The Freeman Law Project – Podcast Episode 3 – Cryptocurrency: A Brief Primer

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Jason B. Freeman

Jason B. Freeman

Managing Member

214.984.3410
jason@freemanlaw.com

Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine , a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

The Freeman Law Project – Podcast Episode 3 – Cryptocurrency: A Brief Primer

For a link to our podcast, The Freeman Law Project, Episode 3 – Cryptocurrency, download here or check out other episodes of The Freeman Law Project.

The following is an uncorrected closed captioned transcript of the podcast episode.

Welcome to the Freeman law project, a podcast with thought provoking insights on tax and white collar matters the art of trial lawyering and the most influential legal issues of the day brought to you by some of the nation’s top legal minds. And now your host,

Jason B. Freeman:       Welcome to episode three [00:00:30] of the Freeman law project. I’m your host, Jason Freeman. Today, I’m going to give you a down and dirty background on cryptocurrencies, a topic that I am particularly partial to, and one that will no doubt be revisiting in our series of cryptocurrencies, raised some very interesting questions, you know, fundamental questions, like what is it, where do crypto transactions occur? For example, as you’re going to see there’s a case to be made [00:01:00] that in a sense they occur everywhere or nowhere at the same time, that makes it fairly hard to tax and regulate that. Should it be regulated who should regulate it? If so,  as you’ll see, there are multiple agencies that have thrown their hats into the ring. For example, we’re going to talk about the IRS. The IRS treats cryptocurrency as property for federal tax purposes. But a sister [00:01:30] agency FinCEN FinCEN is a sister Bureau of the treasury department.

FinCEN actually treats it as something else. It treats it as more of a substitute for currency, which of course brings it under FinCen’s  jurisdiction. Now, other agencies have also chosen to treat cryptocurrency as something different. For example, the com the commodities futures trading commission, the CFTC [00:02:00] has actually taken the position that cryptocurrencies are generally commodities, of course, bringing it under its jurisdictional purview, the securities and exchange commission. The sec for its part has taken the position that many tokens, for example, ICO or initial coin offerings, constitute securities for purposes of federal securities laws. That of course brings them under the jurisdiction of [00:02:30] the sec. And we have not even begun to get into how the various States are looking at it and how other countries and their regulatory agencies are looking at it. You know, just canvassing the various federal agencies that have, have looked at it. I think I can, can sum it up. And one, a simplified proposition. It seems that federal agencies are going to construe this as whatever is that [00:03:00] brings it under their jurisdictional purview.

But when it comes to tax professionals, there are some serious reasons that you need to get a handle or have a handle on the way that cryptocurrencies are treated. If for no other reason, it is out there, your clients are using it, whether you know it or not, and the IRS is taking serious enforcement actions. Now we can look back at [00:03:30] and draw some very interesting parallels, looking back again to the international realm over the last 10 years or so, there has been really a revolution in international tax enforcement, and you can trace it back to some events that occurred during the 2008, 2009 time period when a whistleblower came forward and actually blew the whistle on UBS, the largest Swiss bank, [00:04:00] um, Switzerland of course, being the poster child for bank secrecy and, and hidden undisclosed accounts. Well, this whistleblower Bradley Birkenfeld was his name. And he ended up as just a side note, um, receiving the largest IRS whistleblower claim reward in history, some 102 odd million dollars. But mr. Birkenfeld basically gave the government [00:04:30] the goods on the Swiss banks, and this led to some prolonged investigations into a number of about a dozen Swiss banks. Well, the IRS, and more specifically the department of justice, cut a deal with UBS back in 2008. And as part of that deal, UBS agreed to turn over the names of several thousand us taxpayers. [00:05:00] Now this got lost in a illegal shuffle, but nonetheless, the IRS was able to really leverage and publicize the fact that it was going to receive, uh, these names of, you know, us taxpayers who had previously failed to disclose their Swiss bank accounts. And as part of that process, the IRS created something known as an offshore voluntary disclosure program that actually was rolled out in 2009. It was a short term [00:05:30] program and the basic deal was, Hey, if you come in before we get your name, uh, you’ll be timely. We’ll take you into this program.

You will, you will pay a uniform tax penalty that is significant, but less than you would receive otherwise. And we’ll give you a criminal amnesty. Well, the IRS ended up rolling out three subsequent, uh, programs of this nature, the course of nearly the following decade. [00:06:00] And at the end of the day between this program and a sister analog program, uh, we see more than a hundred thousand us taxpayers come forward and disclose previously undisclosed foreign bank accounts, not just Swiss accounts, but all across the globe and some 11 plus billion dollars, um, brought into federal coffers. Uh, now you attack on the, the civil audits [00:06:30] and the criminal prosecutions that ensued from, you know, all of this, and you really, really had a revolution in, uh, the international tax enforcement realm. Well, let’s go back to the subject of today’s podcast. So the, the international, uh, investigations really,  stemmed out of the use of something known as John DOE summonses, the IRS utilize these John DOE summonses [00:07:00] to extract information, uh, from foreign banks.

Well, what you see them doing now in the context of cryptocurrencies is utilizing that same play from that international tax playbook. Um, the, we saw just a couple of years ago, uh, DOJ and the IRS, uh, issue a John DOE summons to Coinbase the largest domestic [00:07:30] virtual currency exchange, uh, in the United States. And we saw legal battle, uh, ensue from that that lasted several years. And at the end of the day, Coinbase ended up turning over several thousand, uh, account holders and their data and has really instituted some reporting regimes. Um, you know, the big takeaway here is, is again, the government is utilizing the exact [00:08:00] same plays from that playbook that led to really the most successful program, uh, in IRS history, in this revolution in international tax enforcement. Now we should also take note of the fact that during this litigation with Coinbase, there were several remarkable, uh, remarkable affidavits that were filed by IRS agents.

One of those indicated that after a thorough review [00:08:30] of IRS records, they had come to the conclusion that over a three year period, this was 2013 to 2015, um, that no more than somewhere between 800 and 900 us taxpayers had properly reported their cryptocurrency transactions. Now I’ll tell you, I take complete issue. I, I find that to be a figure that is difficult, uh, to believe, uh, just based on anecdotal observations, [00:09:00] but nonetheless, the important takeaway that you can’t really argue with is the IRS believes there is significant, significant under reporting and noncompliance, and it has sunk a lot of costs, uh, and resources into enforcement in this area. It’s going to be a focus for years to come. So what are cryptocurrencies and what is Bitcoin let’s, let’s go back and [00:09:30] put this in historical perspective. And again, we take a trip back to the 2009 timeframe.

You know, it was really in 2008 that Bitcoin was first kind of published at least a white paper on the subject. And that was published by the inventor, the tsunami emus inventor, Satoshi Nakamoto, and we still don’t know Satoshi Nakamoto is actual identity. The first, [00:10:00] um, uh, Bitcoin was issued in January of 2009, it was, what’s known as the Genesis block of the Bitcoin blockchain. And now I said something fairly interesting there, I made a reference to blockchain and many are not aware that Bitcoin was actually the first application or use of blockchain technology. It leveraged a blockchain, um, infrastructure. [00:10:30] Now during the first few years, it was certainly Bitcoin that received, you know, all of the publicity and the hype, but I think some years later, many caught onto the fact that perhaps it was blockchain that even held the greater potential for revolutionary, you know, social and economic change, but go back and think about the historical context in which this was, was released in that, in that 2009 timeframe [00:11:00] what’s the Atashi Nakamoto was trying to do here was to create a system of currency that did not rely upon a trusted third party intermediary, or a trusted financial intermediary, that in this context being the fed, the fed of course in our monetary system or banking system essentially keeps the books and ensures that we don’t have double counting in accounts and therefore [00:11:30] a runaway inflation and assists us.

We, we, we place a degree of faith in the fed and in those books and therefore in our monetary system. Well, what Satoshi Nakamoto was trying to do was to introduce a system that really democratized or decentralized, um, the monetary system and got rid of the need for this third party intermediary. In other words, the goal here [00:12:00] was really to create a system of economic transactions that could take place on a peer to peer basis. And importantly, it was done in a manner where those viewing the monetary system, the Bitcoin monetary system could have faith in the supply and the location of those of the cryptocurrency. What has been a fairly interesting [00:12:30] evolution of Bitcoin in particular, but cryptocurrencies generally is that we have really seen a trading of that historic financial intermediary of the banking system and the fed, uh, we’ve seen that traded out for what are now virtual currency exchanges and a potential downside here is they have in general, not been subject to the same level or have not submitted to the same level [00:13:00] of regulation and governmental oversight, which, you know, some see as a pro and some see as a con.

Okay. So cryptocurrency, what the heck exactly is it, um, what is a blockchain, uh, you know, let’s, let’s take up the concept of blockchain first, um, blockchain at heart, as much as they’re as much hype and mysticism as there is behind the concept at heart, it is essentially a data structure, [00:13:30] a database, if you want to think of it that way. Um, and it is a data structure that’s maintained through a distributed ledger. And what that means is it’s not a centralized ledger in the sense that the fed to keeping the books. And my prior example, uh, would have been it’s a non centralized or distributed ledger. It’s an append only data structure. At least your typical public [00:14:00] blockchain is append only. And that means it has some built in security features that don’t allow for, uh, the blockchain, the, the data, the blocks of data or information contained in those blocks to be removed.

They are append only as the name suggests now, how do we decide what goes into this distributed ledger and gets recorded in these blocks, these chained blocks [00:14:30] of data? Well, we decide what goes in there through a consensus protocol and I’ll save the technical mumbo jumbo of that for a subsequent podcast in the series. But what you can think of that is, is they are the rules of the game at time zero. They are, the rules are the constitutional that we all agree upon. And in following those rules, that’s how we determine. And that’s how we agree that a particular [00:15:00] ledger or representation of the current state of affairs is the current state of affairs and accurately represents the assets that are intended to be represented by that blockchain, that distributed ledger. Now from a tax perspective, perhaps, um, probably it’s enough for the professional to recognize or understand that the ledger [00:15:30] is essentially tracked by nodes across the world on this distributed ledger that is actually housed on each node.

And it’s for that reason that, you know, I made the statement earlier that in a, in a very real sense, there is a cogent argument that transactions on the blockchain or on a blockchain occur everywhere or nowhere at the same time, [00:16:00] depending on your perspective. Okay, what is a digital currency that utilizes this blockchain infrastructure or distributed ledger? Well, you know, digital currency is, as the name suggests is created and held electronically, it’s not printed, it’s a digital file, much like a PDF or an MP3. You know, it can be lost, it can be stolen. And in fact, there are many stories of lost [00:16:30] or stolen, uh, cryptocurrencies, um, you know, and millions of dollars, essentially evaporating as a result, I’ll use an analogy that helps really drive home the concept, think of the digital currency as something of a bank account. Now, the account is represented or located at some specified location [00:17:00] on a blockchain, uh, the currency or the account holders, ownership of currency is signified by information that appears on the account.

Now that account will not have the account holders or account owners identifying information, unless of course they, uh, wish to place that on the, uh, on [00:17:30] the account or on the blockchain to allow viewers to identify them with the asset holdings. Now, how does an account holder use the coins or the assets that are associated with their account or, or place on the blockchain? Well, this is where concepts of public key, private key cryptography, uh, really come into play. And you can think of it [00:18:00] kind of like this each, each, uh, account or, or coin if we’re talking about Bitcoin has a public key and a private key, um, uh, you can think of the private key as something of a, of a password of an extremely complex, uh, uh, extremely complex strand of alphanumeric characters that really [00:18:30] function as a password and no one can access or utilize the Bitcoin that are associated with a public key. That is again, associated with the, with a spot on the blockchain. If you want to think of it this way. Um, no one can access that without coming forward with the private key, the password, and mathematically, [00:19:00] it works as such where the public key and the private key

Are cryptographically linked in a very complex, uh, through a very complex cipher algorithm. And they are linked in such a way that, you know, under, under assumptions of current computing power, one could not, uh, or the world could not go out and through brute force, um, take wild guests, [00:19:30] wild guesses at the, uh, password that would unlock, or that would sync up with the public key, at least not in the, the, uh, time of the existence of the universe, but it is, it is such where, when someone comes forward with that private key, while it is very, very, very difficult, if not impossible to guess, a, a match or an alphanumeric strand that, that matches [00:20:00] up, um, it is very, very, very easy to verify or validate that one who’s come forward with that private key does in fact have the private key and it’s that, that unlocks and allows for the use of the Bitcoin or other crypto asset that’s associated with a spot on the blockchain.

Okay. So again, in a nutshell, that’s basically how it works. We’re going to come [00:20:30] back to this topic and we’ll delve in, on future episodes, uh, into some of the, some of the nuances on how exactly this works. Um, but for now, you know, that’s enough to get a working understanding, to have some grasp on, you know, for our tax, some grasp on the working rules, rules that by the way, have existed for decades, um, or that you just need to apply to this, you know, this new technology [00:21:00] and new, uh, way of transacting business. So I mentioned earlier that the IRS treats cryptocurrency as property, and that’s an important, fundamental rule that really everything else flows from. Um, the IRS had a choice here. It could have treated cryptocurrency as something else as currency. Instead, it has chosen to treat cryptocurrency as property. [00:21:30] Um, one important consequence that flows from this, every transaction is effectively a barter transaction, bartering property for something else, for services, for other property, for other cryptocurrency that is property.

And that means every transaction is a potentially taxable event. And exchange of property was just like in the world world, [00:22:00] you know, outside of this context is a taxable event, and that means we need to know the fair market value of the property we’re giving up. And we need to know our basis in that asset that we’re giving up in order to calculate the gain or the loss on the transaction. And anytime your calculating a gain or loss on the transaction, it gives rise to the question of, well, what’s the character of that gain, for example, [00:22:30] uh, is it capital, is it ordinary income? Um, and the answer here is it depends. Um, it has always been a question with any, in any property transaction. It’s always been a question of the manner in which, and the intent with which the holder of the property holds that property.

For the vast majority of transactions out there, they’re going to be capital transactions. [00:23:00] Um, but you will have some, you know, it’s certainly very easy to identify or think of, uh, some situations where, uh, the holder of the cryptocurrency may actually be holding it in a manner that looks more like inventory, um, you know, a manner that would give rise to ordinary income, but again, for the vast majority of cryptocurrency holders, it’s going to give rise to capital transactions, capital income, or loss. [00:23:30] Um, what about where you receive cryptocurrency, um, for providing services? Uh, unfortunately it’s taxable just like receiving cash or just like receiving any other property gives rise to a event it’s taxable. Uh, what about mining? Um, mining gives rise to taxable income as well. You know, the IRS has taken the position that [00:24:00] minors, um, uh, minors, their activities give rise to income when they receive, uh, or successfully mine, a cryptocurrency like, uh, the way that the Bitcoin, uh, uh, ecosystem or block blockchain structure operates to compound the bad news for minors.

The IRS also takes the position that, where those activities, you know, the miner’s activities rise to a significant [00:24:30] enough level. Um, those activities, um, actually constitute a trade or business and therefore also give rise to self employment income. Um, and so, you know, the miners out there, you’ve gotta be aware of that. There are a host of other, you know, uh, other more nuanced issues for miners. Like the question of whether mining pools may, uh, may actually give rise to partnerships that that need to file a 10 65 [00:25:00] for, for federal tax purposes. So there are just a host of interesting issues and topics, um, dealing with, you know, how our system grapples with and treats cryptocurrency, uh, dispositions and transactions. And we are going to dive into some of those, uh, more esoteric, more, uh, interesting or higher level topics, [00:25:30] um, in some of our future podcasts, uh, where we’ll look at things like the taxation of hard forks, um, what are the international tax reporting implications, um, are there, uh, section 10 31 non-recognition treatment, uh, consequences for some, uh, cryptocurrency transactions?

What are the tax consequences for an ICO, an initial [00:26:00] coin offering? So again, we’ll dive into some of these topics in, in future episodes and really drill down, you know, and, and, and answer some of these interesting, interesting questions for now. I really wanted to get an episode out there to start giving our listeners some general background, uh, and moorings, and exactly how you know, how this, uh, technology cryptocurrency and blockchain, uh, operates [00:26:30] on a, on a somewhat basic level. So want to thank you for joining in, I hope you’ll join us on the next episode of the Freeman law project.

Cryptocurrency and Blockchain Attorneys

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