Taxable Bitcoins 2: We’re Not Gonna Pay it!

Reason magazine’s Brian Doherty recently addressed the IRS’s recent announcement that bitcoin transactions are taxable. As I addressed in my last piece, while the IRS may have sought to clarify their taxation process for bitcoins, it has only caused further confusion. I agree with Doherty that this announcement is not detrimental to bitcoin, but there are unresolved issues that need to be considered.

The plan is for the IRS requires users to self-report their transactions to the IRS; it is easy to see why compliance might be a problem. For a currency based upon subverting government regulations, there will likely be a group of Bitcoin users who choose to avoid payment of taxes to the IRS wherever possible. The question at this point is how likely is it that the IRS will be able to actually enforce taxation on bitcoins.

This is where the debate gets messy. The block chain, bitcoin’s public ledger, is a record of all transactions that have occurred between bitcoin users. The block chain uses digital wallets as a medium for storing and transferring bitcoins between individuals. It is possible for the IRS to monitor the block chain — which is publicly available for viewing online — and discern when a transaction occurs that meets the taxation threshold.

Each wallet has a unique 32-character address that does not tie itself directly to an individual’s real identity offline. So while the IRS could note certain transactions as being taxable on the block chain ledger system, they could not directly identify whether the person was within the U.S. or who they are. Of course, it is possible for the IRS to track down the IP address of the wallet’s computer and find the location of the computer used for the transaction. But this would take a lot of time and effort, and would have to be done for every individual instance in which a transaction is not reported to the IRS.

Furthermore, there is already a project called Dark Wallet which is seeking to further anonymize bitcoin wallets, through encryption. This would further complicate the ability for the IRS to enforce taxation. It is feasible to imagine the IRS enforcing taxation within this environment, but only if bitcoin became more widely adopted so that the effort to enforce taxation would be worth the resources needed.

The question facing the bitcoin community is whether it is better to conform with the standards set by government agencies, like the IRS, or do bitcoin users want to challenge government by developing more complex technologies to circumvent said agencies? We could be witnessing the early stages of an arms race.