Is Cryptocurrency the New Swiss Bank Account?
Imagine you have a coin that is worth thousands of U.S. Dollars. Except unlike the traditional coin that you can hold in your hand, this coin only exists digitally. This is the concept behind Bitcoin, the first and most well-established class of cryptocurrency. Cryptocurrency is a new class of asset that is becoming increasingly popular, not only in the United States but across the world. Cryptocurrency defies the traditional notions of “currency”, in the sense that there is no central issuing authority or governmental regulatory body. Exchanges and transfers of cryptocurrency are encrypted so that each exchange or transfer is anonymous, the data is decentralized, and no third party can control the currency.
Bitcoin constitutes forty percent of the cryptocurrency market and is the most well-known form of cryptocurrency. Its “high risk, high return” and unregulated nature have made bitcoin very popular for investors, traders, and, unfortunately, people trying to hide their money from their spouses.
In addition to the problem of determining if a spouse has any bitcoins, there is a huge issue in the valuation of bitcoin during the pendency of divorce due to its high volatility. The value of certain types of cryptocurrency can also vary drastically from day to day. For example, in December 2017, Bitcoin hit a high of $20,000, but less than two months later, dropped to $6,000. As bitcoin only started gaining popularity over the past few years, there are very few legal opinions written on the subject. This article will address the basics of bitcoin trading and tips for lawyers to help protect and educate their clients.
How Do Bitcoin Transfers Work?
In order to help clients or spouses of bitcoin holders, it is helpful for divorce lawyers to have a basic understanding of how bitcoin is exchanged. Bitcoins are exchanged over a worldwide peer-to-peer network. Every time a bitcoin is exchanged or transferred, there is an “entry” on a global, decentralized ledger known as the “blockchain.” A helpful analogy to explain the blockchain is thinking about it like a giant, worldwide poker game where the players left their chips and cash at home. In order to keep track of all the transactions, multiple players keep their own ledger on their own notebooks and compare their lists of transactions to catch any discrepancies. You can think of each “page” as a “block” of transactions “chained together” on a ledger, hence the name “blockchain.” Therefore, for each proposed bitcoin transaction, the bitcoin holder will need to announce to the network their account number, the account number of the person they are sending bitcoins to, and how many bitcoins they want to send. This ensures the blockchain is updated with all bitcoin transactions.
To further protect user identities, when a user creates an account (a “wallet”) on the bitcoin network, the account is linked to two “keys”, unique to the given user. The user has one public key and one private key. For each proposed bitcoin transaction, the user will “sign” the transaction using their private key, which only they have access to. The other members of the bitcoin network will then be able to use that user’s public key to verify the transaction. Each user also has a unique “wallet address”, which can be used to look up any cryptocurrency transactions for that given user.
Tax Consequences of Bitcoin Transfers
An often-overlooked issue when dealing with bitcoin and divorce are the potential tax consequences of bitcoin transfers. The IRS considers bitcoins as capital assets subject to capital gain or loss treatment on all sales and exchanges. In fact, earlier this year, the IRS specifically issued a statement warning that “taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of virtual currency transactions.” There are two recommended approaches for tax reporting for bitcoin transfers/exchanges: (1) Convert Bitcoin to U.S. Dollars for each purchase and sale transaction using the Bitcoin market price that day in U.S. Dollars, or (2) Use Bitcoin as a functional currency, using an average Bitcoin vs. U.S. dollar conversion rate for the tax year. Regardless of the approach a bitcoin holder utilizes, the potential capital gains are substantial and should be contemplated in a couple’s marital settlement agreement or final judgment.
An important distinction to note is that unlike sales of stocks or bonds where your typical brokerage firm or bank will send you a statement, Coinbase will only issue a statement if a spouse has realized over $20,000 in gains and had at least 200 transactions. Therefore, the burden falls on the bitcoin holder to accurately report gains and losses from bitcoin transfers for a particular tax year. When negotiating settlements, lawyers or professionals may consider using websites like Bitcoin.tax and Cointracking.info to help estimate how much tax may be owed in a given tax year.
Cryptocurrency in Divorce Proceedings
Divorce is difficult and you often times have trust issues between the spouses when one believes the other is hiding money or property to gain an advantage during the divorce proceedings. The difficulty is seeing another layer in this day and age of virtual currencies, such as Bitcoin, that are easy to hide and have values that extremely volatile and difficult or impossible to determine.
Parties have a duty to fully disclose their assets and liabilities, however, with the purchase and sale of virtual currencies like Bitcoin being anonymous it may be a new way for a spouse to hide money during or in contemplation of a divorce. The lack of a paper trail lends itself to the potential for deceit. If you obtain cryptocurrency online or with funds from a bank account, there will be a trial to follow. However, if someone were to trade using a virtual wallet it makes tracing more difficult. Even more difficult is if the digital wallet is transferred from a computer, smartphone, or tablet onto a USB, not only is there no trail — there is very little or no evidence that a transaction has taken place. Another example of this virtual power to obtain cryptocurrencies without having a withdrawal on a bank statement is by purchasing items on Amazon, which are then sent to the seller in exchange for Bitcoin.
Bitcoins: Treated Like Cash but Mined Like Gold
There is also the potential to “mine” cryptocurrency. Mining is the terms used to describe the creation of new units. This needs some explanation:
Bitcoins are treated like cash but are mined like gold. There are three ways to obtain (1) buying them on an exchange; (2) accepting them for goods or services; and (3) mining new ones, like finding gold! In the virtual world of mining for cryptocurrency — it really means the verification of a bitcoin transaction, such as Joe buys a radio from Bob with bitcoin and in order to make sure Bobs bitcoin is genuine, he will have to verify or “mine” the transaction. And it is not just one transaction that Joe will have to verify. He will have to use a computer program(s) to find the key to open the virtual padlock on many transactions that have been gathered together in a blockchain. Once the computer finds the correct combination that verifies and unlocks the box, it pops open which means the transactions are verified and the reward to the “miner” is 25 newly generated bitcoins. It is published that the current number of attempts it takes to find the correct key is approximately 1,789,546,951.05 (Blockchain.info — a top site for the latest real-time bitcoin transactions). Even with so many attempts necessary, the reward of the 25 mined bitcoins was given out about every 10 minutes in 2017 and in 2018 the reward for mining transactions will be cut in half to 12.5 and will continue to cut in half every four years. Why is this you ask? It gets even more interesting.
When this Bitcoin algorithm was created in 2009, it was under the pseudonym Satoshi Nakamoto — which I understand to be a very common Japanese name. This individual set a limit on the number of bitcoins that will ever exist at 21 million. Currently, 16.6 million are in circulation which means less than 5 million bitcoins are waiting to be mined. The way this system was set up was that it was easier to mine for cryptocurrency in the beginning and as we get closer to that 21 millionth bitcoin it gets much more difficult, exponentially more difficult with a greatly reduced reward. At the current rate of creation, it is estimated that the final bitcoin will be mined in the year 2140. That 21 millionth bitcoin — it has a name, the smallest unit of currency possible for bitcoin is a Satoshi (named after guess who) which is 0.00000001.
How to “Find” and Transfer Cryptocurrency
To give you an idea of how the value of bitcoin has grown over time, the first retail purchase using bitcoin was on May 22, 2010, when a guy in Florida paid 10,000 bitcoins for two pizzas worth $25. At the time, bitcoin had an exchange rate of a few cents. Today one bitcoin is worth $11,390. Those pizzas in today’s value are $113,900.00.
So you suspect your spouse has been purchasing cryptocurrency and you want to know how to find it so that it can be properly valued and accounted for in divorce proceedings. There are services and forensic experts available that trace Bitcoin transactions, but they are not yet widely available because this type of work is so specialized. You also want to keep in mind that you are not just looking for Bitcoin. Although Bitcoin is the most well-known of the cryptocurrencies, there is also Etherium, Litecoin, Ripple and Monero and over a thousand other cryptocurrencies available for purchase and there are more coming available to the open market almost every day.
Discovery Requests and Seeking Evidence of “Virtual Currency”
It is important to formally request documentation concerning cryptocurrency as you would any other financial account. Initially, you would take a look at all of the financial statements for signs of cryptocurrency transactions. Look for large, unexplained cash withdrawals and entries showing “localbitcoins.com” or other peer-to-peer sites on a bank statement and outgoing wire transfers could be a clue.
Include in your standard discovery a request for all information regarding bitcoin and cryptocurrency in general and when you start getting more specific you may want to define the terms such as “Virtual Currency” with a definition perhaps as “any medium of exchange that operates like a currency to some but does not have all of the attributes of legal tender, whether or not that medium of exchange is recognized as legal tender.” A document request may continue like this:
- All documents regarding virtual currency in your possession, custody or control, including all documents relating to Virtual Currently wallets, and all documents evidencing any transfers of Virtual Currency made by You to and/or from any third party
- All documents showing public IDs or public keys you have used to transact in Virtual Currency
- All documents relating to the person or entities you have transacted in Virtual Currency
- All documents related to your purchase of Virtual Currency including the source of funds used to purchase, the person or entity from whom purchased, and the time, date and manner of the purchase
- All documents and communications related to the purchase of equipment or software used to mine Virtual Currency (again you will need to define “mine”)
- All documents and communications related to the amount of Virtual Currency you acquired, owned or held at any time through mining
Web-based Wallet Address, Hardware Wallet and Private Keys
Keeping in mind there may not being any document trail if the cryptocurrency is being kept in a web-based wallet or moved to a hardware wallet which is a USB memory stick that stores your private bitcoin key and requires you to use that USB to transact without exposing your “key” to the internet where it could be vulnerable to hackers. A private key is a secret, alphanumeric password/number used to spend/send bitcoins to another Bitcoin address. It is a 256-bit long randomly selected number which is generated as soon as you make a wallet. This is how the Bitcoin private key looks (it always starts with 5):
5Kb8kLf9zgWQnogidDA76MzPL6TsZZY36hWXMssSzNydYXYB9KF. If you lose your private key, there is a 24-word seed phrase that you can use to unlock your account to still access your virtual wallet.
Bearing lack of documentation in mind, it is important, just as with any asset, to do your due diligence in considering the addition of targeted questions, either in the form of written interrogatories or in an oral deposition, along with the lines of the following:
- Do you own any form of cryptocurrency?
- Have you ever owned any form of cryptocurrency?
- Does anyone hold any cryptocurrency for you?
- Do you or have you ever had any form of an e-wallet?
- If you have cryptocurrency account, what exchange(s) do you use?
- What are your wallet address, private key, and public key?
- Have your reported capital gains on any virtual currency exchanges?
You may anticipate some pushback in terms of requesting the private key, as it is akin to asking for someone to give you the password for their bank account. For all practical discovery purposes, having the wallet address should be sufficient for purposes of determining what cryptocurrency exchanges the holder has performed. Once you have their wallet address, you can also look up the holder’s incoming and outgoing transactions by typing the wallet address into the explorer for the specific currency.
Obtaining the wallet address is also the most critical piece of information in the event your client wants to divide the cryptocurrency in kind, rather than agreeing upon a cash buyout or offset against another asset based on a valuation date. Specifically, say you represent Wife (the spouse with no cryptocurrency) and she wants Husband to transfer coins to her. Your final divorce agreement would have to provide a process similar to the following:
Husband needs to provide either 1) an accounting of all cryptocurrency he holds or 2) his wallet address within x number of days to the non-holder spouse so Wife can verify all existing coins.
The Wife would need to obtain a wallet and the necessary hardware and provide the Husband with her wallet address.
Within x number of days of receiving the Wife’s wallet address, Husband would transfer the coins to the Wife’s wallet.
Alternatively, in this same example, if Wife wants to agree on a valuation date and buyout/offset for negotiation and balance sheet purposes, you can look at coinmarketcap.com, a website that calculates the average coin price based on all the exchanges. One important note is that there is no “open” or “close” time like in the stock market, so in addition to a valuation date, you should also consider specifying the time of day for valuation or agree to the average price for the day. This is critical given the amount of volatility a particular coin can have even on one day.
Be Aware of Cryptocurrency Issues in Divorce
Many attorneys and people generally stray away from addressing cryptocurrency holdings because they are new and foreign concepts to them. However, at the end of the day, cryptocurrency holdings are conceptually very similar to stock or stock options, which family law attorneys deal with regularly. The question at the end of the day becomes if a spouse wants to ride out the risk of taking a coin “in kind”, or if they want to just take a cash buyout/offset against other assets up front. The most important takeaways are to become knowledgeable about this new type of currency including its associated tax consequences, adjust your discovery requests accordingly, and understand how to transfer it or calculate a buyout in a final divorce settlement.
This article is was co-authored by Janice L. Boback, Anderson & Boback, ISBA Privacy and Information Security Law Section Council Member and Stephanie L. Tang, Kogut & Wilson, L.L.C., ISBA Family Law Section Council Member.
THIS ARTICLE WAS PREVIOUSLY PUBLISHED AT: https://illinoislawforyou.com/property-division/cryptocurrency-divorce-proceedings/