Cryptocurrency first gained widespread recognition when Bitcoin skyrocketed to a value of $20,000 per coin at the end of 2017. Even as the digital currency came back down to earth, eventually sinking as low as $3,000 before returning to its current value of about $8,000, interest in crypto remains significant.
The rise of Bitcoin and other digital currencies developed in its wake has also raised legal questions for regulators, investors and entrepreneurs alike. Small businesses could possibly benefit from the adoption of cryptocurrencies, especially as a support infrastructure is developed around them; however, understanding the legal implications and how the shifting regulatory landscape could ultimately impact digital payments is critical.
What is cryptocurrency?
Cryptocurrency is generally defined as a decentralized digital asset that relies on encryption techniques to verify transfers and exchanges. Cryptocurrencies are referred to as decentralized because transfers do not require a middleman, such as a bank or payment processor. Instead, digital assets can be transferred directly from buyer to seller.
"Today, [cryptocurrency] is treated widely as a 'store of value' rather than an everyday currency that can be used to pay for basic goods and services," said Michael Yuan, a technologist and chief scientist at The CyberMiles Foundation. "Why? Like gold or diamonds, the value of cryptocurrency is not its underlying utility but how much people believe in it."
Typically, the underlying technology behind cryptocurrency is blockchain, by which many users or "nodes" all hold a complete record of all transactions that have ever occurred on the platform. Because the full ledger of historic transactions exists across all computers on the blockchain, it is very difficult to forge fraudulent transactions; every user has access to a complete, verified record and could see any discrepancies that arise from foul play. This is referred to as a "distributed ledger."
"Such verification is made possible with blockchain technology, the digital ledger in which transactions made in a cryptocurrency are recorded chronologically and publicly," said Yuan.
To verify and add a new "block" of pending transactions to the "chain" of previously verified blocks, computers on the network must come to a consensus that the new block is legitimate. They do so by solving for a mathematical equation in a process that is known as "mining."
That might seem like a lot to take in, but the bottom line is this: Cryptocurrencies are designed to be securely transferred at will between multiple parties without the need for a central authority, like a bank, to control the process.
"It holds the promise of simplifying … [business-to-business] payment networks, from faster payments to lower transaction fees," Yuan said.
Cryptocurrency and the law
As a relatively new phenomenon, cryptocurrency has drawn the attention of governments around the world. However, exactly how it will be regulated remains unclear. In the U.S., the Securities and Exchange Commission (SEC) regulates most cryptocurrencies as securities. Their status as a securitized asset has made it difficult for small businesses to use cryptocurrencies as typical legal tender.
That could soon change, said Nash Foster, CEO of Pyrofex. Legislation is working its way through Congress to address the ambiguity around accepting digital assets as payment. While the creation of new cryptocurrencies and their distribution would remain a matter for the SEC, new laws could remove barriers to using digital currencies as payment.
"It appears that Congress is going to pass several bills simplifying legal issues for merchants and small businesses," Foster said.
For example, he pointed to an effort led by Reps. Warren Davidson and Tulsi Gabbard, known as the Token Taxonomy Act, which would eliminate the tax liability imposed on merchants for transferring cryptocurrencies, currently considered a securities trade under the current definition of digital currency.
"This … was really the biggest problem for small businesses that just want to take payments in cryptocurrency, because the tax accounting could just be ruinously complicated," said Foster. "That should be worked out by later this summer, and then there will likely be very little for small businesses to worry about."
Taxation of cryptocurrency
Tax policy remains as muddy as the regulatory landscape. Taxation varies from place to place, so it can be difficult for businesses to know exactly what their obligations are when they start accepting digital currency. Generally, businesses accepting cryptocurrency should account for it based on its cash equivalent.
"For example, if you send out an invoice for $1,000 for landscaping services and you agree to be paid in cryptocurrency, the $1,000 must be booked as revenue, and income taxes must be paid on the same, even though you did not receive the physical cash," said Shira Kalfa, founder and partner of Kalfa Law.
But what happens when that cryptocurrency fluctuates in value? If you collect a cryptocurrency payment and the token increases in value, that could be considered capital gains and be subject to the relevant taxes.
"Using the example above, your business … must pay income tax on the $1,000 it received … let's say [the] crypto's value increases to $2,500 in equivalent cash value," Kalfa said. "This accrual also captures tax … and this tax would be a capital gains tax, being the difference between the adjusted cost base of $1,000 and the disposed fair-market value (FMV) of $2,500."
Needless to say, accepting cryptocurrency could quickly lead to a significant increase in record-keeping. Be prepared to track all cryptocurrency transactions and changes in value if you choose to accept crypto payments. What are the consequences of failing to do so? The U.S. Internal Revenue Service (IRS) recently signaled it's about to crack down on crypto tax avoidance.
According to IRS tax investigator Gary Alford, the agency is poised to begin criminally charging Bitcoin holders who don't pay their taxes. Alford told crypto publication CCN, "We already are aware that there are cases to be made. We just didn't know if we were at the point where we can bring it for criminal prosecution. We believe we are at that point now."
Cryptocurrency for small businesses
The concept of cryptocurrency offers a few immediate promises for small business transactions. Cryptocurrency payments are direct from buyer to seller, significantly reducing or eliminating fees charged by payment processors and banks. Payments in crypto are also irreversible once the transaction is verified, meaning businesses do not run the risk of chargebacks on disputed transactions.
"While Visa charges between 3% and 15% in fees per transaction, cryptocurrency networks typically charge less than 1%," Foster said. "And there is no risk of chargebacks, because cryptocurrency transactions aren't reversible the way that credit card transactions are. Crypto operates more like cash, where the end user has to deal with security risk, instead of the merchants accepting all the risk."
However, accepting cryptocurrency still comes with risks. Chief among these is the price volatility, which could result in some cryptocurrencies drastically changing value moments after the transfer. If a cryptocurrency crashes before a business can convert it to dollars, it could result in a loss. In addition, Foster said, the support infrastructure for cryptocurrency simply isn't in place yet.
"Cryptocurrency allows merchants and end users to do more of what centralized payment processors and banks used to do, but that means you have to learn something about what you're doing," Foster said. "Even if you are taking payments in Bitcoin, that doesn't mean your landlord will accept Bitcoin for the rent."
Business owners who accept crypto payments must learn about converting tokens into cash, the security of exchanges or crypto wallets, when any fees would be triggered and more. That learning curve has contributed to another challenge: Adoption simply isn't widespread among consumers. While customers are more familiar with digital wallets than ever, widespread adoption of cryptocurrency has not yet occurred, meaning implementing a system for accepting cryptocurrency might be a solution in search of a problem.
Still, Foster believes it is an optimal time for small businesses to get ahead of the curve and prepare for what could be the next evolution in payment method. Mass adoption, he said, could come sooner than expected.
"I'm a firm believer that now is a great time for [small businesses] to begin adopting cryptocurrency for their regular flow of payments," he said. "Customers are already comfortable setting up digital wallets on their smartphones … getting customers to adopt the technology won't be particularly difficult."