While the IRS’ recent ruling comes as a certain relief to Bitcoin enthusiasts who feared it would be deemed completely illegal and/or entirely shut down, such relief has been bittersweet...

The Bitcoin system is a peer-to-peer digital payment system utilizing open source software and a form of digital currency known as “Bitcoin” that was created by Satoshi Nakamoto in 2009. Satoshi Nakamoto is actually an alias and the true identity (or identities) of Nakmoto remains a mystery. Nakamoto is rumored to possess approximately one million Bitcoins, which is equivalent to $444,700,000 U.S. Dollars as of April 28, 2014.

Since its inception, the Bitcoin system has spawned a flourishing online economy which continues to grow in notoriety and popularity. In fact, an increasing number of retailers, including eBay, PayPal, OKCupid, TigerDirect and Tesla, now accept Bitcoins in lieu of traditional currency and other payment methods.

Despite its growing reputation, there are several risks inherent in the Bitcoin system. Principal among these is the extreme volatility of Bitcoin value, which is capable of drastically dropping or increasing in value unexpectedly. In addition, the electronic nature of Bitcoin creates ample opportunities for cyber theft and hacking, the threat of which was most prominently illustrated by the 2011 security breach suffered by the now-defunct Mt. Gox Bitcoin exchange resulting in the loss of hundreds of millions of users’ dollars when a hacker created an enormous “ask” order at any price.

The legality of Bitcoin has remained an unanswered question since its inception, and only very recently has the U.S. Government shed any light on how it views or intends to treat Bitcoin.

In a Notice issued by the Internal Revenue Service (IRS) in March 2014, the IRS ruled that virtual currency “does not have legal tender status in any jurisdiction.”  Further, the IRS held that virtual currencies like Bitcoin are considered “property transactions” under current tax law. Because Bitcoin is “convertible”, meaning it can be exchanged for other real currencies, transactions involving the sale or exchange of Bitcoin and other virtual currency have “tax consequences that may result in tax liability”.

While the IRS’ recent ruling comes as a certain relief to Bitcoin enthusiasts who feared it would be deemed completely illegal and/or entirely shut down, such relief has been bittersweet and somewhat tempered by the recent flurry of government rulings and public scrutiny aimed at imposing regulation and increased structure on the virtual currency industry. Alas, the primary underlying goal of the Bitcoin system – to function as the world’s first completely decentralized, untaxed, and anonymous currency system – seems to have been compromised by its own popularity.

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[Part of our JD Supra Perspectives series in which we asked our contributors, experts in their fields, to write about examples in which technological innovation has outpaced the law. Margaret (Maggie) Arcaro is an associate in the Denver office of Sherman & Howard L.L.C., where she focuses her practice on technology transactions and intellectual property.  You can reach Maggie at marcaro@shermanhoward.com.]