Don Katz on Cybercurrency Bitcoin

By Steve Thorpe

Legal News

The Katz Law Firm announced recently that it will begin accepting Bitcoin as payment for earned legal fees. Don Katz is the Managing Member of the Birmingham firm. Katz focuses his practice on business planning, mergers and acquisitions, commercial transactions in the aviation and automotive market sectors, as well as taxation matters. He has also been published on the topics of taxation, aviation, government contracting, and e-commerce.

Thorpe: Bitcoin is a cryptocurrency. What the heck is that?

Katz: Cryptocurrencies, such as Bitcoin, are digital currencies that utilize cryptography to ensure the holder is the only recipient of any value associated with that particular digital currency. Bitcoin transactions are reflected on a public ledger displaying each peer-to-peer transaction involving the digital currency absent of any and all banking authority; transfers can be completed direct from holder to recipient, generally without fees. Such transactions are public but the parties can remain anonymous. Cryptography is the method of storing or sending information so only the creator or intended recipient can access it. Most people refer to this as encryption and decryption. This process provides an ultra-high level of security, which can make it much more difficult to counterfeit digital currencies.

Digital currencies like Bitcoin differ from traditional currencies (a.k.a fiat currency) because digital currencies do not derive their creation, derivation or value from government regulation or support; they operate on a public ledger, independent of central banks. Bitcoin has a fixed quantity that will ultimately be in circulation, unlike fiat currency, which can be printed and regulated in accordance with the issuer's monetary policy. Similarly to fiat currency, Bitcoin is not backed by an underlying asset, such as gold. However, Bitcoin is not "legal tender" which would require its acceptance for debts by law.

As lawyers, we look at these instruments and the surrounding issues pragmatically. To the extent that Bitcoin or other digital currencies are units of value, perceived or otherwise, the reality is that they are being traded and exchanged for goods and services all over the world. We simply see this as commerce, the underlying asset is legal and transferrable. Whether it's Bitcoin or pork bellies, these transactions are part of the economic landscape, attracting miners and speculators alike. The assets have tax consequences and an economic impact on those involved in the Bitcoin market, so naturally we are interested in advising on transactions and taxation issues surrounding these assets. Currently, the available exchanges may not provide the epitome of liquidity, but there are buyers, sellers, and listed exchange rates, which in our estimation, creates sufficient economic validity. While it true that Bitcoin has achieved some legitimacy in the investment world, we still feel the tax consequences will more likely than not hamper Bitcoin's mass adoption by consumers, at least in the United States.

Thorpe: Why and when did your firm start thinking about accepting Bitcoin?

Katz: We were certainly aware of the existence and use of digital currencies for the past four years or so, but we felt that the "unknowns," particularly the asset classification and ambiguous tax treatment of Bitcoin, were outside our risk tolerance. However, two contemporaneous events occurred that triggered our closer examination of Bitcoin. In March, the IRS issued guidance on the classification and taxation of digital currencies; that same week, a foreign-domiciled client expressed a desire to pay for our services in Bitcoin. Since we are a client-driven business, we decided that it was prudent to examine the role of Bitcoin for our clients and develop a strategy to address digital currencies. It was clear that Bitcoin, or some digital currency, would likely remain a meaningful part of the economic landscape for years to come. Consequently, we invested time and resources to establish a policy and infrastructure to accommodate clients that choose to pay us in Bitcoin.

Thorpe: What sort of infrastructure did you have to put in place to accommodate Bitcoin?

Katz: The firm established a digital wallet and transactional account with Circle Internet Financial to accept payments and convert digital currency to fiat currency. The firm's account is insured and will not be used for retainers or fees not yet earned. We did a complete risk and tax assessment. With respect to the collection of retainers, fees and reimbursable costs when accepting Bitcoin, we were greatly concerned about compliance with our professional responsibilities. Currently, we have not developed a hedging strategy that would address the price fluctuations in Bitcoin, but if the payment amounts become significant, we will need to develop a strategy to address such risk because we are lawyers, not Bitcoin day-traders.

Thorpe: What type of client might prefer to deal in Bitcoin?

Katz: International clients may prefer the speed and convenience of delivery, especially in jurisdictions where there are central bank restrictions on the removal of the local currency to foreign jurisdictions. Also, individuals or companies that wish to have transactions remain private might see Bitcoin as protecting their identity because the ledger recording the transaction is transparent for the world to see, but the parties to the transaction can remain anonymous. The privacy issue is not completely settled as there are certainly discovery rules, subpoena powers, and other disclosure exposures that do not make the privacy foolproof.

Additionally, some clients might feel that their negotiating posture is somewhat improved when dealing in Bitcoin rather than fiat currency because the quoted value of Bitcoin may be public but the deferred tax attributes are private, which singularly affects the value of the Bitcoin to the holder of that asset. That is, unlike fiat currency, the after tax value of Bitcoin is not a constant, nor the same for every party to a transaction.

Thorpe: What are some of the ethical and tax considerations involved with Bitcoin transactions?

Katz: In the first quarter of 2014, the IRS took a clear position on Bitcoin as property and not a "currency." This finding was a serious blow to the Bitcoin community because it did not extend Bitcoin the same treatment as other fiat currencies as "legal tender."

Bitcoin, like other digital currencies that are "convertible" by sale or exchange with fiat currencies, will always result in a taxable event to the taxpayer either disposing or receiving Bitcoin. The tax consequences from transactions involving Bitcoin can be immediate or deferred. Further, the resulting tax effect may be at varying rates, depending on the nature of the transaction and who is acquiring or disposing of the Bitcoin. For example, a buyer of legal services that pays with Bitcoin is taxed on the liquidation of the position being transferred. If that Bitcoin position was held as inventory because he was a trader in Bitcoin, the tax result would stem from Bitcoin as an ordinary asset, not a capital asset. Conversely, if such a position was held as capital asset, the liquidation to pay a legal bill would result in capital gain or loss depending upon the basis the client has in the Bitcoin and the rate of tax would depend upon how long the asset was held, over or under twelve months, just like a stock or bond.

The IRS has made it clear that Bitcoin will not be a "currency" under U.S. tax law anytime in the near future, which alleviates our principal ethical (or legal) issue that we had with Bitcoin. With the IRS finding that Bitcoin is "property," we feel that any potential conspiracy charges claiming Bitcoin transactions undermine the coinage or currency of the United States are essentially moot. Prior to the IRS guidance in Notice 2014-21, we felt this was a real concern. However, Bitcoin is arguably just a security program to which people have attached a value, just like any other property.

Whether the Bitcoin holder will be paying for dinner or a pack of chewing gum as a matter of course remains to be seen. We think the tax reporting and accounting burden make such transactions impractical and therefore unlikely in United States. That said, there are certainly transactions where Bitcoin and other cryptocurrencies can take advantage of tax planning techniques and gain efficiencies not available in fiat currencies. Of course, those tax strategies are proprietary and we will not share them here.

Thorpe: You're not planning on using Bitcoin for client trust accounts. Why?

Katz: Once we had proper guidance from IRS Notice 2014-21, with respect to the classification of Bitcoin as property, we were able to more fully analyze the economics of transactions involving Bitcoin as they related to our professional obligations as well as reconcile the legal and tax principals with our risk profile.

Without getting too technical on the tax issues, in Notice 2014-21, the IRS determined that virtual or digital currency, such as Bitcoin, constitutes "property" and not a currency or legal tender, whereas such asset classification establishes different responsibilities for lawyers when accepting certain types of payments into client trust accounts. Firstly, we couldn't figure out how to accept and hold the property in kind in the client trust account and freeze the value so that the transaction would not be subject to price fluctuations before liquidation and settlement of the client's account. Therefore, converting the retainer to U.S. dollars would be problematic in the event the retainer or a portion was returned, which often happens. If the Bitcoin value rose dramatically, the firm's responsibility about the amount to be returned would be in question. These risks remain unclear, and upon some informal discussions with the State Bar of Michigan ethics attorneys, we determined that only payment for services performed would be consistent with our professional obligations

Published: Mon, Dec 22, 2014

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