Five years ago, one bitcoin sold for less than $15. Two years ago, the unit price was about $500. Now, the price of a bitcoin has topped $15,000, and it's climbing fast enough to garner front-page attention by major newspapers. Since its inception, bitcoin has invoked thoughts of a shadow network where users trade in an untraceable electronic currency for drugs, weapons and other illicit goods and services. That world is not a fantasy, and some bitcoin holders have gone so far as to use bitcoins to hire hitmen, see, e.g., United States v. Ulbricht, 858 F.3d 71 (2d Cir. 2017).

But there's a mundane side to bitcoin, too. At bottom, virtual “currencies” like bitcoin are assets. According to the Commodities Future Trading Commission, they are also treated as commodities. And like many assets and commodities, bitcoins are subject to regulation. The U.S. Securities and Exchange Commission (SEC) has even begun filing enforcement actions against those who conduct “initial coin offerings” in violation of federal securities laws.

Bitcoins, however, are not traditional currency because they are not customarily used and accepted as a medium of exchange and they do not hold legal tender status, meaning that they are not backed by any central bank or government.

Here, we leave behind the glamorous—and often frightening—underground world of bitcoin and other “cryptocurrencies” and address some recent legal issues and developments affecting all U.S.-based bitcoin holders.

Yes, You Owe Federal Taxes on Profitable Bitcoin Transactions

According to the IRS, virtual currencies that can be converted into traditional currency are property for tax purposes. Because bitcoins fall into this category, taxpayers can realize a taxable gain or suffer a loss on bitcoin transactions. Given the staggering appreciation of bitcoins, this issue is especially pertinent now.

The IRS believes that cryptocurrency gains are underreported and, recently, the IRS began conducting an investigation to determine the identity and correct federal income tax liability of Americans who have participated in bitcoin transactions. In support of that investigation, the IRS served a summons on Coinbase, Inc., a virtual currency exchange, to ascertain information about Coinbase account holders who may not have paid federal taxes on profits they realized from cryptocurrency transactions. And while a federal court did not allow the IRS to obtain all of the Coinbase records it requested, the court did permit the IRS to obtain some account information for high-volume traders, as in United States v. Coinbase, Inc., Case No. 17-CV-01431-JSC, (N.D. Cal. Nov. 28, 2017).

The point is, bitcoins cannot be used as a tax shelter. Like most, if not all gains on assets, profits on bitcoin transactions must be reported.

No, You Cannot Run an Informal, Unlicensed Bitcoin Exchange

In March 2013, the Treasury Department's Federal Crimes Enforcement Network (FinCEN) issued guidance regarding virtual currency exchangers. According to this guidance notice, those who engage in the business of exchanging virtual currency for real currency, funds, or other virtual currency must register with FinCEN as a money transmitting business.

In United States v. Lord, CR 15-00240-01/02 (W.D. La. April 20, 2017), two defendants, a father and son, started a business through which they exchanged cash, credit card payments and other forms of payment for bitcoins. The two posted advertisements for bitcoin exchange services on a website. In exchange for payment, they would purchase bitcoins from Coinbase and transfer the bitcoins to the customer. The defendants charged a commission on each transaction.

The defendants eventually registered their business with FinCEN, but not before handling more than $2.5 million in bitcoin transactions. Because of their initial failure to register as money transmitters within 180 days of establishing their business, as required by the applicable Treasury regulations, the defendants were indicted for conspiracy to operate an unlicensed money services business.

Here, the lesson is that even though bitcoins are not as mainstream or well-understood as the dollar, they are still subject to many of the same regulations that govern the exchange of traditional money.

Other Recent Developments

If you're wondering where bitcoins come from, you're not alone—and you may need to use your imagination. Bitcoins are generated through “mining,” a process in which one uses specialized computers and software to solve computational puzzles. In exchange for solving these puzzles, the miner receives a newly minted bitcoin.

As bitcoins appreciate, so too do the value of bitcoin mining machines and services. In Bevand v. BF Labs, No. 16-1115-CV-W-FIG, (W.D. Mo. Sept. 26, 2017), the plaintiff brought several claims against a manufacturer and retailer of bitcoin mining machines. According to the plaintiff, who ordered bitcoin mining equipment from the manufacturer, the manufacturer used the machines to mine for its own benefit, rather than delivering the machines to the plaintiff.

Even though the case was dismissed without any factual development, it appears that the case may be a textbook example of efficient breach. In other words, the manufacturer may have concluded that the benefit of keeping the machines for itself would outweigh the cost of litigation. Some historical context supports this theory. In Bevand, the plaintiff ordered multiple bitcoin mining machines in August 2013, when the cost of a bitcoin was about $100. By November of that year, the unit price for a bitcoin rose to almost $1,000. From a purely economic perspective, the manufacturer may have come out ahead by keeping the machines, despite the legal battle that ensued.

While Bevand concerns the bitcoin market in 2013, its lessons are still relevant today. When, as now, bitcoins are in a period of rapid appreciation, manufacturers and retailers of mining equipment may be reluctant to give that equipment up, even if they are contractually obligated to do so. Bitcoin miners should be wary of these market forces.

Finally, for litigants who want to raise their bitcoin disputes in a federal forum on the basis of diversity jurisdiction, it is necessary to allege the amount in controversy in U.S. dollars, rather than bitcoins. Parties should not assume that the court will automatically take judicial notice of the conversion rate, or that the court has a working understanding of virtual currency, as in Gordon v. Dailey, C.A. No. 14-7495 (D.N.J. March 30, 2017).  

Ethan M. Simon is an associate in Blank Rome's Philadelphia office. He is a member of the firm's blockchain group and focuses his practice on a wide range of litigation matters.