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Virtual currency in the sharing economy: Navigating the existing and new regulatory standards.

Summary: While the sharing economy has ushered in a new way for participants to share goods and services, it is the novel media through which many ...

While the sharing economy has ushered in a new way for participants to share goods and services, it is the novel media through which many of these transactions take place that can present the most unique challenges for legislators, regulators, and courts. New forms of virtual currency -- such as Bitcoin -- require application of existing regulations to new models or, in some cases, development of new regulatory schemes altogether. Bitcoin users should be aware of the regulations that govern transactions with the virtual currency, including rules promulgated by the Internal Revenue Service, the New York State Department of Financial Services, and a bill that is currently before the California legislature. This article surveys these regulations.



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Bitcoin is a decentralized, convertible digital currency that "functions as a medium of exchange, a unit of account, and/or a store of value." (Internal Revenue Service Notice 2014-21) Although virtual currency (alternatively referred to as cryptocurrency) "does not have legal tender status in any jurisdiction," it can, in certain instances, "operate[] like 'real' currency -- i.e., the coin and paper money of the United States or of any other country that is designated as legal tender . . . ." (Id.) Not surprisingly, then, the sale or exchange of a virtual currency like Bitcoin generally gives rise to tax consequences that may result in tax liability. (See id.)

These tax consequences, however, are determined by treating virtual currency as property -- not cash -- for federal tax purposes. (Id.; but see United States v. Ulbricht, 31 F. Supp. 3d 540, 570 (S.D.N.Y. 2014) (holding that Bitcoin transactions can give rise to liability under a federal money laundering statute, even though the IRS treats virtual currency as property, because "Bitcoins can be either used directly to pay for certain things or can act as a medium of exchange and be converted into a currency which can pay for things").) Calculating tax liability for a Bitcoin transaction thus requires computing the fair market value of the virtual currency at various stages of a deal (most notably at the time of receipt or payment) by converting virtual currency listed on an exchange into U.S. dollars at the then-current exchange rate. (IRS Notice.) Because a taxpayer must recognize a gain when he or she receives property exceeding the fair market value of the virtual currency's adjusted basis (and must recognize a loss in the inverse situation), taxpayers may be incentivized to frame a virtual currency transaction in a way that creates favorable tax treatment. For example, a taxpayer might attempt to categorize virtual currency as a capital asset, thereby avoiding recognition of an ordinary gain -- with attendant higher taxes -- upon disposition. Similarly, taxpayers should be mindful of the types of underlying activities through which they obtain or dispose of Bitcoins: virtual currency received by an independent contractor for performing business services constitutes self-employment income, while virtual currency received in connection with a hobby does not. (See id.; see also Internal Revenue Service Notice FS-2007-18, April 2007, Business or Hobby? Answer Has Implications for Deductions).

In addition to being mindful of IRS tax regulations, virtual currency businesses that engage in commerce with New York customers will soon need to obtain a license per New York's newly enacted BitLicense virtual currency rule. (New York State Department of Financial Services, Title 23, Chapter 1, Part 200: Virtual Currencies) On June 24, 2015, New York became the first state to adopt a comprehensive virtual currency regulatory regime. The rule, which covers most business activities that deal in centralized or decentralized virtual currencies, requires those involved in "Virtual Currency Business Activities" to submit an application, along with a $5,000 non-refundable application fee, to obtain a license. Qualifying business activities are defined to include (1) receiving virtual currency for transmission or transmitting virtual currency (except for non-financial purposes and of a nominal amount); (2) storing virtual currency for others; (3) buying and selling virtual currency as a customer business; (4) performing exchange services as a customer business; or (5) controlling, administering, or issuing a virtual currency. (Id., A* 200(q).) The Rule does not, however, require a license for consumers who buy, earn as salary, invest, or use virtual currencies for purchase of goods and services. (Id., A* 200.3(c).)

The rule imposes a host of regulations on digital currency companies, targeted at consumer protection, anti-money laundering compliance, and cyber security. Then-superintendent of Financial Services in New York, Benjamin Lawsky, acknowledged the delicate balance required in enacting such a regulatory scheme, stating, "We have a responsibility to regulate new financial products in order to help protect consumers and root out illicit activity . . . . However, by the same token, we should not react so harshly that we doom promising new technologies before they get out of the cradle." (Superintendent Lawsky's Remarks at the BITS Emerging Payments Forum, June 3, 2015)

New York is not alone in imposing regulations on Bitcoin businesses. A bill currently before the California legislature titled the "Virtual Currency Act" would require that "virtual currency businesses" -- currently defined as "maintaining full custody or control of virtual currency in this state on behalf of others" -- obtain a license to continue operation. (California Assembly Bill AB-1326, Virtual Currency.) The proposed regulation was recently amended to include a provisional application process for early-stage industry services, which would allow smaller businesses (with less than $1,000,000 in outstanding obligations) to seek conditional approval from the State's Commission of Business Oversight. (See id.)

As Bitcoin and other forms of virtual currency continue to expand their reach across the sharing economy, businesses, regulators, and consumers will need to navigate new challenges. New York's newly imposed regulations, the IRS's pronouncements, and the California Assembly Bill have provided early guidance and rules, but Bitcoin enthusiasts must be cognizant as other state and federal bodies enact regulations to govern this new realm of commerce.

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Publication:Inside Counsel
Date:Aug 13, 2015
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