In this high tech era of GPS trackers and unmanned drones, new concerns are emerging over the erosion of personal privacy space. A new federal law compels the Federal Aviation Administration to allow drones to be used for all sorts of commercial endeavors – from selling real estate to monitoring oil spills. That same law also makes it easier for local police to send up their own drones. This raises new concerns about how much detail the drones will capture about lives down below. Some advocacy-rights groups are quick to point out that this is nothing more than “routine aerial surveillance of American life.”

But as frightening as it might be to think that you could come face-to-face with a drone taking pictures outside of your third-floor fire escape, there is something even more frightening. And that is the piercing stare of an IRS Special Agent knocking on your door. Like the eagle-like eyes of an unmanned drone, the IRS is watching. And what they see might surprise you.

Ever heard of virtual currencies? Virtual currencies, such as Bitcoin, are revolutionizing the payments industry. At its most primitive level, they are a software-based online payment system that does not require fungible bank notes – such as dollars or Euros – as its medium of exchange. Instead, payments are recorded in a public ledger using its own unit of account.[i]

With 13 million coins in circulation and an estimated market value of approximately $ 7.9 billion, Bitcoin dominates the market.[ii] Lest you think that virtual currencies are used only by the most tech savvy and sophisticated computer users, you would be sadly mistaken. On the contrary, they have become as mainstream as pop music and reality television shows.

There is no better example of Bitcoin’s mainstream use and acceptance than the fact that large corporations, such as Expedia and the United Way, now accept it.[iii] And there is no mystery why: transaction fees are lower than the 2-3% typically imposed by credit card processors.[iv] In addition, New York leads the nation as the first state to have issued proposed regulations for licensing virtual-currency exchanges.[v]

Does all this hoopla surrounding Bitcoin sound too good to be true? If you worked in the Criminal Investigation division of the IRS, this is exactly what you would be thinking. For all its positive attributes, Bitcoin carries a dark secret. The very same characteristics that make it so desirable – namely speed and secure transfer – make it vulnerable to exploitation by white-collar criminals who seek to use it as a tool to facilitate illicit transactions.[vi] And this is precisely the reason why Bitcoin has drawn so much scrutiny by the IRS.

Now you might think of exploitation of bitcoin in the sense of a grandiose and elaborate scheme to defraud, such as “computer hacking” or the surreptitious planting of malware on a computer server. On the contrary, the most common scheme used by those with sinister motives to exploit bitcoin is quite simple: they outright steel it[vii], making chargebacks – i.e., a return of funds – next to impossible.[viii] And the fact that bitcoin is a “decentralized virtual currency” – it is “exchanged on a peer-to-peer network independent of central control”[ix] – makes it that much harder for law enforcement to monitor illicit transactions,[x] thus making it more susceptible to being “hijacked” by criminals.[xi] For example, in October of 2013, the FBI shut down the Silk Road online black market and seized 144,000 bitcoins worth $ 28.5 million (US).[xii]

But the IRS’s fixation with investigating Bitcoin is much broader than just hunting down the “usual suspects” – namely cyberthieves, money launderers, and rogue states. Instead, as so eloquently put by Josh Ungerman in his Forbes article entitled, “Are Virtual Currencies The Next Offshore Bank Account for Tax Evaders?,” it has more to do with what “a potential tax evader who is too young to have hidden money offshore [might] think he can gain by using the cyber currency Bitcoin.”

And that harkens back to why an earlier generation parked their money in banks located within offshore tax havens in the first place: to hide it from the government in order to avoid paying tax on the interest. In other words, for a dual purpose: (1) secrecy and (2) “an obtuse trail of funds.” Thus, the reason why IRS Criminal Investigation has committed a team of Special Agents to investigate Bitcoin is to prevent a new generation of would-be tax evaders to do with Bitcoin what those in an earlier generation did with offshore bank accounts: hide it from Uncle Sam.

In order to use Bitcoin, the IRS knows that “one needs a virtual wallet along with private keys and public addresses.” Unlike most “crypto currencies,” however, bitcoin does not provide complete anonymity. To understand why, it is necessary to have some background information on how bitcoin transactions are recorded.

Bitcoin transactions are permanently recorded in a public ledger called the “block chain.”[xiii] Approximately six times per hour, a group of accepted transactions, known as “a block,” is added to the block chain.[xiv] These transactions, in turn, are quickly published to all network nodes.[xv] This allows bitcoin software to determine when a particular bitcoin amount has been spent, a creative solution for preventing double-spends in an environment that lacks any regulation.[xvi] Bitcoin software stores its own copy of the block chain, making verification of the chain-of-ownership of any bitcoin amount “as easy as one two three.”[xvii]

As you might imagine, the block chain has proven to be a treasure trove of information for the IRS, allowing it to obtain the identity of bitcoin users. As Mr. Ungerman describes, the IRS does so in three steps:

“The IRS is simply accessing the block chain to review all Bitcoin transactions [Step One]. From that point, the IRS works its way back to the public address that was used in the Bitcoin transaction [Step Two]. While the public address itself does not identify the user, the IRS has been very clever in associating the public address with the identity of the Bitcoin user [Step Three].”

The IRS’s investigation into the use of virtual currencies is nothing new. For example, it has undertaken many an investigation into virtual currencies in connection with money laundering cases. However, what is new is the purpose that virtual currencies now serve law enforcement: to identify “tax cheats” who are hiding virtual money from Uncle Sam in order to avoid paying taxes. The IRS’s recent classification of “convertible virtual currency” as property and not foreign currency (for income tax purposes) proves how serious it regards the threat posed by virtual currency in the tax evasion sphere.[xviii]

Try as one might to appear non-willful in the wake of failing to disclose his Bitcoin, a tax-dodger might just as well be trying to sell snow to the Eskimos. No matter whether it is viewed upside down, sideways, or backwards, it is tax evasion. And this is where the wisdom of Shakespeare prevails even in a tax setting. Just as the quote, “A rose by any other name would smell as sweet” is used to imply that the names of things do not affect what they really are, a similar principal prevails in tax law: “substance over form.” The principal of substance over form is used to describe how the economic substance of a transaction supersedes its legal form in order to present a true and fair view of the affairs of an entity. Thus, the principal of “substance over form” might just be a “tip of the hat” (or should I say, “beret”) to the greatest English poet of all time. And who can forget the famous quote coined by yet another famous English writer that might best describe the inspiration behind the principal of “substance of form”: “imitation is the sincerest form of flattery,” by Charles Caleb Colton?

The takeaway is this. Used correctly, bitcoin is an amazing tool that offers “unparalleled consumer access to a global payment system” in an age where technology is breaking down the geographical barriers of commerce. Used incorrectly, it is a dangerous tool for those with a propensity for engaging in illicit activities, such as tax evasion. The very fate of virtual currency – i.e., whether it will live up to its potential as a revolutionary payment system and become a legitimate and trusted medium of exchange or be banished into the ethers of cyberspace – depends on “whether law enforcement and private industry succeed or fail in creating innovative safeguards to counter these new threats.”[xix] And on that note, the IRS has a word of caution for anyone who might be tempted to use virtual currency or bitcoin for anything other than a lawful purpose: “the taxman cometh!”

Original Post By:  Michael DeBlis

Footnotes:

[i] “Regulation of Bitcoin in Selected Jurisdictions”. The Law Library of Congress, Global Legal Research Center. January 2014. Retrieved 26 August 2014.

[ii] “BitPay Passes 10,000 Bitcoin-Accepting Merchants On Its Payment Processing Network”. Techcrunch. Techcrunch.com. 16 September 2013. Retrieved 21 October 2013.

[iii] Luke Sully and George Prokop, “Convertible Decentralized Virtual-Currency: A New Payment System; A New Financial Crime Threat,” Criminal Justice Section Newsletter, Volume 23, Issue 1: Fall 2014.

[iv] Wingfield, Nick (30 October 2013). “Bitcoin Pursues the Mainstream”. The New York Times. Retrieved 4 November 2013.

[v] Luke Sully and George Prokop, “Convertible Decentralized Virtual-Currency: A New Payment System; A New Financial Crime Threat,” Criminal Justice Section Newsletter, Volume 23, Issue 1: Fall 2014.

[vi] Luke Sully and George Prokop, “Convertible Decentralized Virtual-Currency: A New Payment System; A New Financial Crime Threat,” Criminal Justice Section Newsletter, Volume 23, Issue 1: Fall 2014.

[vii] Nathaniel Popper (5 December 2013). “In the Murky World of Bitcoin, Fraud Is Quicker Than the Law”. The New York Times. Retrieved 12 December 2013.

[viii]Jerry Brito and Andrea Castillo (2013). “Bitcoin: A Primer for Policymakers”. Mercatus Center. George Mason University. Retrieved 22 October 2013..

[ix] Luke Sully and George Prokop, “Convertible Decentralized Virtual-Currency: A New Payment System; A New Financial Crime Threat,” Criminal Justice Section Newsletter, Volume 23, Issue 1: Fall 2014.

[x] Luke Sully and George Prokop, “Convertible Decentralized Virtual-Currency: A New Payment System; A New Financial Crime Threat,” Criminal Justice Section Newsletter, Volume 23, Issue 1: Fall 2014.

[xi] “Statement of Jennifer Shasky Calvery, Director Financial Crimes Enforcement Network United States Department of the Treasury Before the United States Senate Committee on Banking, Housing, and Urban Affairs Subcommittee on National Security and International Trade and Finance Subcommittee on Economic Policy”. fincen.gov. Financial Crimes Enforcement Network. 19 November 2013. Retrieved 1 June 2014.

[xii] Andy Greenberg (23 October 2013). “FBI Says It’s Seized $28.5 Million In Bitcoins From Ross Ulbricht, Alleged Owner Of Silk Road” (blog). Forbes.com. Retrieved 24 November 2013.

[xiii] Bitcoin, Wikipedia, http://en.wikipedia.org/wiki/Bitcoin#cite_note-capcont-24. Retrieved 10 October 2014.

[xiv] Id.

[xv] Id.

[xvi] Id.

[xvii] Id.

[xviii] Luke Sully and George Prokop, “Convertible Decentralized Virtual-Currency: A New Payment System; A New Financial Crime Threat,” Criminal Justice Section Newsletter, Volume 23, Issue 1: Fall 2014.

[xix] Luke Sully and George Prokop, “Convertible Decentralized Virtual-Currency: A New Payment System; A New Financial Crime Threat,” Criminal Justice Section Newsletter, Volume 23, Issue 1: Fall 2014.