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Bitcoin and Taxes (Your Favorite Topic!)

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“Each $5,000 of annual tax payments made over a 40-year period reduces your net worth by $2.2 million assuming a 10% annual return on your investments,” reports James Dale Davidson in The Sovereign Individual: Mastering the Transition to the Information Age

Just let that sink in for a bit please. Mull over the figures in your delicate psyche. Imagine the impact of $2.2mm on your future.

… now, who’s ready to talk about taxes?!

Is Bitcoin useful for tax evasion?

(NOTE: This is not tax advice, nor am I suggesting you seek to evade paying taxes. This post is for entertainment purposes only.)

There are two types of taxation regimes the world over: You either live in a country with competent or incompetent tax authorities.

If incompetent, there are a dozen other ways to avoid paying taxes, probably all of them easier than Bitcoin.

The United States is certainly one of the more competent tax collectors in the world via its ‘revenue’ (talk about a euphemism) arm, the IRS.

So our question is really: is it possible to use bitcoin for tax evasion within the US?

What can the IRS do, exactly?

As of today, the IRS simply hopes that you report any capital gains on profits obtained on net BTC purchases. However, it’s clear the IRS is trying to move from ‘hope’ to ‘coerce’ as its policy verb of choice: they’ve just asked for a broad and sweeping disclosure from Coinbase regarding its customers’ historical transaction data. Should this data be handed over to the Feds, you can bet they will start building a ledger for each customer - purchases made (volume and price) net of sales (again, volume and price) and send you a capital gains bill for any PNL realized on those transactions.

However, this doesn’t address situations in which you’ve used Coinbase (or another exchange like Gemini) solely to purchase your coins, and immediately withdrawn them to your personal, private wallet.

What will the IRS’ policy be regarding these murky situations? Remember, I’m saying ‘murky’ here because they do not know the fate of your withdrawn bitcoins. That means that you could have:

  • lost your coins -> you’d claim a capital loss in this case, since the capital you outlaid upfront is now worth exactly $0
  • held onto your coins -> you’d report nothing as you only incur capital gains upon sale of your investment
  • sold your coins -> you’re supposed to report this honestly and pay capital gains

As you can see, the main issue here for the IRS is their total and utter lack of transparency. Bitcoin does not need the IRS’ nor the Federal government’s blessing to exist - it just does. It is a completely separate, autonomous payment network that is under the control of no single individual or entity. There is no one rubber-stamping transactions like the Federal Reserve does in this country.

Some open questions, however, remain regarding the extent to which the IRS could pursue an individual (i.e. audit them) if they suspect misreporting of capital gains/losses regarding cryptocurrency holdings. Will they conduct rigorous blockchain analysis - which is extremely computationally expensive (by design, in a way… more on this in another post perhaps) - to try and piece together a story and send you a tax bill? This strategy is feasible in theory, but would represent a huge consumption of their resources in practice.

The fact is that the tools at the disposal of the IRS are limited at best.

Perhaps, though, this is for the better.

A better tax regime

In bitcoin, you pay taxes on every transaction - it’s called the transaction fee. You can voluntarily pay a higher fee and you will increase the likelihood that your (probably time-sensitive) transaction will be part of the network’s next block, i.e. your transaction will be settled in a much more timely manner. This is an example of a voluntary tax system (credit to @TravisPatron for exposing me to this concept).

[The Bitcoin] transactions queue represents a voluntary, pay-for-performance taxation structure where the performance derived from the system is dependent upon how much taxation [a user is willing to] pay.

Bitcoin puts the power back in the hands of its users. If you value the service, the right to use the Bitcoin network to move value between two nodes in the network, then you pay tax for that performance.

Imagine a system where you pay tax for roads only when you use the roads to drive. Or you only pay taxes to schools in the form of some tuition cost when your children are attending those schools.

I think that a tax regime that aligns a person’s tax liabilities with his or her behaviors (where a behavior is an expression of their preference) is a compelling vision for the future. Perhaps you will agree.

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