DISRUPTION BY DECENTRALIZATION: BLOCKCHAIN, BITCOIN, & TAXABLE TRANSACTIONS, Vol. 1
Since the advent of blockchain, a new ecosystem of applications has emerged that looks to disrupt how we go about our everyday lives—comparable to the internet’s effect by many forward thinkers. Naturally, blockchain and its applications have come into contact with the furthest boundaries of our regulatory landscape. The focus of this series is to illustrate the regulatory system’s response to blockchain.
Simply put, blockchain refers to an ever-growing digital list of records, like transactions, that are bundled together to form blocks, which are linked and secured using cryptography. The formation and linking of blocks, collectively referred to as blockchain, is the process of verifying and encrypting the transaction through a series of mathematical equations. The blockchain can function as an “open distributed ledger” of transactions, managed through a peer-to-peer network adhering to a protocol for validating new blocks—similar to the Internet Protocol, the system that allows for internetworking. This peer-to-peer network is composed of users who verify and secure blocks through cryptography. Blockchain and the “open distributed ledger” decentralizes the storage of information by recording transactions on a shared peer-to-peer encrypted network.[1] Like the Internet, regulators are having to play catchup with blockchain technology companies—namely, bitcoin and ethereum.
Bitcoin entered the scene in 2009 looking to disrupt the payments system model. In short, bitcoin uses blockchain technology to record transactions between buyers and sellers who use bitcoin as the medium of exchange. In theory, the use of bitcoin eliminates the need for depository banks and other intermediaries that verify transactions between buyers and sellers. The users that manage the distributed ledger are part of the peer-to-peer network, regulated by a protocol, and compensated with bitcoins, a type of cryptocurrency that compensates users. In the context of bitcoin, these users are referred to as miners. Thus, bitcoins can be obtained through mining or purchased on a secondary market. Besides speculation, demand for bitcoin is based on its distinct characteristics of anonymity, security, low transaction cost, and speed.[2] Demand for bitcoin does not appear to be going away and federal regulatory bodies are now marching in uncharted territory.
The Internal Revenue Service (IRS) was among the first regulatory bodies to add structure to the cryptocurrency regulatory framework. In 2014, the IRS determined that cryptocurrencies are classified as property, not as a currency, and subject to taxation upon sale. Consequently, there is concern as to whether a loan denominated in bitcoin would trigger a taxable event because it would involve the disposition of property. Generally, loans are tax neutral transactions because the medium is a form of fungible currency whereas bitcoin denominated loans would be treated as a taxable disposition of property.[3] We should expect the IRS to provide further guidance for structuring loan agreements denominated in cryptocurrency.
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