Bitcoin first appeared in January of 2009 as a creation of a person or group known only as Satoshi Nakamoto. In only the past couple of years, the use of Bitcoin has grown substantially, which has presented a host of novel legal issues.

To clear up one initial misconception, Bitcoin capitalized refers to the technology itself while bitcoin lowercase refers to the actual currency. 

What is Bitcoin?

Virtual currencies and online payment systems have been around for years. However, Bitcoin is unique in several ways. Bitcoin is the world’s first convertible (can be bought or sold for real currency or accepted as a substitute), open source (its controlling code is open to public view), and peer to peer (transactions do not require a third-party intermediary such as Paypal or Visa) decentralized digital currency.

Bitcoin has made peer to peer online transactions possible without the need for an intermediary. Exchange rates for the virtual currency are determined essentially by supply and demand and are sent through an online “wallet.” Major retailers such as Overstock.com accept bitcoins directly as payment for their products and even more like Dell, Expedia, and Microsoft have partnered with Bitcoin processors to allow for the direct conversion of bitcoins into cash to be used for purchasing their products.

bitcoins can be acquired in one of two ways. The first is simply purchasing them online using a bank account, wire transfer, credit card, or simply using cash to purchase them from someone with a Bitcoin wallet. The second method of obtaining bitcoins is by “mining” them. This process involves using special software and an enormous amount of computing power to solve complex mathematical problems from which the miner will receive a certain number of bitcoins in exchange. Anyone who has the software and computing power can mine for bitcoins. To give an idea as to how difficult it is to mine bitcoins, the typical high-end computer would take longer than 435 years to mine a single bitcoin.

There is a fixed cap of 21 million bitcoins that will ever exist and sources differ has to how many have been mined at the time of publishing this article. According to the Bitcoin exchange network, as of March 2016 nearly 15.5 million bitcoins have been mined which is nearly 75% of the total available bitcoins. Yet, this number is deceiving as there are likely far fewer bitcoins actually in circulation due to lost or forgotten wallets, irrecoverable passwords, hardware failure, or death of the owner.

Advantages & disadvantages of Bitcoin

Due to its unique nature as a virtual currency, bitcoins have several distinct advantages over traditional currencies. Wallets and transactions involving bitcoins are nearly anonymous as a result of their highly encrypted nature. Wallets are assigned an “address,” similar to an e-mail address, that is identified by an alphanumeric string. Each transaction is also assigned a series of letters and numbers, stamped with the date and time of the transaction, and posted on a public ledger, which is shared with every device on the Bitcoin network. The highly encrypted nature of Bitcoin not only provides security from data and identity theft, but also provides transparency for every transaction.

There are also a number of factors that may discourage use of Bitcoin. First, there is a lack of backing from a financial authority, bank, or government. As a result, there is no insurance for instances of fraud, hacking, or other breaches in security. The digital nature of Bitcoin makes wallets and exchanges especially vulnerable to cyber attacks. Furthermore, the conversion rate to U.S. currency tends to be volatile which is typical more of a commodity as opposed to a form of currency. This volatility suggests that the market for bitcoin is being driven by speculative investors, which creates an incentive to hoard bitcoins rather than spend them. There is also concern that Bitcoin has the potential to facilitate money laundering or be used as payment of services for other illegal activities, due to its private nature.

Can bitcoins be used as a form of compensation for employment?

The short answer is yes, but in only limited circumstances. All employers must comply with the overtime and minimum wage requirements of the Fair Labor Standards Act (“FLSA”), which generally stipulate that minimum wage and overtime must be paid with cash or a negotiable instrument (a check). Beyond these requirements though, the form of compensation is entirely up to the employer and employee. Thus, employers could pay additional compensation amounts with bitcoins.

Bitcoin and securities

The Commodity Futures Trading Commission (“CFTC”) has also provided some clarity on bitcoins and securities. In an order issued on September 21, 2015, the CFTC settled charges against an online platform for conducting activity related to bitcoin transactions without complying with the Commodity Exchange Act (“CEA”) and CFTC regulations. The platform was offering bitcoin options without registering as a swap exchange under the CEA and CFTC regulations. This is the first time that the CFTC has affirmatively placed bitcoins within the definition of a “commodity” under the CEA. Consequentially, this order has definitively placed virtual currencies within the regulation power of the CFTC. In combination with this order, the CFTC also issued its first ever temporary approval order to a bitcoin derivative startup for its application to register as a swap execution facility.

How are bitcoins taxed?

On March 26, 2014, the Internal Revenue Service (“IRS”) released a notice providing guidance virtual currency. The IRS has stated that virtual currency will be treated as property under the tax code. A taxpayer must include virtual currency in his or her computation of gross income at the fair market value (“FMV”) of the currency measured in U.S. dollars at the date the currency was received. Yet, virtual currency is not treated as “currency” in terms of the ability to generate foreign currency gain or loss. The IRS also established the basis as the FMV at date of receipt, which is determined using the exchange rate in a reasonable manner that is consistently applied. In instances where there is an exchange of virtual currency, the taxable gain depends on its characterization as either a capital asset (taxed as a capital gain), or inventory held for sale to customers in a trade or business (taxed as an ordinary gain).