Bench & Bar

SEP 2018

The Bench & Bar magazine is published to provide members of the KBA with information that will increase their knowledge of the law, improve the practice of law, and assist in improving the quality of legal services for the citizenry.

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| SEPTEMBER/OCTOBER 2018 10 BITCOIN IS NOT ILLEGAL. Often, Bitcoin is mentioned in news stories in relation to illegal drug deals, computer hacking stories, money laundering arrests, or other unsightly transactions. Bitcoin advocates would be quick to point out that traditional, paper cash is also used often in drug and other criminal transactions. Of course, Bitcoin is also used for perfectly legal transactions. For example, the popu- lar online retailer and travel website each accept payment in the form of Bitcoin. Others are slowly starting to accept it as payment as well. Kentucky lawyers should understand that while Bitcoin is sometimes used for ille- gal transactions, it is not illegal merely to possess Bitcoin or to use it as a medium of exchange in the United States. BITCOIN HAS IMPORTANT TAX IMPLICATIONS. In 2014, the Internal Revenue Service (IRS) published Notice 2014-21 to assist tax preparers in applying existing tax prin- ciples to transactions involving virtual cryptocurrencies like Bitcoin (yes, Bitcoin is the best known of a number of cryptocur- rencies). According to the Notice, Bitcoin is to be treated as property that should not be treated as a foreign currency whenever there is a gain or loss in its value. e IRS also acknowledged that Bitcoin was being used to trade for goods and services and held for investment purposes. The IRS Notice suggested that tax preparers should compute the fair market value of the Bit- coin as measured in U.S. dollars on the date it was received. e IRS also suggested that a taxpayer "generally realizes ordinary gain or loss on the sale or exchange of virtual currency that is not a capital asset in the hands of the taxpayer." 9 Notably, Kentucky was among the first states in the nation to also issue tax guid- ance on Bitcoin. In June 2014, the Kentucky Department of Revenue's Kentucky Sales Tax Facts, "A Revenue Publication for the Business Owner," stated that Kentucky would follow the IRS guidance and added W H A T K E N T U C K Y L A W Y E R S S H O U L D K N O W that "[a]ny business that accepts Bitcoins as a form of payment must convert the Bitcoin into U.S. dollars, and charge six percent Kentucky sales and use tax on any taxable transaction for which Bitcoin represents the financial instrument of consideration. Documentation must be maintained to verify the value of Bitcoin at the time of the transaction." 10 In November, 2016, the New York Times reported that the IRS was investigating customers of Coinbase, a popular online Bitcoin marketplace or "exchange" based in the United States, to identify users who failed to report income from Bitcoin trans- actions. 11 An IRS agent swore in a related federal suit in California that only 802 taxpayers reported income from the sale of Bitcoin. 12 e IRS suspects there are many others who profited handsomely from sharp increases in Bitcoin's value but who never reported those gains. Most popular Bit- coin exchanges do not provide convenient year-end forms detailing gains or losses like those sent to investors with retirement or brokerage accounts. Clients might be tempted by the esoteric and relatively private nature of Bitcoin to underreport Bitcoin assets to the IRS, or not to report them at all. eir lawyers need to remind them that the gains and losses realized in Bitcoin trades must be reported and that the gains are, in IRS parlance, an accession to wealth clearly realized and are therefore taxable. For example, if you have a client who owned Bitcoin in October, 2016, that client likely recently enjoyed a nearly 300 percent or more increase in the value of those Bitcoins. If they were sold, that gain and the resulting income should probably be reported as income. e privacy afforded by Bitcoin and other cryptocurren- cies paired with their volatile price could tempt your clients to underreport this income or the overall value of their assets. However, tax collectors at both the state and federal levels are already looking for these new, valuable digital assets. GET EXPERT HELP LOCATING BITCOIN IN LITIGATION. Because Bitcoin users may serve essentially as their own bank, Bitcoin can be easy to hide. For example, an individual desiring to hide his or her assets might purchase Bitcoins and store them on a personal com- puter hard drive or even a common USB thumb drive, just as if the Bitcoins were cash stuffed under a mattress. Alternatively, the Bitcoins could be deposited with an online third-party exchange serving as a makeshift bank, though these third-party "banks" have little to no government over- sight and many have a poor track record when it comes to security. Many of these exchanges are regulated as money transmit- ters rather than banks or traditional stock trading platforms, but more on that later. There is no entity to subpoena or call upon to produce records of Bitcoin trans- actions. e blockchain ledger is public, but transactions are only identified by a long series of letters and numbers that is unintelligible that looks something like this: 1 J C 3 e t j G 6 o S A 2 AY Z S 5 9 5 7 B 5zaZEWZbrMXW —thus, Bitcoin is "semi-anonymous." is can make track- ing Bitcoin transactions and even specific "coins" possible, but difficult for the unini- tiated. Enterprising companies are already developing ways to track transactions and identify users in order to make Bitcoin transactions less anonymous. If you're intent on locating Bitcoin assets in dis- covery, it is probably prudent to engage an expert to guide you along the way. For example, the $1.6 mil lion worth of Bit- coins seized by federal law enforcement as part of the infamous "Silk Road" investi- gation and then auctioned to the public in August 2016 13 could conceivably be traced to the buyers and then to whomever received them, though the actual identity of the buyers and subsequent holders would be much more difficult to ascertain if the only evidence available looks like source code or an impregnable internet password. Bitcoin can be easy to hide, is semi-anonymous, and Features: CRYPTOCURRENCY

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