November 17, 2014

Bitcoin for Merchants: Legal Considerations for Businesses Wishing to Accept Bitcoin as a Form of Payment

Stephen T. Middlebrook

Bitcoin is a so-called “cryptocurrency” that can be used as a medium of exchange to make payments and facilitate consumer and business transactions – primarily over the Internet. It has garnered a lot of attention among technocrats and has also been written about extensively in the popular press. While its user base is still quite small compared to that of checks, credit and debit cards, and electronic funds transfers, a growing number of businesses are adopting bitcoin as a payment option for those customers who wish to use it. Nationally known merchants such as Dell, Expedia, and Overstock.com have jumped on the bitcoin band wagon, along with a number of smaller companies such as the New Mexico Tea Company and Grass Hill Alpacas. Even the United Way now accepts donations in bitcoin. 

This article examines the legal risks and issues that a business should evaluate before accepting bitcoin as a form of payment. It provides a brief overview of bitcoin, addresses potential registration and licensing issues, and examines the tax implications of accepting the virtual currency. This article also discusses the use of bitcoin merchant service providers (BMSPs), which act as intermediaries between a business and a customer wishing to pay in bitcoin. The BMSPs provide a range of services including accepting bitcoin and paying the merchant in dollars, removing many of the barriers to accepting this new payment mechanism. 

A Quick Overview of Bitcoin 

Bitcoin is an Internet-based virtual currency which can be used to transfer value between parties. It is often classified as a “cryptocurrency” because it relies on cryptography to authenticate transactions. A bitcoin has no physical presence and no central authority administers the currency. It is not backed by any government and is not legal tender in any jurisdiction. It is not issued by or redeemable at any financial institution. A bitcoin only has value because other participants in the ecosystem ascribe value to it. The authenticity of any particular bitcoin may be verified by consulting a master database of bitcoins (called the “block chain”) which is maintained over a peer-to-peer network on the Internet. The entities which provide the hardware and software to host the database and authenticate transactions are called “miners” and they are periodically rewarded for their public service by being given a few bitcoins. This is how new units of the virtual currency come into existence. 

Bitcoin users are identified by their “public key” which is essentially a very large number. The public key is cryptographically associated with another large number, the “private key” which the user keeps confidential and uses to mathematically sign transactions. Because keeping track of these large numbers can be cumbersome, users typically employ a special piece of software called a “wallet” to manage their public and private keys. That software may be located on a personal computer or smartphone or hosted in the cloud by a service provider. While bitcoin is sometimes described as an anonymous currency, every transaction is recorded in the publicly accessible block chain and is associated with a public key. Tying a particular public key to an individual or company may be difficult, but it can be done. Bitcoin users, and merchants in particular, should assume that their bitcoin transactions are public knowledge. 

To make a payment, a person uses his or her cryptographic credentials to sign a transaction transferring some amount of bitcoin to another person and submits it to the block chain. The miners perform the mathematic calculations necessary to verify the transaction, and if it is deemed authentic, update the block chain to indicate the transfer of ownership. The whole process takes a couple of minutes maximum. Once written to the block chain, the transaction is not reversible. 

The price of a bitcoin relative to the U.S. dollar has fluctuated dramatically over time. In the early days of the virtual currency, it was worth on a few cents. As its fame increased and speculators began to invest, the price increased dramatically, reaching a high of $1,162 on November 30, 2013. The exchange rate has since retreated from that peak, falling to around $300 in early October 2014. Volatility is likely to be an aspect of the bitcoin market for the foreseeable future and consequently should be a consideration for businesses which engage in transactions denominated in bitcoin.

Licensing and Registration Requirements for Bitcoin Related Businesses 

At both the federal and state levels, there are requirements that entities engaged in certain financial service activities register or obtain a license if they wish to operate within the jurisdiction. While the boundaries of these laws are not always as sharply delineated as business lawyers might like, it seems reasonably clear at this point in time that a business which merely accepts bitcoin as a payment mechanism on its own behalf has no obligation to register or obtain a license. As is discussed below, however, the law in this area is in a state of flux and merchants accepting bitcoin are advised to stay current with developments which may affect them. 

At the federal level, the Bank Secrecy Act (BSA) requires an entity which issues traveler’s checks or money orders, performs check cashing, engages in money transmission, or provides certain other services to register as a Money Services Business (MSB). Along with the duty to register, an MSB is obligated to develop an anti-money laundering plan, keep certain records, and report certain transactions and other suspicious activity to the government. The Financial Crimes Enforcement Network (FinCEN), the agency which administers the BSA, has issued guidance explaining when a bitcoin business might be deemed to be engaging in money transmission and thus be obligated to register. 

For BSA purposes, money transmission is defined as the acceptance of currency or other value that substitutes for currency from one person, and the transmission of that currency or substitute to another location or another person by any means. Currency is defined to mean the legal tender of the United States or another country. Under these definitions, bitcoin is not a currency, but it is something that can substitute for currency, and thus its acceptance and transfer to another person or location would constitute money transmission. In its guidance, however, FinCEN makes clear that when a person obtains bitcoin and uses it to purchase goods or services, there is no acceptance from and no transfer to another person. Consequently, a person or business that uses bitcoin solely for its own purposes and not for the benefit of another is not an MSB. While FinCEN’s guidance does not directly address the merchant scenario, it seems clear that a business may accept bitcoin in exchange for goods or services and not be obligated to register. Furthermore, the business may hold on to that bitcoin, exchange it for dollars, or even use it to pay a vendor and not trigger the rule. A merchant that is careful to limit its use of bitcoin to its own purposes and does not provide bitcoin services to others should have no obligations under the FinCEN rules. 

At the state level, many jurisdictions also require entities engaged in money transmission to obtain a license and to meet certain requirements for safety and soundness, as well as consumer protection. While the concept of money transmission at the state level is similar to that expressed in FinCEN’s rules, there are differences between state and federal law, and indeed, a fair amount of variance among the state statutes. A few states have opined on the application of their money transmitter laws to bitcoin related businesses. In April of 2014, Texas regulators confirmed that bitcoin does not constitute “money” or “monetary value” as defined in their Money Services Act, and thus bitcoin transactions are not covered by the law. Kansas reached a similar conclusion under its statute. These regulators did acknowledge, however, that bitcoin related businesses such as wallet providers, currency exchanges, and ATM operators which receive government-issued currency for certain purposes might still be covered. 

In contrast, the North Carolina Commissioner of Banks has stated that bitcoin does constitute “monetary value,” and thus activities involving the cryptocurrency may be covered by the state’s money transmitter law. The agency indicated that it is working on new regulations to address when virtual currency users are engaged in money transmission and noted that changes to the underlying statute may be necessary in order to keep up with the market place. New York has taken a different approach, proposing a regulatory scheme just for virtual currencies. On July 17, 2014, the New York Department of Financial Services issued a draft version of its “bitlicense” regulations for public comment. The rules would cover entities engaged in “Virtual Currency Business Activity” which includes receiving, storing, and transmitting virtual currency. The rule, however, would not cover merchants accepting bitcoin in consumer transactions. 

It seems reasonable at this stage to conclude that a merchant that accepts bitcoin or other virtual currencies for its own account in order to facilitate the sale of goods and services will not need to be licensed by or register with any governmental entity. The merchant should be careful, however, not to provide bitcoin related services such as transfer or exchange to its customers. And finally, because this body of law will continue to grow and change, the prudent business will actively monitor regulatory developments in this area. 

Tax Implications of Accepting Bitcoin 

When a business or individual conducts a transaction in a foreign currency, there are special rules which govern how gains or losses from the exchange of foreign currency are handled for tax purposes. Many bitcoin users assumed that those rules would also apply to virtual currencies. Such hopes were dashed by IRS guidance issued in March 2014 which concludes that, for federal tax purposes, bitcoin and other virtual currencies should be treated as property and not foreign currency. This interpretation by the IRS has enormous business implications for merchants accepting bitcoin and has been criticized by commentators. 

The IRS explains that for tax purposes virtual currency should be treated as property and that general tax principles which apply to property transactions will govern the tax treatment of bitcoin. When acquiring property, one is required to record the fair market value of the property which is deemed the owner’s “basis” in the property. When the asset is later exchanged, if the fair market value has increased, then the owner has a taxable gain. If the sale price is less than the taxpayer’s basis, he or she has a loss. Applied to virtual currency, this means if a person accepts a bitcoin on Monday when the value is $400 and then makes a purchase with that same bitcoin on Friday when the value is $410, he or she has a $10 gain. Imagine a merchant that acquires bitcoin in multiple transactions over a month during which the price of bitcoin fluctuates. Its basis in each individual bitcoin may be different depending on the market price at the time of the transaction. When the merchant decides to cash out some of its bitcoin for dollars, it will need to decide not just how much bitcoin to sell but also which particular bitcoins to part with – because exchanging this bitcoin over that bitcoin will determine the amount of a reportable gain or loss. Needless to say, the amount of record keeping necessary to track the basis in each bitcoin and compute gains and losses makes it impractical for many businesses to accept bitcoin. One work-around for this problem is for a merchant to exchange bitcoins for dollars immediately upon acceptance before the fair market value of the asset can change. An automated procedure to handle these exchanges would simplify but not eliminate the merchant’s record-keeping obligations, although creating such a process would involve a significant investment in time and resources. Lucky for merchants, third-party service providers exist to offer just this type of service. 

Using a Bitcoin Merchant Service Provider 

In response to the tax accounting and record-keeping issues described above and other legal and operational problems facing merchants which wish to accept bitcoin, a new category of service provider has emerged – the BMSP. Coinbase and BitPay are probably the best known of this class of vendors, but a quick Internet search reveals a growing number of players in this space. The BMSP essentially acts as an intermediary, accepting bitcoin from the customer and providing dollars or some other currency to the merchant. 

In a typical implementation, the merchant adds a button to the checkout page of its website labelled “pay with bitcoin.” If the customer chooses this option, he or she then interacts with the BMSP’s servers to provide information necessary to pay using bitcoin. The BMSP initiates the bitcoin transfer and notifies the merchant when the bitcoin transaction is complete. The merchant then completes the purchase transaction with the customer and ships the goods. The BMSP settles with the merchant on a prearranged schedule, usually daily, by electronically transferring dollars or euros or some other supported currency to a bank account designated by the merchant. Some BMSPs also support settling in bitcoin or other virtual currencies. While pricing varies, several providers offer plans with no transaction fees. 

An obvious benefit of using a BMSP is that a merchant can enable its customers to pay with bitcoin without ever actually having to receive or hold bitcoin itself. Such an arrangement would reduce or eliminate the accounting and record-keeping obligations associated with the IRS guidance, making virtual currency acceptance a significantly easier and more attractive option. Introducing an intermediary into the relationship with a customer, however, brings new risks which require careful evaluation. Before engaging a BMSP, a merchant might want to ask the following questions:

  1. Is the BMSP a registered MSB? A BMSP accepts bitcoin from a consumer and provides dollars to the merchant. This action clearly constitutes money transmission under the BSA as discussed above. Merchants should confirm their BMSP is properly registered and in compliance with FinCEN regulations. Ask the provider for a copy of its written anti-money laundering compliance program. If it doesn’t have one, it’s not in compliance.
  2. Is the BMSP a licensed money transmitter in the appropriate states? While there is more variance and uncertainty in state law, it seems likely that a BMSP would also be deemed to be a money transmitter in at least some states. A prudent merchant will determine if the BSMP is licensed in the jurisdiction in which the merchant operates, and if not, why not.
  3. What is the settlement risk in using a BMSP and how can it be mitigated? There will be a delay of several days or more between the time the BMSP accepts your customer’s bitcoin and the time you get paid. There is always a risk that the BMSP won’t settle on time or at all. Merchants should evaluate and understand this risk before engaging a BMSP. Settling more frequently will reduce the risk of nonpayment. In addition, a licensed money transmitter will be required to post a bond or pledge collateral to ensure its ability to make good on its obligations to its customers. Consequently, licensure reduces settlement risk.
  4. Are there sufficient disclosures explaining the transaction and the role of the BMSP? Is the consumer given sufficient information to understand the transaction and the fact that he or she is paying the BMSP and not the merchant? Does the consumer understand that by paying with bitcoin, he or she will not have the consumer protections associated with credit and debit card payments? Merchants should review the Consumer Financial Protection Bureau’s advisory to consumers using virtual currency and ensure that their disclosures appropriately address the agency’s concerns.
  5. How is the exchange rate determined and disclosed? How is the exchange rate being applied to the customer’s bitcoin transaction being calculated? How is it disclosed to the consumer? Is the rate fair and competitive? Especially in situations where the BMSP is not charging the merchant a fee, there may be concern that the exchange rate will be padded in order to generate additional revenue.
  6. How will the merchant handle refunds? Typically, merchants make customer refunds using the same payment method employed in the original transaction. While some BMSP offer the ability to make refunds in bitcoin, that process may not be convenient. If a refund is made in bitcoin, will you refund the dollar amount or the bitcoin amount of the original transaction? Are your policies in compliance with the Federal Trade Commission’s recently updated Mail, Internet, or Telephone Order Merchandise Rules requiring refunds be made either in the method used by the buyer or by cash, check, or money order? Is the refund policy as it applies to bitcoin transaction properly disclosed to the customer?
  7. What privacy protections govern the bitcoin transaction? What information about your customer are you providing to the BMSP? What are the BMSP’s practices regarding the collection and disclosure of personal information about your customer? Are the BMSP’s privacy practices adequately disclosed? Do the BMSP’s privacy policies mesh with your own? 

Conclusion

Given the increasing interest in bitcoin among the public, merchants understandably want to be able to accept it as a form of payment. Managing the legal and tax implications associated with virtual currencies is a new challenge which business lawyers must address. The use of a properly managed BMSP can simplify the operational issues and reduce the legal risks of accepting bitcoin.

Additional Resources

For other materials on this topic, please refer to the following. 

Selected Regulatory Guidance on Bitcoin

FinCEN Guidance on Virtual Currencies (March 18, 2013)

IRS Guidance on Virtual Currency (March 25, 2014)

CFPB Consumer Advisory on Virtual Currencies (August 2014)

FTC Mail, Internet, Telephone Order Merchandise Rule (September 11, 2014) 

Business Law Today

The Past and Future of Bitcoins in Worldwide Commerce
By Denis T. Rice
November 2013

BLS Programs Material Library

Bitcoin and Electronic Payment Platforms: Commercial Lending Opportunities and Obstacles (PDF) (Audio)
2014 BLS Annual Meeting

Stephen T. Middlebrook

Stephen T. Middlebrook is general counsel at FSV Payment Systems, Inc. He serves as co-chair of the Electronic Payments Subcommittee of the Cyberspace Law Committee, ABA Business Law Section. He is also the Section’s advisor to the Uniform Law Commission’s Study Committee on Alternative and Mobile Payments. The opinions expressed in this article are those of the author and do not necessarily reflect the views of his employer or any other entity.