IRS takes on cryptocurrencies

The Internal Revenue Service is going after more than 10,000 cryptocurrency holders who failed to report income and pay taxes, and not a single person should be surprised.

Skirting the law isn’t a bug in bitcoin, ethereum, litecoin or any of the other thousands of virtual currencies on the internet. It’s a feature.

Shady behavior and criminal activity have been part of the appeal and intrinsic value of cryptocurrencies since inception. As I reported back in 2013 following bitcoin’s value first surpassing $900 (it now sits above $10,000), researchers established a link between the first bitcoins mined and Ross William Ulbricht, the creator of the criminal black market website Silk Road. Mr. Ulbricht is now serving a life sentence for money laundering, computer hacking, conspiracy to traffic narcotics over the Internet and conspiracy to traffic fraudulent identity documents.

Bitcoin was the only currency allowed on Silk Road, where 70% of sales were drugs. Copycat black markets on the dark web — where people can buy weapons, stolen credit cards, child pornography and even assassinations — similarly conduct business in cryptocurrency.

And don’t forget ransomware attacks, where criminal hackers take control of a computer system and threaten to erase everything unless the victim pays a ransom in, you guessed it, bitcoin.

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Even previous attempts to legitimize cryptocurrencies as a viable investment vehicle have met setbacks. Charlie Shrem, a founding member of the Bitcoin Foundation, a nonprofit dedicated to improving the reputation of cryptocurrencies, was sentenced to two years in prison in 2014 for using bitcoin to send money to Silk Road.

Cryptocurrency’s meteoric rise in value and popularity among consumers has only helped to attract grifters looking to take advantage.

Even cryptocurrency enthusiasts like Tyrone Ross, formerly managing partner of NobleBridge Wealth Management, now a financial consultant in Woodbridge, N.J., urges investors to keep a critical mind.

“I don’t think you can go beyond five [cryptocurrencies] that are credible, but you’re even stretching at that point. Most of the conversations right now revolve around Ether or bitcoin,” Mr. Ross said. “I’ll be honest with you, as I’ve grown more bullish, I’ve grown more skeptical … I’ve seen what happens when the price rises.”

Yet advocates don’t believe the technology’s history of abetting crime should stop Wall Street from embracing cryptocurrency. As proponents like to point out, criminals using cash doesn’t harm the value of the U.S. dollar.

In fact, they see the IRS’s enforcement as just another step towards credibility. Even though old-school cryptocurrency users tend to have libertarian “taxation is theft” leanings, more of the crypto community realizes it has to play by the rules if wants to be sustainable.

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“I think it’s a good thing. I think it’s something that the institutional investors on the sidelines want to see,” before diving into crypto assets, Mr. Ross said. “If you’re in this space full time like I am, you do see a lot of things that make you think the market is maturing.”

Hunter Horsley, CEO of Bitwise, an asset management firm developing index funds of crypto assets, said that it is “factually inaccurate” that a primary value of cryptocurrency is that it’s for nefarious purposes. In fact, it’s inferior for criminal activity than cash, he said.

“While its origins were in some of the darkest parts of the Internet, that is no longer the case,” Mr. Horsley said. “I sort of view [the IRS action] as a positive step in the maturation of the industry, like we are experiencing in many other parts of crypto.”

Yet even he will admit the presence of bad actors in the crypto space. For Mr. Horsley and Mr. Ross, the presence of grifters looking to take advantage of cryptocurrencies’ buzz is just proof of why financial advisers need to understand the space.

Because despite its dark past, crypto is here to stay, Mr. Ross said. The fact the IRS is acting to ensure it gets a piece is only more proof.

Now it’s up to advisers to cross the T’s, dot the I’s, and make sure clients don’t break the rules.