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Bitcoin: A Primer

Original Article by Jessica Craven | LEX LOCI CONTRIBUTOR

By now, most people have heard of the term Bitcoin. However, not many understand exactly how Bitcoins work and the legal implications of using the Bitcoin system. It is this lawyer’s
humble opinion that all attorneys should have a basic understanding of the Bitcoin system, including the potential legal ramifications, in order to best serve their clients. This article is the “Cliff Notes” version of the Bitcoin network, a “Bitcoin for Dummies” if you will.

What is Bitcoin and how does it work?
According to, “Bitcoin is a consensus network that enables a new payment system and completely digital money. It is the first decentralized peer-to-peer payment network that is powered by its users with no central authority or middlemen. From a user perspective, Bitcoin is pretty much like cash for the Internet.”

Bitcoins were created by a programmer or programmers using the pseudonym Satoshi Nakamoto. Bitcoins can be created through a process called “mining” or they may be purchased or traded for goods and services. Since its creation in 2009, bitcoins have become increasingly popular, and are now accepted
at many popular online retailers, including Virgin Galactic, WordPress, and Bitcoins are stored in a “digital wallet” that exists either on the user’s computer or in the cloud, and each transaction is recorded in a public log using only the buyer’s and seller’s
wallet IDs. In order to receive Bitcoin, you need a Bitcoin “address,” which is similar to an email address or bank account number. If someone knows your Bitcoin address they may send you Bitcoin, but they cannot take your Bitcoin or even find out your identity. Using the digital wallet, Bitcoin users may also send Bitcoin to others as long as they know the recipient’s Bitcoin address. When you send Bitcoin, the wallet application deducts a transaction fee, usually about a half a cent per transaction. For most transactions, only a fraction of
a Bitcoin is sent; as of July 10, 2014, one Bitcoin was worth about $660.

Bitcoins are not backed by the FDIC and can be lost. Most famously, Mt. Gox, one of Bitcoin’s largest virtual exchanges, filed for bankruptcy in Japan and the United States. Bitcoin owners who had used Mt. Gox were left with little recourse. In addition to bankruptcy,

Bitcoin exchanges are also vulnerable to hacking. Bitcoinica, another virtual exchange, was reportedly hacked twice and is now being sued by investors to recover approximately $460,000 in lost deposits. Even illicit Bitcoin exchanges are not safe from hackers. In December 2013, the Sheep Marketplace, a drug bazaar, was compromised, with hackers stealing more than $100 million.

Although volatile, the digital wallet and exchange technology provide a degree of anonymity not found with any other money system (other than cash). That anonymity is precisely what has
led to a variety of legal issues. On the civil side, how does one report Bitcoin transactions on a tax return? Is this even required? On the criminal side, Bitcoins are being used in drug and money laundering transactions. Trace Meyer, an expert on Bitcoin taxation, has described digital currencies, such as the Bitcoin, as the “ultimate offshore bank account.”

Civil and Tax Implications of Bitcoin In an attempt to clarify these complex issues, the IRS issued Notice 2014-21, which applies to all virtual currency, including Bitcoin. First and foremost, Bitcoin transactions are taxable events and any income from Bitcoin transactions must be reported on the individual’s income tax return. Virtual currency (Bitcoin) is treated as property for federal tax purposes. Virtual currency is not treated as currency. A taxpayer
receives a basis in the virtual currency equal to the fair market value of the virtual currency in U.S. dollars as of the date the currency is received, using the exchange rate established by market supply and demand.

So what does this mean? Suppose that I buy a Bitcoin on day 1 and it is worth $7. On day 5, I use that same Bitcoin to buy a cup of coffee. That Bitcoin is now worth $10. As a result, I have a capital gain of $3. The coffee shop has an income of $10. It seems like a lot of work for a
simple cup of joe, right? As a practical matter, the IRS may not know about Bitcoin transactions unless one of the parties involved issues a Form 1099 reporting the transaction. With the anonymity of the Bitcoin system, it is unclear how the IRS would enforce the reporting and taxability of virtual currency transactions. However, as practitioners, it is wise to advise clients that all income is required to be reported on a tax return, regardless of whether the recipient receives a Form 1099 or other similar IRS reporting form.

What effect the new rules will have on the popularity of the Bitcoin remains to be seen. “The implications this decision will have on the Bitcoin ecosystem are far-reaching, and will be burdensome for both individual users of Bitcoins, Bitcoin-focused business and for the general adoption of virtual currencies,” said Charles Allen, chief executive officer of BitcoinShop Inc., an online marketplace. Others, however, believe that the new ruling gives the Bitcoin system a legitimacy that it didn’t have before. Ajay Vinze, associate dean at Arizona State University’s business school, believes that the ruling “puts Bitcoin on a track to becoming a true financial asset.”

Money Laundering and Other Criminal Implications of Bitcoin Virtual currency has had far-reaching implications in criminal law. Because of their anonymity, bitcoins are increasingly
used for money laundering, firearm purchases, and drug transactions. Certain websites, known as “bit laundry” sites, allow users to exchange dirty Bitcoins for clean Bitcoins. The clean bitcoins are then exchanged for currency and deposited into federally regulated banking establishments.

In addition to “bit laundry” websites, other websites exist that permit users to buy
firearms and drugs anonymously, accepting the only Bitcoin as payment. These websites are accessible only through a “Tor browser,” that hides the user’s IP address, thereby preserving anonymity. On October 2, 2013, the FBI shut down one such website called “The Silk Road” and charged its operator with drug trafficking conspiracy, computer-related fraud and conspiracy to launder money. The website was referred to as the “most sophisticated and extensive
criminal marketplace on the Internet today” in the FBI’s complaint. Although the Silk Road was shut down, it wasn’t long before the Silk Road 2.0 and other similar websites were established to take its place.

In addition to the drug market, Bitcoins are increasingly being used as fodder
for Ponzi schemes. On July 23, 2013, the Securities and Exchange Commission (SEC) alleged that Trenton Shavers, the founder, and operator of Bitcoin Savings and Trust (BTCST), offered and sold Bitcoin-denominated investments which, the SEC alleged, was a sham transaction. Shavers raised at least 700,000 Bitcoins with a value of approximately $4.5 million through BTCST. According to the SEC, BTCST used Bitcoin from new investors to make purported interest payments and cover investor withdrawals, as well as pay Shavers’ own personal expenses. The SEC released an investor alert on “Ponzi Schemes Using Virtual Currencies.”

In short, the use of Bitcoin can have wide-ranging legal effects, spanning from tax reporting obligations to their use in criminal affairs. As new issues emerge, the controversy surrounding the Bitcoin network will continue to fuel new regulations and guidance. As attorneys, we should be aware of the issues so that we can advise our clients accordingly.

This article originally appeared in the Northern Kentucky Bar Association newsletter, August 2014 issue. CLICK HERE to download the August 2014 newsletter.