Bitcoin: What a Divorce Attorney Needs to Know
Cryptography – the art and science of concealing messages; today, encryption is how programmers apply cryptography to add passwords to files, create secure logins, and verify identities.
Bit of History
The Cypherpunks group was formed by several members of an online cryptography group. This group had been working on things they needed to ensure online privacy and held a fundamental belief: that privacy was the fountainhead of all other rights. They needed four basic systems to ensure online privacy: strong, open source cryptography, anonymous email forwarding, and digital signatures. They built these three systems and their solutions are still used today. They also needed an electronic money system so they could transact and store value privately. Electronic money was a hard problem to solve; cryptographers had been trying to build solutions since the eighties. In 2008, a solution was posted to that same cryptography group that basically said, “Hey guys, you know that really hard problem you’ve been working on? Here’s the solution,” and bitcoin was born.
Bitcoin used code from all the other cryptography systems, hence “crypto-” and is a system that enables peer-to-peer exchange, hence “currency;” therefore, cryptocurrency. The Cypherpunk’s published manifesto states, “We cannot expect governments, corporations, or other large, faceless organizations to grant us privacy out of their beneficence…We must defend our privacy.” They ensure privacy with their use of encryption and they defend their right to encryption with the second amendment, not the fourth.
While there are many different people involved in cryptocurrency today, the ideological privacy concerns that drove cryptocurrency evolution still persist. People involved in cryptocurrency tend to value transparency, collaboration, and privacy - and they are getting divorced. The collaborative divorce process lends itself to supporting these values. Marketing the cryptocurrency values that are inherent in the collaborative process can generate awareness in the cryptocurrency community and develop a new market for your collaborative practice. The collaborative process is a divorce structure that preserves the fundamental values of cryptocurrency enthusiasts.
Digital Asset Holdings
Bitcoin is just one of many different cryptocurrencies in existence today. There are so many partly because bitcoin is open source, so anyone can copy the code, make some changes, and create a new cryptocurrency and partly because Ethereum, a different blockchain system, was released around 2014. Ethereum allows for automation, known as smart contracts, within its system, and made creating new cryptocurrencies, or tokens, even easier. XRP is another type of blockchain designed to connect banks and payment processors with its identity compliance requirements. Hyperledger is another blockchain system that was released by the Linux Foundation and has garnered support from IBM, Intel, and Cisco. Lisk (LSK) is yet another blockchain system designed for web developers. Blockchains do not necessarily require an associated cryptocurrency to function.
In addition to different blockchain systems, some systems, like Bitcoin, can be copied to create new cryptocurrencies and award that new cryptocurrency to current holders. These kinds of copies are called forks. On the date a fork happens, everyone who has holdings in the original cryptocurrency, suddenly also owns some amount in the new forked cryptocurrency. Some of these forks develop into valuable blockchains all on their own, while others never develop into something with a value at all.
If your clients owned any bitcoin prior to the fork dates, they may also own the same amount (or some ratio) of the fork. Forked cryptocurrencies are entirely separate assets, disconnected from the original cryptocurrency, that may have their own value. Bitcoin has been copied over twenty times, creating some forks that have their own value including Bitcoin Cash (BCH), Bitcore (BTX), Bitcoin Gold (BTG). Ethereum has also been copied, creating Ethereum Classic (ETC), EtherZero (ETZ), Ethereum Fog (ETF), and more.
As the attorney, you need to know that these assets exist and how to ask about them. Keeping your request broad enough to cover different types of cryptocurrency and specific enough so that you get the information you need is sufficient in a collaborative divorce case where the parties have agreed to full disclosure. Knowing some of the indicators that cryptocurrency is involved can help determine if one party has not fully complied with the full disclosure agreement.
How to Ask about Cryptocurrency
Users engage with cryptocurrency in many ways including through mining, through peer-to-peer transfers, through third-party exchanges, and through coin offerings (ICOs or SAFT offerings). Bitcoin’s blockchain, like most blockchains, is fairly straightforward – it shows addresses, amounts of bitcoin stored at that address, and any past transactions that address was involved in. The transactions are also linked so by knowing one address, an expert can trace transactions back to the beginning of bitcoin’s blockchain (January 2009) as well as any transactions that sent bitcoin out of that address.
Mining: Miners earn cryptocurrency for participation in a blockchain system (e.g. in bitcoin, miners receive fees in bitcoin). Fees are earned by miners for their participation and are not purchased with cash or another asset. A financial investigation will not show cash output in exchange for mined bitcoin. Indicators of mining may include computers that run loudly and frequently, specialty software installations, specialty equipment, extra cooling equipment, or excessive purchases from retailers who accept bitcoin.
If cryptocurrency is earned by mining, you should request all addresses that received mining fees or rewards; this will allow your financial expert to verify total digital asset receipts from mining.
Wallets: Wallets enable peer-to-peer transfers; they allow users to send and receive cryptocurrency. You should ask for all wallets, associated user names, and all associated addresses. Some wallet providers also maintain transaction history so you should also ask for all transaction history associated to any wallet.
Third-Party Exchange: Third-party exchanges, such as Coinbase or Kraken, allow users to send, receive, buy, and sell cryptocurrency but, they do not always provide users with all of the addresses used in their transactions. Because these organizations group transactions to conceal senders and recipients, users will have access to some addresses, but not all of them.
If third-party exchanges are involved (and they usually are), you should ask for the balances from each account as well as all transaction history reports for each account. These reports may be divided between transfers (send and receive) and sales (buy and sell); you want to ask for all of them. A party may have used an exchange that no longer exists; in that case, you want to ask for any statements or history of transactions they have, any user names used, any connected bank account information, and an email backup file of the email associated to an account (older exchanges issued confirmations of transactions by email); this detail will allow a financial expert to determine an amount appropriate for division.
For most cryptocurrency, providing the addresses involved in storage and transactions along with transaction histories from exchange accounts and wallets is sufficient to determine and verify digital asset holdings. Access to cryptocurrency stored at different addresses is controlled by private keys –these are similar to bank account login credentials. Do not ask for private keys; private keys provide direct access to cryptocurrency stored at any associated address.
Considerations During Transfers
If one party uses an exchange to transfer cryptocurrency, that exchange may automatically generate tax reports that show the receipt as income to the receiving party. Some digital assets are stored on hardware devices that must be accessed before a transfer can occur, this access can trigger a taxable event for the sender prior to the transfer. Under the fork guidance of the IRS, when a person illustrates dominion and control over forks, such as accessing them using a hardware device, they may be liable for taxes on all digital asset holdings. Consider specifically addressing the tax liability for these events in your agreement.
If the digital assets themselves are determined to be separate property, but have increased in value, that increase may be divisible but may not be easily separated from the digital asset without liquidation. Depending on the liquidation method, high fees may be incurred. Consider addressing who is responsible for these fees and whether your property division amounts are inclusive or exclusive of transfer fees.
A simple transfer of current assets to another wallet may not sufficiently divide total digital asset holdings. For instance, some wallets maintain the ability to claim forks while newer wallets will not have that same ability. If one party transfers only digital assets that have been claimed, they may be able to claim forks that have occurred in the past, during marriage, after separation. Consider addressing the state of claimed or unclaimed digital assets in your agreement.
Finally, knowledge and consent regarding cryptocurrency transactions may also complicate digital asset valuation. A transfer or liquidation without knowledge and consent from the other party may have resulted in a loss of future value to be considered in property division.
If digital asset holdings are substantial, consider consulting a tax expert or trust expert to assist in structuring transfers. Other solutions for division include charitable donation, providing for future tax liability in a trust, or transferring ownership for future access by the children in a trust.
Disclaimer
This overview is just that, a simplified overview to increase your comfort level with cryptocurrency. It does not substitute for professional legal, tax, or financial advice. There are caveats, exceptions, and pitfalls to cryptocurrency tracing, valuation, and transfer. Next to concealment, two of the biggest are tax implications and the values of forks. Simplistic value calculations such as Price at Date x Volume may not be appropriate for matrimonial litigation but may be sufficient for a settlement discussion. Make sure your expert has the financial forensic expertise or valuation expertise to determine appropriate asset values and convey the difference in valuation methods; these are the same qualifications and requirements as traditional financial experts, who you may already know how to vet.
Several certifications in cryptocurrency tracing have recently become available; however, you should be wary. These certifications are awarded by organizations that may not have experience tracing assets, providing testimony, or determining values; several also rely on specific software released by data aggregation vendors. While specialized crypto-certifications may convey some basic knowledge about cryptocurrency or tracing, traditional financial expertise remains critical in choosing an appropriate financial expert to assist in property division.
In collaborative engagements, where asset division can be more creative and full disclosure forms the basis of the engagement, a financial expert who can consider tax implications, past loss in value, future loss in value, and other traditional aspects of divorce calculations may be more important than an expert who can explain the inner workings of the world’s blockchains.