Crytocurrency FAQs

There is no central regulator of the technology; instead, a regulatory patchwork has emerged at both the state and federal level, and regulators do not necessarily classify the technology consistently. For example, for tax purposes, the IRS currently treats convertible virtual currency as property rather than currency. Thus, taxpayers are taxed on the receipt of such cryptocurrency and recognize a gain or loss on its sale.

The Financial Crimes Enforcement Network (“FinCEN”), a sister bureau of the Department of Treasury, also polices cryptocurrencies. Currently, those who fall under FinCEN’s definition of “exchangers” and “administrators” of cryptocurrency are treated as “money service businesses” subject to a regulatory regime under the Bank Secrecy Act that governs currency reporting and anti-money laundering.

The Securities & Exchange Commission has become increasingly active in the cryptocurrency realm.

The Commodity Futures Trading Commission (“CFTC”) has also played a role in developing the regulatory landscape. The CFTC has taken the position that virtual currencies are commodities for purposes of the Commodity Exchange Act (“CEA”), thus falling within its regulatory purview as well

Virtual and cryptocurrencies are built on blockchain technology—a technological innovation that allows for a distributed, decentralized digital ledger generally built upon cryptographic mechanisms and complex consensus protocols.

Virtual currency is a digital representation of value, other than a representation of the U.S. dollar or a foreign currency (“real currency”), that functions as a unit of account, a store of value, and a medium of exchange.  Some virtual currencies are convertible, which means that they have an equivalent value in real currency or act as a substitute for real currency.  The IRS uses the term “virtual currency” to describe the various types of convertible virtual currency that are used as a medium of exchange, such as digital currency and cryptocurrency.   Regardless of the label applied, if a particular asset has the characteristics of virtual currency, the IRS will generally treat it as virtual currency for Federal income tax purposes.

Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain.  A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.

Virtual and cryptocurrencies are built on blockchain technology—a technological innovation that allows for a distributed, decentralized digital ledger generally built upon cryptographic mechanisms and complex consensus protocols.

Fundamentally, a blockchain is a type of database-a chronological ledger of transactions recorded by a network of computers. A copy of the blockchain is saved on each computer in the network, so there is no need for a centralized administrator. The system is, in other words, “decentralized,” and therefore often referred to as a shared, distributed digital ledger.

A blockchain structure does not require a “trusted” third party to serve as an intermediary or clearinghouse in order to validate a transaction. This is a key aspect of its popularity. In our modern economy, banks typically play the role of trusted intermediary with respect to non-cash electronic transactions. Banks validate transactions and keep a centralized ledger that parties rely upon to ensure a proper accounting and to guard against double spending of currency, a problem that could otherwise give rise to runaway inflation. Blockchain, however, provides a mechanism that allows two parties that do not know or trust each other to directly engage in a transaction (i.e., on a peer-to-peer basis) without the need for a bank. It is, therefore, referred to as a “trustless” system.

Put simply, a blockchain is a ledger that records data, documents, and transactions. “Blockchain” is a combination of the words “block” and “chain.” Data recorded on the ledger is stored on the blocks, and blocks are chained together in a cryptographical sequence.

More specifically, blockchain protocol possesses three fundamental traits: decentralization, a peer-to-peer network, and distributed storage of data.

First, a blockchain is a decentralized network made up of multiple nodes or members. It does not have a central authority. Instead, control over the network is distributed among multiple participants. In a centralized structure, the entire system fails if the main node is compromised. However, a decentralized distribution ensures that the blockchain network continues to function even if one or more of the nodes is compromised.

Second, members directly interact with one another on a peer-to-peer network. For instance, transactions on the Bitcoin blockchain are conducted directly between two unknown entities without any intermediary organization, such as a bank. Similarly, two unknown entities can directly transact finance or data without any intermediary organization monitoring the process, instilling trust among the members and eliminating the need for a middleman.

Finally, the blockchain ledger stores data in a distributed network. Instead of a centralized cloud structure, data is stored on the hardware of multiple nodes in the system. In a cloud structure, data remains vulnerable to hacks every time the cloud is attacked. However, with distributed storage, hackers cannot gain control over the blockchain network’s data because it is distributed across multiple nodes. Because it has a distributed database that does not require a central authority, blockchain is often referred to as Distributed Ledger Technology (DLT).

Virtual currency is treated as property and general tax principles applicable to property transactions apply to transactions using virtual currency.

Cryptocurrency is treated as property for federal tax purposes. The IRS treats cryptocurrency as it would any other property, and applies general principles of taxation to virtual assets. Taxpayers must, therefore, claim as gross income the fair market value of cryptocurrency received in exchange for goods or services. Fair market value is calculated as of the date of receipt of the cryptocurrency in U.S. Dollars.  Taxpayers should exercise care in valuing cryptocurrency, as we anticipate a number of future challenges with respect to crypto valuations.

The IRS also warns that taxpayers must report gains or losses associated with cryptocurrency exchanges and must recognize the fair market value of any successfully mined cryptocurrency as income. Professional miners may also be subject to self-employment taxation based on the net earnings of their cryptocurrency mining activities. Employees who are paid in virtual currency are subject to the same federal withholding requirements that would apply if they were paid in U.S. Dollars. Bitcoin and related virtual currency payments may be considered legal wages in the United States, the value of which is determined by the fair market value of bitcoin in U.S. Dollars at the time of payment.

The IRS warns that underreporting the value of cryptocurrency may result in tax and penalty liability. In fact, the IRS has stated that it is “actively addressing potential non-compliance in this area through a variety of efforts, ranging from taxpayer education to audits to criminal investigations” in light of major cryptocurrency underreporting in earlier years.

Bitcoin was created by a pseudonymous founder known as Satoshi Nakamoto, who released a white paper titled Bitcoin: A Peer to Peer Electronic Cash System describing Bitcoin as a “purely peer-to-peer version of electronic cash.” Bitcoin is built on an underlying blockchain structure. Bitcoin was first introduced in 2009 against the backdrop of a global financial crisis that many consider to have been the worst since the Great Depression.  Bitcoin promised a mechanism that did not require a traditional “trusted” intermediary to conduct electronic transactions.

A fork is an event on the blockchain that copies the original software and adds the desired changes to it. Because the two blockchains cannot coexist, the new blockchain splits into two branches, forming a fork-like diversion  from the main blockchain.

Forks are updates or upgrades to the blockchain’s software protocol that result in a split in the main blockchain network. If there is a cryptocurrency running on an old blockchain, for example, a fork on that blockchain will result in the creation of a second cryptocurrency on the new, forked blockchain.

With a hard fork, the rules of the blockchain protocol are updated or changed so that the old blockchain and the resulting blockchain are incompatible.

While a hard fork is a backward-incompatible upgrade to the blockchain, a soft fork is a forward-compatible change to the rules. Because the fork is a forward-compatible change, the old blockchain will continue to accept blocks from the newly updated blockchain protocol, even though there is a change in the rules because of the new software.

Put simply, a soft fork tricks the old blockchain into accepting the new rules and, therefore, accepting both the updated blocks and the old blocks of transactions at the same time. Thus, unlike a hard fork, a soft fork maintains the old blockchain by maintaining two lanes with different sets of rules. An example of a successfully implemented soft fork is the Segregated Witness (SegWit) Bitcoin protocol update of 2015.

Cryptocurrency mining using the proof of work consensus algorithm is how new coins are created on some blockchains. Bitcoin, Monero, Ethereum 1.0, Litecoin, and Dogecoin are among the cryptocurrencies that mine their own coins.

The proof of work consensus algorithm existed long before Bitcoin, having first been introduced in the 1990s to help address the problem of spam email. In the early 2000s, Hal Finney applied it to secure digital money, and in 2008, Satoshi Nakamoto used it in his Bitcoin white paper, making Bitcoin the first blockchain to extensively use the proof of work algorithm.

It is called proof of work because nodes (devices and individuals present in the blockchain) are required to perform work that is necessary to validate a transaction. This involves solving a complex mathematical equation to unlock a transaction secured in a block. Blockchains that use proof of work algorithms are secured and verified by virtual miners with sufficient computational resources.

This algorithm helps prevent users from spending their cryptocurrency more than once in the blockchain (double-spending). The first block is hardcoded into the blockchain network to form the Genesis Block. New blocks reference the previous block and contain a copy of the ledger.

The proof of stake algorithm is the second most popular consensus algorithm, having been launched in 2012 as an alternative to its proof of work counterpart. Unlike the proof of work algorithm, it has no need for miners, and instead uses validators. Participants are required to have a sizable stake so that they can partake in validating transactions and creating new blocks.

However, they can only create blocks that are proportional to their stake in the blockchain. Most blockchains today, including Cardano, Polkadot, Tezos, and Atmos, use different variants of this algorithm. It requires no computational power and, as such, is entirely virtual. Validators are chosen based on their stakes.

The proof of stake algorithm randomly selects validators with a specific amount of staked cryptocurrency to validate transactions. This serves as cryptographic proof of their ownership and vested interest in the project. These selected nodes are responsible for verifying a valid transaction, signing it, and proposing the block for validation.

Unlike proof of work blockchains, new blocks are minted or forged. To participate, a validator must have locked a certain amount of the blockchain’s native coin into a special contract. However, staked cryptocurrencies can be lost if users breach the network’s consensus. This algorithm uses the time of stake and randomization to make node selection unpredictable.

Post-quantum cryptography (PQC) is also known as quantum-resistant cryptography, and the main goal is to develop a secure system that operates with existing network and communication protocols. It is also important that the system is shielded against both quantum and classical computers as well. In turn, these systems ensure that their personal information and other information, such as communications, business processes, and transactions remain protected against unauthorized persons.

Smart contracts are a set of promises, usually specified in a digital format, that act as the basis upon which the parties in a transaction fulfill their specific promises. A smart contract automatically pays the other party when they perform their contractual duties. Due to smart contracts’ unique nature and inherent complexity, whether they fit into the legal framework of traditional contract law is difficult to determine.

The United States has no federal contract law that applies to the country as a whole. Accordingly, contract law varies from state to state. Plus, as of October 2020, no federal law or guidance explicitly defines smart contracts’ or their legal validity. The only exception is the Electronic Signatures in Global and National Commerce Act of 2000, which provides limited legal validity to smart contracts. Since smart contracts’ legal validity is unclear, however, they are likely to result in lengthy litigation processes.

Public key infrastructure (PKI) is perhaps the most common cryptography method.

PKI involves a set of physical components (computers and software or hardware cryptographic equipment such as Hardware Security Module “HSM” or smart cards), human procedures (checks, validation), and software (system and application), all of which issue and manage the life cycle of digital certificates or electronic certificates. These tools enable cryptographic operations (e.g., encryption and digital signatures), which promote the following key security characteristics during the transmission of data:

• Confidentiality:only the legitimate receiver (or owner) of data has intelligible access to it;
• Authentication:the legitimacy of an entity’s access request (human, system, etc.) to system resources (systems, networks, applications, etc.).
• Integrity:the data has not been altered, accidentally or intentionally.
• Non-repudiation:the data source cannot deny the data’s sending authenticity.

For more, see Cryptography: Public Key Infrastructure (PKI)

The digital signature process ensures the authenticity of the sender (authentication function) and verifies the integrity of the received message. The digital signature also provides a non-repudiation function: it prevents the sender from denying having sent the message.

It contains the algorithm identifier (hash function) used by the certification authority to sign the certificate and the value of the digital signature. The hash function is used to generate a “hash value” for the encrypted message to be sent. The function always returns the same hash value if the message is not changed. However, if even one character in the message is changed, added, or deleted, the hash function will generate a different hash value. By encrypting the hash value using the sender’s private key, a digital signature of the message is generated. This signature is sent in addition to its encrypted message. The receiver can verify the message’s integrity by decrypting the signature and producing the received message’s hash value. If the hash function generated by the receiver is the same as the hash function included in the received message, the message integrity is validated.