How Virtual Currency Works

The following is a description of how virtual currency works, based on IRS documentation.

What Is Virtual Currency?

Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and a store of value. In some situations, virtual currency operates like “traditional currency,” i.e., the coin and paper money of a country that is designated as legal tender.

However, it does not have legal tender status in any jurisdiction. A virtual currency is “convertible” if it has an equivalent value in traditional currency or acts as a substitute for traditional currency.

Wallet

Convertible virtual currency can be digitally traded between users and can be purchased for or exchanged into U.S. dollars, Euros and other traditional or virtual currencies. In a virtual currency system, a user creates a “wallet.” A wallet is a digital computer file that contains information used in sending and receiving units of a virtual currency. When the wallet is created, a random wallet address is generated; this is a unique alphanumeric identifier, which is analogous to an e-mail address. Basic wallets can be created free of charge.

A wallet holds any number of public keys with their associated private keys. The public key and private key are similar to a user ID and a digital signature, respectively. A virtual currency user will electronically send their public key to anyone with whom he or she wants to exchange units of virtual currency. The public key contains information that verifies the wallet and the private key is used to authenticate a transaction. If the transaction is signed by both parties, the transaction is complete. A completed transaction is then introduced to a network of computers monitored by competing groups of people called “miners.” Miners maintain the integrity of a sequential public list of all transactions called the “blockchain.” Miners also validate transactions that go into the blockchain with the motive of earning virtual currency.

The Blockchain

After computers on the network confirm that a transaction is authentic, the transaction is posted to a “block,” which is a grouping of transactions. When a specified number of confirmed transactions have been grouped, a block is formed. Miners then compete against each other to find a solution to a mathematical puzzle that depends on the contents of the block. Once a solution is found, that block will
be added to the blockchain. When a new block is added to the blockchain, new virtual currency coins are generated and awarded to the miner who discovered the mathematical puzzle solution that allows the new block to be added to the blockchain. The cycle then repeats.  All transactions in a virtual currency blockchain can be viewed by the public on any computer connected to the Internet. However, the blockchain transactional history only reveals the date, the time, the amount (denominated in virtual currency), and the wallet addresses associated with a transaction. The blockchain does not identify the actual identities of the wallet owners. There are nearly a thousand virtual currencies, but the most widely known virtual currency and largest by capitalization is Bitcoin. Other virtual currencies mimicking Bitcoin using blockchain technology are known as alternative coins or Altcoins for short. Just a few examples of Altcoins are Ethereum, Litecoin, Ripple, Feathercoin, and Dogecoin.

Purchasing Cryptocurrency

In order to buy virtual currency with a medium of exchange denominated in a traditional currency, such as a conventional check, credit card, wire or Automated Clearing House (ACH) electronic payment, the virtual currency user will have to find some way to transfer traditional currency to someone who already has virtual currency and wishes to exchange it for traditional currency. This exchange can occur with anyone holding a virtual currency, but tends to be handled through businesses called Virtual Currency Exchangers that trade between virtual currencies and traditional currencies.

Currency Exchange

A Virtual Currency Exchanger functions much like an exchanger for traditional currency, except it can exchange virtual currency for traditional currency or vice versa. Because Virtual Currency Exchangers may receive conventional checks, credit card, debit card, or wire transfer payments in exchange for virtual currency, they are a link between virtual currency systems and conventional banking and money-transmittal systems. A virtual currency exchanger may operate on one or more virtual currency platforms. The exchange rate between traditional currency and virtual currency and between different virtual currency systems is typically set by supply and demand and different exchangers compete for business.

Some virtual currency exchangers are registered with the U.S. Treasury Department Financial Crimes Enforcement Network (FinCEN) as Money Services Businesses. Registration carries with it the requirement of following Anti-Money Laundering (AML) rules, including Know Your Customer (KYC) rules. KYC principles require a registered exchanger to confirm and document the
identities of its customers and to relate each account to a known beneficial owner.

IRS Tax compliance concerns associated with the use of virtual currencies

The primary virtual currency receiving attention regarding taxable transactions and tax compliance is Bitcoin, because it is the most traded virtual currency and the largest by capitalization. Bitcoin is a virtual currency that exists only on the Internet, does not have legal tender status (in contrast to U.S. dollars or Euros) and has its own value units. The value of Bitcoin against the U.S. dollar, as with many other world currencies, is determined by supply and demand on the open market and affected by factors that are typically difficult or impossible to forecast, such as an increase in investment into Bitcoin financial technology startups, security breaches, geopolitical regulatory issues, and Bitcoin exchange collapses. In the simplest concept of supply and demand, when demand for Bitcoins increases, the price increases and when demand falls, the price falls.

A tax compliance challenge faced by taxpayers transacting in virtual currency is that it may be difficult for individuals receiving income from virtual currencies to determine their tax basis for calculating gains because they may have trouble determining the value of the virtual currency when they first obtained it or in maintaining documentation to determine their tax basis. However, some taxpayers may deliberately use virtual currencies as a way to evade taxes. Because transactions can be difficult to trace and many virtual currencies inherently have a quasi-anonymous aspect, taxpayers may use them to hide taxable income. Further, in the experience of the IRS, tax noncompliance increases when there is no third-party information reporting. That is, taxpayers are less likely to report and pay taxes on income that is not independently reported to the IRS by a third party. IRS “tax gap” studies consistently show that compliance is far higher when reported income amounts are subject to information reporting by third parties. The most recent such study, conducted in April 2016 by the IRS based on 2008-2010 data, concluded that the overall rate of underreporting of income that was not subject to third-party information reporting was 63%, compared to 7% for amounts subject to substantial information reporting but no withholding and 1% for amounts subject to substantial information reporting and withholding.

Because there is no third-party reporting of virtual currency transactions for tax purposes, the risk/reward ratio for a taxpayer in the virtual currency environment is extremely low and the likelihood of underreporting is significant.

Regulatory Challenges Posed by Virtual Currency

Virtual currencies pose challenges for central banks, departments and ministries of finance and financial regulators. The main regulatory challenges posed by virtual currencies are the prevention of money laundering, collection of taxes, consumer and investor protection and the calibration of monetary policy.

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