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Closer Scrutiny For Cryptocurrency

physical tokens representing various cryptocurrencies, including Ethereum and Bitcoin.
photo by FXTM Thailand on Flickr (forextime.com), licensed under CC BY

The Internal Revenue Service would very much like to know whether you have engaged in any transactions involving cryptocurrency. The rest of us can only wonder why you would bother.

The Wall Street Journal recently reported that the IRS plans to place a question about cryptocurrencies front and center in the individual income tax Form 1040 for 2020. It is a straightforward yes-or-no query, and there will be no getting around it: “At any time during 2020, did you sell, receive, send, exchange or otherwise acquire any financial interest in any virtual currency?” The question’s prominent placement will make it difficult for taxpayers to claim that they didn’t know they had to report this information.

It is legal to engage in such transactions, but the IRS does not view bitcoins and similar artifices as money – mainly because they aren’t. They are a form of intangible property. Buying them is not a taxable event, but selling them, or receiving them in exchange for other property, generally is. Because units of cryptocurrency fluctuate constantly (and often wildly) in dollar terms, any sale or exchange of cryptocurrency may trigger a taxable gain. That is a big reason for the IRS’ interest in such activities.

It is not the only reason, however. More than a decade after Bitcoin came into general public use in 2009, we still can’t use bitcoins to buy a package of toilet paper at Amazon, anywhere in the world. You can’t use it in the vast majority of legitimate business transactions.

Money serves two functions: as a medium of exchange and as a store of value. Anything that won’t buy toilet paper at Amazon is not a medium of exchange. And anything whose value is prone to dramatic and abrupt changes in price when measured against other benchmarks – whether the benchmarks are dollars or toilet paper – is not a store of value. Hence, cryptocurrency fails both tests.

But that does not make it useless. Quite the opposite: Cryptocurrency has become a cornerstone of nearly every illicit industry on the planet, from sanctions-busting to ransomware. That does not mean no one can use it in legitimate ways, and its devotees make a point of doing so. It just seems to be far more trouble than it is worth, either to its users or to society.

The IRS is in the early stages of a campaign to drag at least some cryptocurrency usage into the open. Its tax-return question actually debuted on the 2019 tax forms, but as part of a schedule that not all taxpayers must complete. The forms Americans will begin using next spring apply to nearly all U.S. individual taxpayers (assuming the question also appears on simplified versions like Form 1040-EZ).

Then again, not all U.S. taxpayers are Americans, and not all criminals bother to file tax forms. Cryptocurrencies have found their market niche as a digital workaround to banking system rules designed to fight money laundering and terrorist financing, among other evils.

Beyond disclosure on tax forms, we can expect regulators to steadily tighten other rules in the years ahead. Exchanges that allow users to convert cryptocurrencies to spendable ones are likely to be licensed and regulated to a far greater extent than currently, both in the United States and abroad. Exchanges in this country are already required to register as money service businesses, subject to some anti-laundering rules; Americans can expect that eventually they will be required route cryptocurrency transactions through these legitimate channels. Globally, exchanges will no doubt face requirements to report transactions, the way banks and brokerages already must. Financial institutions that do business with illicit exchanges will be sanctioned.

A critical step that needs to be implemented worldwide is a know-your-customer rule. This will drive the cybercriminals out of the system, or at least make it much more cumbersome for them to use it to conduct business.

The hackers who recently attacked the Las Vegas school system, posting students’ personal information online when the system refused to pay a ransom to recover its data, were sending a message to other targets: Pay up or face consequences. It’s just an old-style protection racket, like telling a restaurateur to pay mobsters or risk an unexplained fire that will destroy his business. But mobsters on the other side of the world can reach targets here, because they do not need to send a bag man in person to collect the tribute.

At the extreme, we could outlaw the use of cryptocurrencies entirely. There is a precedent in the 1982 legislation that eliminated the issuance of “bearer bonds” in this country. A bearer bond is payable to whoever holds the paper certificate. They were issued in the U.S. for well over a century, usually with coupons that bearers would clip and redeem periodically for interest payments. These bonds’ anonymity offered the type of privacy protection that cryptocurrency users often value today. But they were easy to lose (as are cryptocurrencies, if an exchange is hacked or a password is misplaced), and readily deployed for money laundering and other criminal purposes.

Cryptocurrencies are today’s bearer bonds. I expect they will eventually meet the same fate. For now, the increasing IRS interest in them is a step in that direction.

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