipient’s wallet.23 Next, each party en- ters its private key into a hashing algorithm, which then provides a data code for each party to “sign” the transaction.24 These transactions can take place on a Bitcoin Exchange, which is a popular platform for people to acquire Bitcoins for fiat currencies,25 or other legal tender.