Goodbye Switzerland. Hello Bitcoins.

Bitcoins are everywhere. Last week, a federal judge in Texas held that the virtual currency qualifies as a form of money and allowed the SEC to charge a promoter of a scheme to invest in bitcoins with violations of the federal securities laws. Earlier this week, the New York Department of Financial Services issued subpoenas to 22 virtual currency companies with an eye to determining whether the industry needs new regulations, and the Senate Homeland Security and Government Affairs Committee asked several federal agencies for information regarding their policies with respect to bitcoins and other virtual currencies. Combined, these actions will undoubtedly fuel calls to regulate the burgeoning virtual currency market, and the IRS will surely be getting in the action soon.

First some background. Bitcoins are a virtual currency that can be used to pay for goods and services around the world. To participate in the bitcoin market, one needs a digital wallet, which can be filled either by purchasing bitcoins for goods, services or currency, or by acquiring them through a complex process known as “mining.” The bitcoins can then be used to purchase goods or services, or sold on an exchange. While virtual currencies have traditionally been used to purchase illicit substances, like guns and drugs, they are now accepted by numerous legitimate businesses for everything from gift cards to jets and yachts.

The potential abuse of virtual currencies has drawn the attention of financial regulators. This past March, the Financial Crimes Enforcement Network (FinCEN) issued guidance making clear that virtual currency exchangers and administrators are subject to registration, reporting and recordkeeping regulations under the Bank Secrecy Act. And in a second report issued this past May, the GAO addressed the tax implications of virtual currencies. After describing how virtual currency transactions can create taxable income, the GAO largely attributes the noncompliance risk to uncertainty and ignorance regarding the tax implications of transactions. Thus, the GAO devotes little space to discussing the potential that virtual currencies can be used to intentionally evade income taxes, and its sole recommendation is that [t]o mitigate the risk of noncompliance from virtual currencies, the [IRS] should find relatively low-cost ways to provide information to taxpayers, such as the web statement IRS developed on virtual economies, on the basic tax reporting requirements for transactions using virtual currencies developed and used outside virtual economies.”

Others have written about the tax principles applicable to bitcoin transactions. In a nutshell, the tax consequences will depend on the transaction in question, with one set of consequences if bitcoins are used to pay for goods and services and another if they are sold at a profit. While there is complexity, the GAO’s focus on the need for further education assumes that participants in virtual currency marketplaces are honest but confused taxpayers who, with additional information, would gladly comply with their obligations to the federal fisc. But given that the allure of bitcoins has been attributed by some to its status as an untraceable alternative to currencies issued by central authorities, there is little reason to assume that bitcoin market participants will honor their tax obligations as soon as the rules are explained more clearly. Thus, it is not surprising that the potential for bitcoins and other virtual currencies to replace offshore accounts as “[t]omorrow’s tax havens” has been the subject of scholarly analysis and commentary (here and here). It remains to be seen how the IRS will attack the use of bitcoins and other virtual currencies to evade income tax obligations.