A Primer on Cryptocurrencies
by Reynold Cicalese III, CPA, MST, Alloy Silverstein Accountants and Advisors –
March 23, 2018
Over the last several years, the economy has seen the development of new currencies in the national marketplace. Traditionally, a consumer would have to pay with either hard cash or credit when closing a transaction. Those are no longer the only options.
Retailers such as Overstock.com, Microsoft, Shopify and others are now accepting cryptocurrencies as a payment method. Unfamiliar with cryptocurrencies? You’re not alone. You’ll need to become familiar with these types of transactions, as all signs point to them becoming more prominent in the market.
If a transaction is taking place in a virtual currency, it is using blockchain to complete the payment process. Blockchain is essentially a network of computers that maintain a database or ledger listing the transactions taking place. It is a public data-base that is stored on computers across the world. Blockchain has security built into the database that prevents the alteration of transaction data. In order for data to be altered, the world-wide computer network would need to be attacked at the same time. The inherent security within the database also allows for the easy verification of the data. Blockchain is a decentralized system, meaning there are no authorities maintaining rules or regulations.
Every blockchain transaction is encrypted with a private key and a public key. The private key belongs to the owner of the cryptocurrency, and it is used to encrypt the data flow between the computer networks. The public key is used by the computer network to decrypt the data. The network then uses a digital signature, which is a combination of the private key and transaction data, to verify the authenticity of the transaction. All transaction data is presented in the form of blocks. In order for a transaction to be completed, all the blocks in the blockchain must be present.
As you can see, there are many benefits of using blockchain to complete a transaction. Using blockchain establishes an identity in a digital marketplace. The public key is how you are identified in the database, and the private key is protected and provides your consent to a transaction. Also, the transactions are completed in highly secured, decentralized database.
Blockchain is used in most virtual currency transactions, but it is also expanding into other areas in the marketplace. For example, banks are researching and developing methods on how to use blockchain in their businesses. Some banks have even gone so far as to develop new cryptocurrencies that can be used to transact business. While Bitcoin is the most well-known of all the virtual currencies, there are many others available for use as well.
As the most well-known cryptocurrency, Bitcoin leads the market in terms of volume and market capitalization. It has been in existence since 2009. Like most other cryptocurrencies, it uses blockchain and there is no central authority controlling it. In August 2017, Bitcoin went through a fork where it was split into two different virtual currencies. The fork resulted in the creation of Bitcoin Cash (BCH). The biggest difference between the two is that Bitcoin Cash can support about eight times as many transactions in a day than regular Bitcoin. As of early January 2018, the market capitalization of Bitcoin was roughly $236 billion, and the USD exchange rate was about $14,000/1BTC. The market capitalization of Bitcoin Cash was about $42 billion, and the USD exchange rate was about $2,475/1BCH.
Litecoin is a cryptocurrency that was developed in 2011. It is an open source currency that is being used globally. Litecoin uses blockchain to facilitate transactions, but it does this about four times faster than Bitcoin. It is not monitored by any central authority. As of early January 2018, the market capitalization for Litecoin was over $13 billion, and the USD exchange rate was about $240/1LTC.
Ethereum is another alternative to Bitcoin. It was developed in 2014. Like other cryptocurrencies, it uses blockchain to facilitate transactions and it is not monitored by any central authority. Also, Ethereum has the backing of large banks and other companies through the Enterprise Ethereum Alliance, an organization with the aim of increasing the use of Ethereum by businesses. As of early January 2018, the market capitalization for Ethereum was $130 billion, and the USD exchange rate was about $1,345/1ETH.
One of the most beneficial features of Ethereum is that it allows for smart contracts. The basic premise of a smart contract is that it allows money to be exchanged after specific conditions are met. As an example, assume a manufacturer sells products to an out-of-state customer. The customer purchases the products using an Ethereum smart contract, and it is agreed that the customer will provide payment once the products cross state lines. A smart contract would trigger payment to the manufacturer once the location condition is met. Not all virtual currencies have this ability, but Ethereum is one that does.
Ripple is a virtual currency that has been around since 2011. The cryptocurrency is part of the Ripple payment network. Essentially, Ripple is the credits used to make purchases on that network. One distinction from other virtual currencies is that Ripple uses its own payment protocol to facilitate transactions. As of early January 2018, the market capitalization for Ripple was roughly $73 billion, and the USD exchange rate was about $2/1XRP.
Virtual currencies are being used more often to conduct business transactions. Realizing this, the IRS provided guidance on the tax implications of using cryptocurrencies. IRS Notice 2014-21 specifically outlines how existing tax law applies to transactions where a digital currency is used in the transaction. Major takeaways from the notice are that (1) virtual currencies are treated as property for federal tax purposes, (2) wages paid to employees using a digital currency are taxable to the employee, (3) virtual currency payments made to independent contractors are taxable and subject to self-employment tax rules, (4) the character of gains and losses on the sale or exchange of virtual currency depend on whether the virtual currency is a capital asset for the taxpayer, and (5) any payment made using virtual currency is subject to the same reporting requirements as any other payment made in property. The IRS has created a Virtual Currency Issue Team, but no further guidance has been provided since 2014.
In an ever-evolving marketplace, accountants must become familiar with new ways business is being conducted. Young entrepreneurs starting businesses today have an in-depth knowledge of virtual currencies and want to work with someone who has a similar knowledge base. Over the last several years, cryptocurrencies have grown in popularity. While Bitcoin is the most common virtual currency, there are many others that can be used in the marketplace as well. Becoming more familiar with these payment options will allow accountants to better understand their clients and provide them with high-quality service.
This content does not constitute a recommendation, endorsement or offering of the products described and serves to provide general information for educational purposes only.
Reynold P. Cicalese
Reynold Cicalese III, CPA, is an associate partner at Alloy Silverstein Accountants and Advisors. He is a member of the NJCPA State Taxation Interest Group and is a director with the Southwest Jersey Chapter. Ren can be reached at email@example.com, 856-667-4100 and on Twitter at R3CPA.
This article appeared in the March/April 2018 issue of New Jersey CPA magazine. Read the full issue.